Tax practitioner issues related to Sec. 1202 exclusion reporting

Editor: Carolyn Quill, CPA, J.D., LL.M.

Co-editors: Richard Mather, E.A., MSA, CAA; Jonathan McGuire, CPA; and Kathleen Moran, CPA, MBA, MT

Sec. 1202 was introduced into the Code in 1993, but until recent years, the tax benefits were relatively small. For more on the history of Sec. 1202 and the requirements for a stock sale to qualify for the exclusion, see Nitti, “Qualified Small Business Stock Gets More Attractive,” 49 The Tax Adviser 734 (November 2018).

Sec. 1202 has been modified through the years. For stock acquired after Sept. 27, 2010, and held more than five years, the exclusion amount was raised to 100%, but the provision was temporary. In 2015, when the 100% exclusion was made permanent, the incentives of the provision rose to a level that investors started taking it into consideration in planning. The planning increased again in 2018 when the corporate tax rate was reduced to 21%, making C corporation stock more attractive.

With the recent boom in initial public offerings and private-equity acquisitions, which often include early investors and early employees seeing multimillion-dollar gains on the sale of their stock, a new dilemma has been created for tax practitioners. How do you obtain the information needed to determine whether a client’s stock is eligible for the Sec. 1202 exclusion? Shareholders who are not founders of the company may not have access to all of the information needed to determine whether their stock sale qualifies for the Sec. 1202 exclusion, and they and their tax return preparers are finding that some companies are not willing to provide the necessary information.

Under Sec. 1202(d)(1)(C), corporations must agree to submit reports as required under the regulations, but to date, no such regulations have been issued. Some requirements of Sec. 1202 should be easily documented by the shareholder, such as the date of acquisition, original issuance for money or property, or whether the stock was received as compensation. Other requirements of Sec. 1202, such as whether the average gross assets of the corporation did not exceed $50 million on the date of issuance of the stock, may or may not be known to the early investors and employees.

However, often, information will not be available to employees or investors to prove that not only has the company been an eligible corporation engaged in a qualified trade or business under Sec. 1202(e)(3) during substantially all of the shareholder’s holding period but also that the requirement under Sec. 1202(e) (1) has been met, that at least 80% of the corporation’s gross assets have been used in the active conduct of one or more qualified trades or businesses and that no disqualifying redemptions occurred that would taint any of the shares of the investor or employee. So, what is a tax practitioner to do?

Whether the corporation cooperates or not, tax return preparers have faced the issue of determining whether a company is engaged in a qualified trade or business. Sec. 1202(e)(3) defines a qualified trade or business as a trade or business other than one that involves the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business of which the principal asset is the reputation or skill of one or more employees; any banking, insurance, financing, leasing, investing, or similar business; any farming business; any business involving the production or extraction of products of a character with respect to which a deduction is allowable under Sec. 613 or 613A; and any business of operating a hotel, motel, restaurant, or similar business.

Since there is little direct guidance from the IRS regarding Sec. 1202 definitions of terms such as services and consulting — which can have wide or narrow interpretations — tax return preparers often face uncertainty when determining whether a sale of stock qualifies for Sec. 1202 exclusion, even when they have cooperation from the corporation. For a deeper discussion of these issues, see Andersson, “Qualified Small Business Stock Exclusion: Who’s Eligible?,” 52 The Tax Adviser 684 (November 2021), and Wiener and Gottschalk, “What Does ‘Consulting’ Mean for Purposes of Sec. 1202?” 50 The Tax Adviser 237 (April 2020).

Since the Sec. 1202 exclusions often involve millions of dollars, a reporting error is likely to result in a substantial underpayment of income tax. Taxpayers are potentially subject to penalties under Sec. 6662 for any substantial understatement of tax, and tax return preparers are potentially subject to penalties under Sec. 6694 for the understatement of a tax liability due to an unreasonable position. Under Sec. 6664(c)(1), taxpayers will not be subject to such penalties if, considering all the facts and circumstances, it is determined that the understatement was due to reasonable cause and the taxpayer acted in good faith. Likewise, under Sec. 6694(a)(3), tax return preparers will not be subject to penalties if there is reasonable cause for the understatement and the tax return preparer acted in good faith. Regs. Sec. 1.6694-2(d) also allows for the preparer penalty to be waived if the position taken has a reasonable basis and is adequately disclosed. But does the lack of information fit into these penalty exceptions?

When the IRS is determining whether to impose Sec. 6694 penalties, one of the factors considered is if the tax return preparer relied on the advice of others. Under Regs. Sec. 1.6694-2(e)(5), a tax return preparer may rely without verification upon advice and information furnished by the taxpayer, another adviser, another tax return preparer, or another party. However, the preparer cannot rely on the information if one of the following applies:

• The advice or information is unreasonable on its face;
• The tax return preparer knew or should have known that the other party providing the advice or information was not aware of all relevant facts; or
• The tax return preparer knew or should have known (given the nature of the tax return preparer’s practice), at the time the return or claim for refund was prepared, that the advice or information was no longer reliable due to developments in the law since the time the advice was given.

Since the tax return preparer knows or should know whether the taxpayer has access to the information required to determine if the stock is eligible for the Sec. 1202 exclusion, the tax return preparer should not assume that he or she can avoid the penalty by relying on the client’s statement that the stock is eligible if the client does not have access to the financial records needed to determine that it qualifies.

Another factor for the IRS to consider under Regs. Sec. 1.6694-2(e)(1) in deciding not to impose a penalty due to the preparer’s reasonable cause and acting in good faith is whether the error resulted from a provision that was complex, uncommon, or highly technical, and a competent tax return preparer could have reasonably made the error. Since there is limited guidance related to Sec. 1202, a tax return preparer might be able to avoid the penalty by relying upon this provision if the information provided by the client is reasonable on its face to conclude that the stock is eligible for the Sec. 1202 exclusion.

Tax practitioners also need to consider whether disclosure of a Sec. 1202 exclusion through an adjustment code on Form 8949, Sales and Other Dispositions of Capital Assets, constitutes adequate disclosure, given the facts and circumstances, or whether Form 8275, Disclosure Statement, should also be filed. Since, as previously discussed, little guidance is available other than the statutory language for determining whether the stock meets the active business requirement — especially involving the definition of a qualified business — tax return preparers should consider filing Form 8275 to meet the requirements of Regs. Sec. 1.6694-2(d) for reasonable basis and adequate disclosure if they are uncertain whether the company meets the definition.

Congress enacted Sec. 1202 to promote investment in startup companies. Sec. 1202 anticipated the need for regulations for companies to provide information to confirm that stock is eligible for the Sec. 1202 exclusion. The lack of guidance and regulations and the unwillingness of some companies to provide information to shareholders places taxpayers and tax practitioners in a difficult situation. The tax practitioner could report the Sec. 1202 exclusion without all of the information necessary to prove that the stock is eligible for the exclusion and thereby open the taxpayer and the tax return preparer up to potential Secs. 6662 and 6694 penalties. Another option is for the tax practitioner to prepare the tax return without the Sec. 1202 exclusion, resulting in the taxpayer’s potentially paying more tax than is legally required. But this is not what Congress intended when it created Sec. 1202.

Editor Notes

Carolyn Quill, CPA, J.D., LL.M., is the lead tax principal at Thompson Greenspon in Fairfax, Va. Richard Mather, E.A., MSA, CAA, is a director at EFPR Group in Rochester, N.Y.; Jonathan McGuire, CPA, is senior tax manager at Aldrich Group in Salem, Ore.; and Kathleen Moran, CPA, MBA, MT, is a director at Pease Bell CPAs in Cleveland. Unless otherwise noted, contributors are members of or associated with CPAmerica Inc. For additional information about these items, contact Carolyn Quill at taxclinic@cpamerica.org.