One of the lesser-known yet very beneficial provisions of the Internal Revenue Code (the Code) relating to business investment is Section 1202.¹ Originally passed in 1993 and amended several times over the years, Section 1202 currently allows for an exclusion of 100% of gain recognized by a shareholder from the sale of qualified small business (QSB) stock (QSBS), subject to limitations and if certain conditions are met.

One important requirement is that the issuing company must be a domestic C corporation. After the 2017 Tax Act, which substantially cut the U.S. federal corporate tax rate to 21% (from 35%), using a C corporation for a new business has become far more popular. In sum, the current tax climate can making an investment in a C corporation very tax efficient if the investment is in QSBS.

We discuss some issues to consider regarding the qualification.

Original Issuance Requirement

For a holder’s stock to qualify as QSBS, the holder generally must acquire the stock directly from the QSB in exchange for cash, property, or services rendered.² While purchasing shares through an underwriter does not disqualify them,³ they cannot be purchased from another shareholder.

A redemption can disqualify an issuance. A redemption is disqualifying if it occurs either: (a) within a 4-year period beginning two years before the stock issuance and stock of certain parties related to the purchasing shareholder is redeemed; or (b) within a 2-year period beginning one year before the stock issuance and more than 5% of the aggregate value of all outstanding stock is redeemed.⁴

If a large shareholder wishes to sell his or her stock and he or she or she knows that new investors may seek QSBS status, the shareholder should sell his or her stock to a purchaser and not the company. However, such purchaser cannot use the QSBS exemption, as it requires an original stock issuance.

Potential investors who wish to ensure they will be able to take advantage of the QSBS exclusion when they sell their stock should seek representations and covenants from the issuer that it has not made, and will not make, any redemptions that would disqualify the stock from QSBS treatment in the future.

Per-Issuer Limitation on Gain Excluded

Section 1202 only allows for an exclusion of gain from the sale of QSBS of up to the greater of $10 million or ten times the taxpayer’s adjusted basis in the stock.⁵ For example, if stock was purchased for $500,000 and sold for $10 million, all $9.5 million of gain would be excluded from taxable income in the year of disposition. If, however, the same stock was sold for $11 million, only $10 million of the $10.5 million of total gain would be excluded, and the remaining $500,000 of gain would be taxed at regular capital gain rates.

Qualified Small Business Defined

The Code requires that the issuing corporation be incorporated domestically, for it to be actively engaged in a qualified trade or business (discussed below), and that the aggregate gross assets of the company cannot exceed $50 million following the issuance.⁶

Qualified Trade or Business. The Code lists several fields of business which are disqualified from QSBS treatment. They include: (i) trades or businesses involving the performance of services in the fields of: (a) health, (b) law, (c) engineering, (d) architecture, (e) accounting, (f) actuarial science, (g) performing arts, (h) consulting, (i) athletics, (j) financial services, (k) brokerage services, or (l) any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees; (ii) banking, insurance, financing, leasing, or investing businesses; (iii) farming businesses, including raising or harvesting trees; (iv) businesses involving the production or extraction of products for which depletion deductions are allowable; and (v) businesses operating hotels, motels, or restaurants.⁷

The disqualification of businesses involved in the production or extraction of certain products can be a trap for the unwary energy business, which must be careful that its activities do not disqualify it from QSBS status. This disqualification is explicitly applicable only to activities which are eligible for depletion deductions under sections 613 and 613A of the Code.⁸ Section 613 lists several types of minerals, wells, and other natural deposits which allow the owner, lessee, or a combination of both to take deductions based on a statutorily set percentages of the gross income from the property.⁹ Section 613A provides for special rules for oil and gas production, which are not calculated for deduction under the percentages provided in section 613(b).¹⁰

The depletion deduction rules under sections 613 and 613A are highly technical and complex, and a prudent taxpayer would consult with their tax advisors to determine if they are eligible for the deduction, and thereby disqualified from QSBS treatment.

Moreover, the IRS will likely scrutinize any claim that a service business is a QSB. Thus, any such business should carefully consider whether it is qualified.

Active Trade or Business. Once a corporation determines that its activities are of the right type to qualify for QSBS treatment, it must also confirm that it is actively engaged in those activities.¹¹ This ensures that a holding company which has many different portfolio investments cannot qualify for QSBS status. Active participation is defined at least 80% of the value of the assets of the corporation are used in one or more qualifying trades or businesses. For purposes of the active business requirement, the statute allows the issuing corporation to look-through to a corporate subsidiary to meet this active trade or business requirement, as long as the parent owns at least 50% of the subsidiary.¹²

Gross Assets Limitation. The final requirement is that the corporation’s aggregate gross assets cannot exceed $50 million following the issuance of the intended QSBS.¹³ This cap includes any amounts received in the actual issuance transaction, and also must calculate the gross assets of any “predecessor corporations,” such as if the corporation was created as result of a reorganization or other restructuring.¹⁴

In general, aggregate gross assets means the sum of the cash on the company’s balance sheet plus the adjusted tax basis of all assets.¹⁵ While tax basis of an established company’s assets can be quite low, there is a large exception for assets actually or deemed contributed to a corporation on a tax-free basis. In such cases, the company must use the fair market value of such assets as of the date of contribution.

In this regard, an LLC incorporation creates a trap for the unwary. An LLC incorporation is treated as a deemed contribution of assets to a new formed corporation. Thus, when a LLC incorporates, the newly incorporated company must use the fair market value of its assets plus cash on the balance sheet to determine if the $50 million threshold has been met.

Burden of Proving QSBS Status

Like in all situations where a statutory exclusion from income is in question, the burden of proof is on the taxpayer in the case of any controversy or contention by the IRS that certain deductions or exclusions from income were improperly taken. Therefore, in the QSBS context as well, it is up to the taxpayer to be able to establish that the stock it holds is QSBS and therefore the income exclusion was proper. Typically, a sophisticated taxpayer will require a company claiming to issue QSBS to give covenants regarding how the company conducted its business in the past and how it will conduct future.

FOOTNOTES

¹ All Section references are to the Internal Revenue Code or Treasury Regulations promulgated thereunder.

² Section 1202(c)(1)(B)(i)-(ii). An exchange for property or services raises additional issues to be considered.

³ Section 1202(c)(1)(B).

⁴ Section 1202(c)(3)(A)-(B). The regulations provide a de minimis exception to both redemption rules. Section 1.1202-2(a)(2), (b)(2)

⁵ Section 1202(b)(1)(A)-(B)

⁶ Section 12020(d)(1)(A)-(C)

⁷ Section 1202(e)(3)

⁸ Section 1202(e)(3)(D)

⁹ Section 613(b)(1)-(7)

¹⁰ Section 613A(a)

¹¹ Section 1202(e)(1)

¹² Section 1202(e)(5)

¹³ Section 1202(d)(1)

¹⁴ Section 1202(d)(1)(A)-(B)

¹⁵ Section 1202(d)(a)(A)