Section 1202’s Qualified Small Business Stock: The Oft-Forgotten Exclusion

8.25.17

By: Paul J. Valentine, Attorney, Jennings, Strouss & Salmon, P.L.C.

Since the advent of the limited liability company, the C corporation has often been the ugly stepchild in choice of entity analysis. Yet, the Internal Revenue Code contains a little known provision that may make the C corporation more attractive. New ventures should consider § 1202’s Qualified Small Business Stock (“QSBS”) provisions before determining which tax regime best suits their needs. Otherwise, upon sale, founders and investors may miss out on significant tax savings.

Potential Tax Benefits of QSBS

As long as an eligible shareholder has held QSBS for five or more years, then all or a portion of the shareholder’s gain upon sale can be excluded from federal tax. The maximum exclusion is the greater of $10 million or ten times the shareholder’s “adjusted basis” (the “QSBS Exclusion”). Any portion that is not excluded is generally taxed at twenty-eight percent (28%).

The amount of the exclusion depends on when the shareholder acquired the QSBS, and is as follows:

Date Stocks Received

Exclusion Rate

Before February 18, 2009

Fifty Percent (50%)

February 18, 2009 to September 27, 2010

Seventy-Five Percent (75%)[1]

September 28, 2010 to Present

One Hundred Percent (100%)

 

Thus, QSBS acquired on or after September 28, 2010, enjoys the benefit of the one hundred percent exclusion rate up to the applicable cap. Additionally, this exclusion is per shareholder, not per company. That means that each of the eligible shareholders may benefit from the QSBS Exclusion.

It is important for shareholders that hope to benefit from this generous tax provision to document the acquisition and operation of a Qualified Small Business (QSB) to properly substantiate the exclusion. State and federal taxing authorities can place roadblocks to claims for the QSBS benefit; therefore, it is worth discussing with qualified tax counsel during the set-up and operation of a QSB to ensure that the business qualifies, and continues to qualify, for this tax benefit.

Requirements for QSBS

Generally, the stock of a C corporation is treated as QSBS if it satisfies all of the following conditions:

1.    The Stock Must be Originally Issued after August 10, 1993

The first requirement is self-explanatory. The enactment of § 1202 by the Revenue Act of 1993 means that to qualify for the exclusion the QSBS must be issued after August 10, 1993.

2.    The Company Must Have Been a C Corporation for the Applicable Time Period

Section 1202 imposes a C corporation requirement in three different subsections. First, it defines a QSBS as stock in a C Corporation[2]. Second, the definition of a QSB is restricted to a domestic C Corporation[3]. Third, the active business requirements specify that a corporation must have been a C corporation during substantially all of the taxpayer’s holding period of the stock for which the taxpayer is claiming preferential treatment. In short, to qualify, the company must be a C corporation for the relevant time periods.

3.    The Shareholder Must Meet the Original Issuance Requirement

QSBS satisfies the original issuance requirement if the taxpayer disposing of it acquired the stock at its original issuance for money, property, or services provided to the issuing corporation[4]. Additionally, shareholders that acquire stock via certain typically tax-free transactions, such as gifts or bequests, are treated as having acquired the stock in the same manner as the transferor[5].

4.    The Company Must be a QSB

As discussed above, only a domestic C corporation is eligible to be a QSB[6]. Such a corporation may pass muster as a QSB only if it meets a pair of gross asset tests:

  • the aggregate gross assets of the corporation (or any of its predecessors) must not have exceeded $50 million at any time on or after August 10, 1993 and before the issuance of the stock for which the preferential treatment is being sought, and
  • immediately after the issuance, the aggregate gross assets of the corporation – including the amounts received at issuance – must continue to be no more than $50 million[7].

It is important to remember that the aggregate gross asset tests apply only through the issuance of the QSB stock. Future growth of the corporation does not deprive stock of QSB status. The purpose of the provision is to encourage entrepreneurs to risk their capital on new businesses.

The QSB statute also requires that the corporation and shareholders agree to submit reports to the Internal Revenue Service (“IRS”), as may be required by the Treasury to carry out the purpose of the exclusion[8]. To date, the IRS has yet to announce any reporting requirements applicable to QSBs or QSB shareholders.

5.    The Company Must Meet the Active Business Requirement

For purposes of claiming the partial gain exclusion under § 1202, a corporation’s stock is not treated as QSBS unless the corporation meets the active business requirement during substantially all of the taxpayer’s holding period for the stock for which it is claiming preferential treatment[9]. Additionally, the corporation must be an eligible corporation[10]. A corporation meets the active trade or business requirement for any period if, during that period, the corporation uses at least eighty percent (80%) of its assets, measured by value, in the active conduct of one or more qualified trades or businesses, and the corporation is an eligible corporation.

  • The Company Must Engage in a Qualified Trade or Business

In general, the term qualified trade or business is defined by negation. It is any trade or business other than:

  • Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial services, brokerage services, or 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;
  • Any banking, insurance, financing, leasing, investing, or similar business;
  • Any farming business (including the business of raising or harvesting trees);
  • Any business involving the production or extraction of products of a character with respect to which a depletion deduction is allowable under § 613 or § 613A; and
  • Any business of operating a hotel, motel, restaurant, or similar business[11].
  • The Company Must Satisfy the Eighty Percent by Value Test

The qualified business test requires that a corporation use at least eighty percent (80%) of its assets measured by value for one or more such qualified trades or businesses[12]. Section 1202(e)(6) provides an exception to the eighty percent requirement, explaining that for purposes of the statute, an asset that is held as part of the reasonably required working capital needs of a qualified trade or business shall be treated as used in the active conduct of a qualified trade or business.

Additionally, excessive holdings of portfolio securities or of real estate will disqualify a corporation from meeting the active business requirement. In both cases, the threshold leading to disqualification is ten percent (10%) of the corporation's assets measured by value. If more than ten percent of the value of a corporation’s assets (in excess of liabilities) consists of portfolio stock or securities, the corporation cannot meet the active business requirement. All stock and securities held by a corporation are treated as portfolio stocks and securities, except for those that are either (a) held as working capital or (b) issued by a subsidiary of the corporation holding the stock or securities[13]. Finally, a corporation cannot meet the active business requirement if more than ten percent of the total value of its assets consists of real property that the corporation does not use in the active conduct of a qualified trade or business. For purposes of determining whether real property is used in the active conduct of a trade or business, the ownership of, dealing in, or renting of real property is not treated as the active conduct of a qualified trade or business[14].

  • The Company Must be an Eligible Corporation

A corporation can satisfy the active business requirement only if the business is conducted by an eligible corporation. The term “eligible corporation” means any domestic corporation other than (a) a domestic import sales company (“DISC”) or former DISC; (b) a corporation for which a § 936 election (a possessions corporation) is in effect for itself or for one or more of its direct or indirect subsidiaries; (c) a regulated investment company, real estate investment trust, or a real estate mortgage investment conduit; or (d) a cooperative.

6.    The Shareholder Must be an Eligible Shareholder

The QSBS exclusion applies to any taxpayer other than a corporation. That means that individuals, trusts, and other pass through entities are eligible to receive the benefit of this exclusion. With regards to pass through entities, each owner (member or partner) is deemed to proportionally own the QSBS held by the pass through entity provided that he or she acquired interest in the pass through entity prior to the date the QSBS was acquired by the pass through, and he or she continues that ownership through the date the pass through disposed of the QSBS.

Conclusion

For applicable ventures, QSBS is an attractive proposition. A ten million dollar (or more) exclusion is hard to beat, even with the most sophisticated tax planning. Companies that are likely to raise capital may wish to consider forming a QSB from the outset, as many sophisticated investors are now demanding QSBS in exchange for their investment. Although a C corporation is generally not perceived as the most tax efficient vehicle, there are techniques to reduce the burden of double taxation. Further, most startups are reinvesting their revenues to generate the desired growth, and a C corporation eliminates tax on phantom income for the company’s founders and investors. In other words, sometimes the ugly stepchild deserves a second look. 

About the Author, Paul J. Valentine  

Mr. Valentine is a Member of Jennings Strouss & Salmon’s tax department. His practice emphasizes structuring corporate, partnership, and real estate transactions, counseling medium and small businesses and tax-exempt organizations in tax matters, litigating tax cases in federal courts, and handling administrative controversies before the IRS |  www.jsslaw.com

About Jennings, Strouss & Salmon, P.L.C.

Jennings, Strouss & Salmon, P.L.C., has been providing legal counsel for 75 years through its offices in Phoenix and Peoria, Arizona; and Washington, D.C. The firm's primary areas of practice include advertising and media law; agribusiness; automobile dealership law; bankruptcy, reorganization and creditors’ rights; construction; corporate and securities; employee benefits and pensions; energy; family law and domestic relations; health care; intellectual property; labor and employment; legal ethics; litigation; professional liability defense; real estate; surety and fidelity; tax; and trust and estates. For additional information please visit www.jsslaw.com and follow us on LinkedIn, Facebook, and Twitter.

 

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Please note that this client alert has been prepared by Jennings, Strouss & Salmon, P.L.C. for informational purposes only. These materials do not constitute, and should not be considered, legal advice, and you are urged to consult with an attorney on your own specific legal matters. Transmission of the information contained in this client alert is not intended to create, and receipt by the reader does not constitute, an attorney-client relationship with Jennings, Strouss & Salmon or any of its individual attorneys.


[1] Shareholders in the seventy-five and fifty percent exclusion period may be subject to an alternative minimum tax (AMT) add-back that is outside the scope of this article. The one hundred percent exclusion rate is not subject to AMT.

[2] § 1202(c)(1)

[3] § 1202(d)(1)

[4] § 1202(c)(1)(B)

[5] § 1202(h)(1)(A)

[6] § 1202(d)(1)

[7] §§ 1202(d)(1)(A)-(B)

[8] § 1202(d)(1)(C)

[9] § 1202(c)(2)(A)

[10] Id.

[11] § 1202(e)(3)

[12] § 1202(e)(1)

[13] § 1202(e)(5)(B)

[14] § 1202(e)(7)