The following article by James N. Phillips appeared in the February 13, 2019 issue of the Business Law Section Blog of the State Bar of Wisconsin and is being reposted from that site with the permission of the author and the State Bar of Wisconsin.
Jim Phillips, Iowa 1979, is a shareholder in the Milwaukee office of Godfrey & Kahn, S.C., where he practices tax and corporate law.
Section 1202 of the amended Internal Revenue Code of 1986 allows exclude up to 100 percent of the gain on sale of stock held more than five years, if such stock meets the definition of “qualified small business stock.” Jim Phillips discusses some of the requirements and traps of Section 1202.
An owner of C corporation stock may be able to exclude up to 100 percent of the gain on sale of stock held more than five years, if such stock meets the definition of “qualified small business stock” (QSBS) under Section 1202 of the Internal Revenue Code of 1986, as amended.
The gain might also be excludable from Wisconsin tax if the corporation is a qualified Wisconsin business and the requirements of Wis. Stat. section 71.05(25)(b) are met.
Given the significantly lower federal income tax rate on C corporation income (21 percent) compared to the federal income tax rate on flow-through income of S corporations and LLCs (37 percent or 29.6 percent, depending on whether the 20 percent deduction of Section 199A applies), the availability of the Section 1202 exclusion can, in some cases, tip the scales toward C corporation status when evaluating the proper choice of entity.
Here is a summary of the requirements and traps of Section 1202.
Section 1202 Offers Partial or Total Exemption from Tax for Certain Capital Gains
Section 1202 exempts from tax a specified percentage of a taxpayer’s gains from the sale of QSBS provided the taxpayer held the QSBS for more than five years (among other requirements discussed below).
The applicable exemption percentage for stock acquired on or after Sept. 27, 2010, is 100 percent. For stock acquired earlier, the exemption may be 50 percent or 75 percent, depending on the taxpayer’s stock acquisition date.
Congress has repeatedly changed the amount of the Section 1202 exemption with varying effective dates. For stock for which the 100 percent exclusion applies, the excluded gain is not a preference under the alternative minimum tax (AMT).
For other exclusion percentages, a portion of the excluded amount is an AMT preference.
The table below summarizes the interaction of Section 1202, AMT, and other code provisions.
|Date of Stock Acquisition||§ 1202 Tax Exemption Percentage||§ 1202 Capital Gain Rate||Effective Capital Gains Rate||Effective Net Investment Income Tax Rate||Effective AMT Tax Rate||AMT rate savings vs. 23.8% regular capital gain rate|
|On or after Aug. 11, 1993, but before Feb. 17, 2009||50%||28%||14%||1.9%||14.98%||6.92%|
|On or after Feb. 17, 2009, but before Sept. 27, 2010||75%||28%||7%||0.95%||8.47%||14.38%|
|On or after Sept. 27, 2010||100%||28%||0%||0%||0%||23.8%|
For example, assume that individual X acquired $1 million of Y corporation stock in 2019, and Y stock is a capital asset in X’s hands. If the Y stock is not QSBS and X sells it in 2026 for $6 million, then X realizes a gain of $5 million. In that case, X could potentially owe federal income taxes of $1.19 million ($5 million gain x 23.8 percent capital gains rate).
However, if the Y stock were QSBS in X’s hands, then X’s entire Section 1202 gain on the sale would be excluded and X would owe no federal income taxes attributable to the sale. Thus, X would have tax savings of $1.19 million. This would be in addition to the lower C corporate income tax rate over the 6-year period. However, choice of entity is usually not just a current or future tax rate issue. A number of factors need to be considered: expected dividend distributions, the flexibility of structuring a potential future sale as an asset sale, estate planning considerations, etc.
Requirements for the Section 1202 Exemption
For stock in a corporation to qualify for the exemption in Section 1202(a), the following requirements must be satisfied:
- Five year holding period – the taxpayer must have held the stock for at least five years.
- Shareholder other than a corporation – the taxpayer claiming the Section 1202 exclusion must not be a corporation.
- Acquisition at original issuance for cash or services – the taxpayer must have acquired the stock at its original issuance either (i) in exchange for money or other property (not including stock) or (ii) as compensation for services provided to the corporation. However, this requirement is waived in certain cases. For instance, if QSBS is transferred by gift or at death, the donee or heir, respectively, steps into the donor or decedent’s shoes for purposes of the Section1202 original issuance requirement and five year holding period.
- Domestic C Corporation – the stock must be a corporation created or organized in the U.S. or any State that is taxed under subchapter C of the Code.
- Gross Asset Test – The aggregate gross assets of the corporation prior to and immediately after the taxpayer acquires the stock must not exceed $50 million. For this purpose, aggregate gross assets includes the amount of cash and the combined adjusted bases of other property held by the corporation. However, the adjusted basis of any property contributed to the corporation is determined as if the basis of such contributed property were equal to its fair market value at the time of contribution.
- Qualified Active Business – The corporation must have conducted a “qualified trade or business,” which is defined in the negative to exclude the following types of businesses:
- any business involving performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of its employee(s),
- 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 deduction is allowable under section 613 or 613A, and
- any business of operating a hotel, motel, restaurant, or similar business.
Additionally, the corporation must be an “eligible corporation,” which primarily excludes a regulated investment company, REIT, REMIC or cooperative.
- 80 percent of assets by value used in a qualified active business – At least 80 percent of the corporation’s assets must have been used in the active conduct of one or more qualified trades or businesses during “substantially all” of the taxpayer’s holding period for the shares.
Common Situations that Prevent Stockholders from Taking Advantage of the Section 1202 Exclusion
Stock redemptions may cause all stock not to be QSBS
Given that the Section 1202 exclusion is designed to incentivize new business investment, the code has two provisions designed to prevent the exclusion from applying when newly issued stock is simply a replacement of a prior investment.
Stock is not QSBS if at any time during the four-year period beginning two years before the stock was issued, the issuing corporation purchases more than a de minimis amount of its stock from the taxpayer or a person related to the taxpayer. Redeemed stock exceeds a “de minimis amount” only if (i) the amount paid for it is more than $10,000 and (ii) more than 2 percent of the stock held by the taxpayer and related persons is acquired.
Under the second provision, stock is not QSBS, if during the two-year period beginning one year before the stock was issued, the corporation repurchased stock in one or more transactions (i) each of which involves a repurchase of more than $10,000 of stock where more than 2 percent of all outstanding stock by value is repurchased and (ii) the sum of all repurchases during the two-year period have a value, at the time of redemption, in excess of 5 percent of the aggregate value of all the corporation’s stock at the beginning of the two-year period.
Large rounds of venture capital financing may cause the corporation to fail the qualified active business test or the gross asset test
The qualified active business test requires that during “substantially all of the taxpayer’s holding period” at least 80 percent (by value) of the corporation’s assets must be used in active conduct of a one or more qualified trades or businesses. Subject to certain allowances for working capital and financing research and experimentation, this means that if more than 20 percent of a corporation’s assets become cash or other non-qualified assets immediately after a venture capital round of financing or at any other time, such corporation may fail this “substantially all” test.
Additionally, in order for stock to qualify as QSBS, the aggregate gross assets of the corporation cannot exceed $50 million at either (i) any time prior to the taxpayer’s stock acquisition date and (ii) immediately after the taxpayer’s stock acquisition date.
Contributions of appreciated property in exchange for stock are subject to further limits
For purposes of the requirement that a qualified small business have aggregate gross assets of $50 million or less, aggregate asset value is generally measured as cash plus the adjusted basis of the other assets. However, the basis of any property contributed to the corporation is deemed to be equal to its fair market value (FMV) for purposes of this gross asset test.
The contribution rule also affects a shareholder’s basis in his QSBS and the calculation of gain on later sale. When a shareholder has contributed property to a qualified small business, the shareholder’s basis in her QSBS is also deemed to be the FMV of the contributed property at the time of contribution, even though for all other tax purposes, the shareholder has carryover basis in her stock equal to her adjusted basis in the contributed property. Only future appreciation is eligible for the Section 1202 exclusion.
Stock must be acquired at original issuance to qualify for Section 1202
Generally, a shareholder must acquire stock at original issuance in exchange for cash or other property or as compensation for the stock to qualify as QSBS. A purchase from an existing shareholder will not qualify for the exclusion.
This strict rule is relaxed a bit, however, in the realm of corporate reorganizations. When a shareholder exchanges QSBS for other stock in a tax-free reorganization, such as a merger or stock for stock acquisition, the new stock received by such shareholder can qualify as QSBS with the holding period tacking. However, the exception only applies to the built-in gain in the stock at the time of the tax-free reorganization. Future gains in the stock received do not qualify for the Section 1202 exclusion, unless the new corporation is also a qualified small business.