Section 1202 Qualified Small Business Stock Benefits Revisited

Jon Christianson

As we make it through 2020 and into 2021, one should consider revisiting the choice of entity in ascertaining which type of business entity is the best entity for a client’s particular needs. Historically, flow-through entities such as partnerships, limited liability companies and S corporations have prevailed over C corporations. Generally, this is a good choice for planning an exit from business ownership through an asset sale of the business.

However, if the client is willing to limit the exit to a stock sale, the use of the C corporation should be reconsidered. This article will highlight the tax benefits of a lower federal C corporation tax, currently of 21% under Code Section 11(b)[1], and join this benefit with the existing benefits of stock sales under Code Section 1202 and under Code Section 1045. This article applies to individuals, trusts, partnerships, or S corporations owning or considering owning C corporation stock.

Code Section 1202 provides that if a non-corporate taxpayer holds qualified small business stock for more than 5 years, gains from the sale or exchange of those shares are excluded from federal income tax within the statutory limits described below. This section has several requirements.

The shares must be qualified small business stock. Code Section 1202(c). Qualified small business stock is stock in a C corporation, issued after August 10, 1993, when the corporation is a “qualified small business,” and when the non-corporate taxpayer acquires the shares at original issue using cash, property or certain services.[2]

To be a qualified small business, the corporation issuing the stock must meet an active business requirement in a qualified trade or business during substantially all of the taxpayer’s holding period for the stock.[3] The corporation meets the active business requirement if at least 80% (by value) of the corporation’s assets are used to conduct one or more qualified trades or businesses, and the corporation is an eligible corporation.[4] A corporation engaged in start-up activities described in Code Section 195(c)(1)(A) is treated as actively conducting a qualified trade or business.[5] The corporation’s aggregate gross assets before the issuance of the shares and immediately after the issuance of the shares must not exceed $50,000,000 and the corporation must agree to submit reports to the Secretary of the Treasury as required.[6] Gross assets are computed based on the cash and aggregate adjusted basis of property held by the corporation.[7] For property contributed to the corporation, however, the basis for this purpose is treated as the fair market value as of the date of contribution.[8]

The non-corporate taxpayer must acquire the stock at its original issue for money or other property (not including stock), or as compensation for services provided to the corporation (other than services as an underwriter of the stock).[9] For shares issued after 2010, there is the added benefit of no alternative minimum tax on the sale of qualified shares.[10]

The corporation must also engage in a qualified trade or business. A qualified trade or business is any trade or business other than the performance of services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, banking and certain financial and investment businesses, farming (including the production and harvesting of trees), businesses involving production or extraction of products eligible for percentage depletion, 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, and any business of operating a hotel, motel, restaurant, or similar business[11]. An eligible corporation generally is any domestic corporation other than a cooperative, a real estate investment trust, a domestic international sales corporation (DISC) or former DISC, a regulated investment company, or a real estate mortgage investment conduit.[12]

If these corporate and investment requirements are met, the non-corporate taxpayer is eligible to exclude gain in the amount of the greater of $10,000,000 or ten times the basis in the qualified shares.[13] This amount is a lifetime limit so that prior exclusions with respect to the shares of the same corporation are aggregated.[14] Considering that the non-corporate taxpayer can exclude tax on the gain for federal purposes without any alternative minimum tax effect for those acquiring shares after 2010, it is worth waiting for 5 years to reap the reward.[15]

If the capital gain is greater than the exclusion limit in Code Section 1202, there is the ability to reinvest the gain under Code Section 1045 and continue to exclude the gain, provided that the shares sold were held for more than 6 months, and the investment occurs within a 60-day period beginning on the date of such sale.[16] Code Section 1045 requires the non-corporate taxpayer to invest the gain into shares of another qualified small business.[17] This provision allows for the continued investment before tax into start-up companies and small businesses. The basis of the replacement stock is reduced to the extent of the gain deferred.[18]

A non-corporate taxpayer may also use Code Section 1045 if the taxpayer otherwise qualifies under Code Section 1202 but for the holding of shares for 5 years. If the non-corporate taxpayer has held the shares for more than 6 months, the non-corporate taxpayer may defer the gain by reinvesting into another qualified small business under this provision. However, the holding period for purposes of Code Section 1202 restarts on the purchase of the replacement shares under Code Section 1045.[19]

The available opportunities presented above are unavailable to owners of S corporation shares, or for members of limited liability companies or partners in partnerships. Because of this distinction, the advisor should inquire about, and understand, the client’s future financial goals when raising the question about investing in or exiting from a business.

In addition to the reduced federal corporate tax rate, establishing a C corporation may have further allure if the client views continued investment in start-ups or new ventures as the way the client will realize financial goals. The C corporation’s income is taxed at 21% at the federal level, with no tax effect to the shareholders. This is unlike the S corporation, limited liability company taxed as a partnership, and partnership, where an owner of any of these entities must include the owner’s respective share of the entity’s net income into the owner’s federal and state income tax returns.

One caution to the advisor is that, if a transaction is structured as a stock sale otherwise eligible for capital gain exclusion, and the buyer of the stock wishes to elect to treat the stock sale as an asset sale under Code Section 336(e) or Code Section 338(h), the selling client should be advised to take into account the loss of the tax benefits discussed above. Before agreeing to the election, the selling client should require the buyer to compensate the client for the loss of the Code Section 1202 exclusion, or the Code Section 1045 rollover of gain.

If you would like further information regarding this aspect of the federal tax law in entity selection, please contact:

Jim Leet, jleet@boutinjones.com, or Jon Christianson, jchristianson@boutinjones.com, at Boutin Jones, Inc. 916-321-4444.

Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.

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[1] All references in this article to “Code” are to the Internal Revenue Code of 1986 as amended

[2] Code Section 1202(c)(1)

[3] Code Section 1202(c)(2)

[4] Code Section 1202(e)(1)

[5] Code Section 1202(e)(2)(A)

[6] Code Section 1202(d)(1)

[7] Code Section 1202(d)(2)(A)

[8] Code Section 1202(d)(2)(B)

[9] Code Section 1202(c)(1)

[10] Code Section 1202(a)(4)(C)

[11] Code Section 1202(e)(3)