Incorporations and reorganizations involving qualified small business stock.

• Author: Bailine, Richard W.

Under Sec. 1202, noncorporate taxpayers who hold qualified small business stock (QSBS) for more than five years are permitted to exclude from gross income 50% of the gain (within specified limits) on the sale or exchange of that stock. Sec. 1202(h)(4), Incorporations and reorganizations involving nonqualified stock, sets the stage for some interesting methods of acquiring QSBS.

Example: Q is a corporation eligible to issue QSBS, and the stock held by Q's sole shareholder, individual A, is QSBS. NQ is a corporation not eligible to issue QSBS, and the stock held by NQ's sole shareholder, individual B, is not QSBS. C is an individual considering a purchase of Q stock from A.

The discussion will explore five scenarios: (1) Q merges into NQ for NQ stock issued to A; (2) A transfers Q stock to NQ in exchange for NQ stock under Sec. 351 or in a Sec. 368(a)(1)(B) reorganization; (3) NQ merges into Q for Q stock issued to B; (4) B transfers NQ stock to Q in exchange for Q stock under Sec. 351 or in a Sec. 368(a)(1)(B) reorganization; (5) C acquires an interest in Q.

Scenario 1: Q merges into NQ for NQ stock issued to A. Sec. 1202(h)(4)(A) provides that the NQ stock received by A in the merger will be treated as QSBS. Under Sec. 1202(h)(4)(B), however, on the eventual disposition of the NQ stock held by A, the amount of gain eligible for the Sec. 1202 exclusion cannot exceed the amount of built-in gain on the date of the merger. in other words, post-merger appreciation in the NQ stock will not give rise to additional exclusions under Sec. 1202.

This limitation would not apply if NQ were itself a corporation eligible to issue QSBS (Sec. 1202(h)(4)(b), second sentence). In that case, all of the gain realized by A would be subject to the 50% exclusion.

B, as a shareholder of NQ, a corporation not eligible to issue QSBS, would be unaffected by the merger. B would continue to hold stock that is not QSBS. Scenario 2: A transfers Q stock to NQ in exchange for NQ stock under Sec. 351 or in a Sec. 368(a)(1)(B) reorganization. All of the results set forth in Scenario 1 would also apply if A received NQ stock in a Sec. 351 transfer or in a B" reorganization. The NQ stock received by A, although not on its face QSBS, is nonetheless treated as QSBS to the extent of gain built in prior to the exchange transaction. Scenario 3: NQ merges into Q for Q stock issued to B. For the favorable "substitution" rule of Sec. 1202(h)(4)(A) to apply, there must be an exchange of...