Interaction between Sec. 1202 and other provisions.

• Author: Koppel, Michael D.
• Position: Gains from sale or exchange of small business stock; LLCs

Sec. 1202(a) allows taxpayers other than corporations to exclude up to 50% of any gain from the sale or exchange of small business stock held for more than five years. One requirement is that the small business stock must be C corporation stock. This rule raises a potentially difficult entity choice decision for start-up firms.

Since the passage of the current version of Sec. 1202 in 1993, all states have enacted limited liability company (LLC) statutes. Treasury, in an effort to provide certainty as to the tax treatment of LLCs, promulgated the check-the-box rules in Regs. Sec. 301.7701-3. These rules allow a multi-member LLC to either actively elect corporate status (using Form 8832, Entity Classification Election) or to maintain a default tax status as a partnership. Treasury chose the partnership form as the default status under the assumption that a majority of businesses would want the flexibility and flowthrough characteristics of the subchapter K rules. However, the default status precludes the benefit of Sec. 1202.

An LLC cannot merely check the box under Regs. Sec. 301.7701-3(g) and convert to a C corporation prior to a sale of the interest in the entity to obtain gain exclusion under Sec. 1202. Sec. 1202(i)(1)(A) states that, when a taxpayer acquires stock in exchange for property other than money or stock, the IRS treats the stock as acquired on the transfer date. The entity's owners cannot use the substituted holding period provisions of Sec. 1223 to meet the five-year holding period requirement. In addition, Sec. 1202(i)(1)(B) provides that, when a taxpayer transfers property to a corporation in exchange for stock, the stock's basis for Sec. 1202 purposes is no less than the fair market value of the property exchanged. This rule precludes taxpayers from transferring appreciated property to a C corporation (e.g., a successful start-up company's assets) or electing association status for an existing LLC, to exclude 50% of the appreciation that occurred outside of the qualified small business.

As a result of these rules limiting the benefits of Sec. 1202, owners of a startup LLC may want to immediately check the box if a later sale of the stock is seen as part of a business plan. Checking the box at an early point in an entity's life will both begin the five-year holding period clock and lock in any appreciation within the qualified small business. In addition, Sec. 1244 may provide relief on the ultimate disposition of the stock...