Internal Revenue Code [section]1202 and You: Analyzing Exclusion of Gain on Sales of Small Business Stock.

• Date: 01 May 2023
• Author: Hogan, Steven M.

Section 1202 of the Internal Revenue Code provides a way for taxpayers to exclude much, if not all, of the gain on the sale of stock in certain small businesses. With the deal volume of recent years, this issue has often arisen with owners of small businesses interested in whether they would qualify for the gain exclusion under I.R.C. [section]1202 when considering the terms of potential sales.

While the rigorous requirements of I.R.C. [section]1202 disqualify many taxpayers, with some foresight and planning businesses in the early or startup phases of their existence can plan for an eventual sale that fits within the I.R.C. [section]1202 framework. Given the tax savings available under I.R.C. [section]1202, planning to meet the statute's requirements may be a way to increase a business' value to its owners in the event of a qualifying sale.

In the more common case, a tax professional will be tasked with examining whether a particular taxpayer's stock ownership will qualify for gain exclusion under I.R.C. [section]1202 after the company has been up and running for years. This article provides a framework for this analysis given the requirements of I.R.C. [section]1202, and highlights issues tax professionals may come across in their examination of a potential sale.

Specifically, this article addresses the application of I.R.C. [section]1202 to businesses that engage in some form of "consulting' as a part of their operations. Because many businesses engage in some form of consulting, and "consulting' businesses are prohibited from enjoying the gain exclusion of I.R.C. [section]1202, the question of whether a business is truly engaged in disqualifying amounts of "consulting' will require close analysis by the tax professional.

I.R.C. [section]1202, In General

I.R.C. [section]1202 offers a way for qualifying taxpayers to exclude from their taxable income some or all of the gain realized from the sale or exchange of qualified small business stock (QSB stock), as long as the taxpayer has held the QSB stock for at least five years. I.R.C. [section]1202(c). Depending on the details, the exclusion amount can range from 50% to 100% of the gain. (1)

The general requirements for exclusion of gain under I.R.C. [section]1202 involve the following elements: 1) The taxpayer must have owned the stock for over five years prior to selling it (2); 2) The stock must be "qualified small business stock' as that term is defined in I.R.C. [section]1202 (3); 3) The corporation in which the stock is issued must be a "qualified small business" as that term is defined in I.R.C. [section]1202 (4); 4) During the taxpayer's entire holding period, the corporation must meet the "active business' requirements of I.R.C. [section]1202, including the requirement that the corporation be involved in a "qualified trade or business." (5)

The tax practitioner examining a transaction for potential gain exclusion under I.R.C. [section]1202 must review each of these elements in detail to determine whether the statute will apply. A framework for that analysis follows below.

The Five-year Holding Period

The taxpayer must hold the QSB stock for five years prior to the sale to meet the requirements of I.R.C. [section]1202. While this is a straightforward requirement, I.R.C. [section]1202 accounts for the fact that taxpayers will often sell their stock before the five-year holding period has elapsed. Specifically, the statute provides that the period during which a taxpayer holds QSB stock can, in some instances, be "tacked on' to the periods that the taxpayer holds other stock following certain transactions.

For example, consider a taxpayer who originally acquires stock in a corporation (Corp 1) that is a "qualified small business' and holds it for less than a year. The stock owner later acquires stock in a second corporation (Corp 2) in exchange for the Corp 1 stock in a reorganization described in I.R.C. [section]368. (6)

When the stock received in a reorganization is issued by a qualified small business, then the stock so received continues to be treated as qualified small business stock acquired on the date the exchanged stock was acquired. In such a case, the stock owner would not be limited to applying I.R.C. [section]1202 to any gain at the time of the transaction, but instead, could continue to hold the stock and potentially apply I.R.C. [section]1202 to a later disposition of that stock. (7)

Practically speaking, this means that if Corp 2 was a qualified small business at the time of the transaction, then the client "tacks on' the original holding period and can continue to hold the Corp 2 stock for potential non-recognition once the required five years have elapsed.

Private Letter Ruling (PLR) 9810010 (1998) explained this treatment as follows:

Based solely on the taxpayer's representations that a portion of the Distributing stock owned by A through N was classified as qualified small business stock under [section] 1202 (Distributing QSBS), a proportionate amount of Controlled stock received by each of A through N in exchange for such individual's Distributing QSBS will be treated as qualified small business stock ([section] 1202(h)(4)(A)). The holding period for the Controlled stock treated as qualified small business stock under [section]1202(h)(4) (A) includes the holding period for which each of A through N held the Distributing QSBS. (8) In this manner, subsequent exchanges of QSB stock can be "tacked" together for purposes of determining (and reaching) the five-year holding period. (9)

Qualified Small Business Stock

If a taxpayer meets the five-year holding period requirement, the next item for analysis is whether the stock at hand is QSB Stock. Under I.R.C. [section]1202, only sales of QSB stock will qualify for partial exclusion of the gain that would otherwise be included in gross income for tax purposes. There are a number of requirements set forth in I.R.C. [section]1202 that determine whether such stock is QSB stock to which the gain exclusion will apply. These requirements are as follows:

1) The...