Qualified small business stock gets more attractive.

• Author: Nitti, Tony

As part of the law known as the Tax Cuts and Jobs Act (TCJA), (1) Congress reduced the corporate tax rate from a high of 35% to a flat 21%. This change has led many to speculate that C corporations, long the entity choice of last resort courtesy of the double taxation that is the hallmark of Subchapter C, (2) are poised for a resurgence.

Should this come to fruition, taxpayers and their advisers will need to familiarize themselves with a tax incentive that has lain largely dormant since its enactment over two decades ago, but that, courtesy of recent changes, offers an unparalleled benefit to those who choose to do business as a C corporation: Sec. 1202.

Sec. 1202, in general

Sec. 1202(a) provides that a noncorporate shareholder can exclude 50% of the gain from the sale of qualified small business (QSB) stock that has been held for five years. (3) QSB stock must be stock in a C corporation; thus, Sec. 1202 is generally not available to exclude gain on the sale of S corporation stock or a partnership interest.

The 50% exclusion percentage was increased to 75% for stock acquired from Feb. 18,2009, to Sept. 27,2010, (4) and then again to 100% for stock acquired on or after Sept. 28,2010. The 100% exclusion, unlike many other tax breaks, is permanent. (5)

This ability to exclude 100% of the gain on the sale of stock--stock sold for cash, moreover--is virtually unmatched throughout the Code. Yet, despite this fact, poll a room full of tax advisers, and, outside of Silicon Valley, surprisingly few are familiar with Sec. 1202.

How is this possible? A quick review of the history of Sec. 1202 reveals the answer, while also shedding light on why so many unanswered questions remain surrounding the application of this tremendously advantageous provision.

History of Sec. 1202

Sec. 1202 was added to the Code as part of the Revenue Reconciliation Act of 1993, (6) with the stated purpose of providing targeted relief for investors who risk their funds in new ventures and small businesses. At the time, long-term capital gain was taxed at the same rates that apply to ordinary income, subject to a maximum rate of 28%.

Under the original version of the provision, gain from the sale of QSB stock acquired on or after Aug. 10,1993, was eligible for a 50% exclusion, resulting in an effective rate on 100% of the gain of 14%. Because of the required five-year holding period, however, the earliest date a shareholder was able to apply the 50% exclusion was Aug. 10,1998.

By 1997, however, Congress had reduced the long-term capital gain rate from a high of 28% to 20%. As part of the same legislation, Sec. 1(h) was modified to provide that any gain excluded under Sec. 1202 was taxed at 28%. (7) This latter change yielded an effective tax rate on a shareholder's full gain on the disposition of QSB stock--including the 50% portion excludable under Sec. 1202--of 14%. (8) When compared to a regular tax rate of 20% on long-term capital gain, the benefits of Sec. 1202 were largely deemed by the tax community to be not worth the effort.

While Sec. 1202 may have been rendered insignificant in 1998, it was virtually eliminated in 2003, when Congress further reduced the top rate on long-term capital gains to 15%. (9) Tax advisers saw little reason to pursue a provision that came with a host of requirements yet yielded a tax rate benefit of less than 1%.

Sensing that the provision had failed to achieve its original objective, in 2009 Congress increased the exclusion percentage to 75%, and again in 2010 to 100%. (10) The move to a 100% exclusion was temporary for several years and routinely extended retroactively after its expiration as part of an extenders package, further muting its impact. It was not until the passage of the Protecting Americans From Tax Hikes Act in late 2015 that the 100% exclusion was made permanent. As a result, the majority of tax advisers have only recently begun dipping their toes into the Sec. 1202 pool.

In addition to failing to provide the intended incentive of spurring investment, the fact that Sec. 1202 went virtually unused for its first two decades resulted in a dearth of relevant authority, whether in the form of administrative rulings or judicial precedent. As a result, there are countless unanswered questions surrounding the provision, from the application of the active business requirement to the definition of "substantially all" to the treatment of corporate liquidations. Thus, while the potential for a 100% exclusion will likely lead to an explosion in the number of taxpayers using Sec. 1202, as this article will explain, those tax advisers must proceed with caution until further guidance addresses these unresolved issues.

Meeting the QSB stock requirements

Only gain from the sale of QSB stock is eligible for exclusion under Sec. 1202. To meet the definition of QSB stock, certain requirements must be met at the time of the stock's issuance, while others must be met during substantially all of the shareholder's holding period of the stock.

Requirements that must be met on the date of issuance C corporation requirement

On the date of issuance, the issuing corporation must be a domestic C corporation, and the stock must be issued after Aug. 9,1993. (11)

Qualified small business requirement

In addition, on the date a corporation issues its stock, the corporation must meet two tests for its gross assets (the gross-assets test): (12)

1. At all times from Aug. 9,1993, through the date of issuance, the aggregate gross assets of the corporation (or any predecessor) must not have exceeded $50 million. (13) Thus, if at any point after Aug. 9,1993, the gross assets of a corporation exceed $50 million, the corporation can never again issue stock that will be QSB stock, even if, on the date of a subsequent issuance, the gross assets are again below $50 million.

2. Immediately after the date of issuance (and after taking into account amounts the corporation received in the issuance) the aggregate gross assets of the corporation must not exceed $50 million. (14)

   The corporation must agree to submit reports as required by regulation, but, to date, no requirements have been issued. (15)

   Example 1: X Co., a domestic C corporation, issues stock to A in 2006 when its gross assets are $20 million. In 2012, and 2014, X Co. issues stock to B and C, respectively, when its aggregate gross assets are $30 million and $45 million. In 2018, X Co. issues stock to D, and immediately after the issuance, X Co.'s aggregate gross assets are $52 million. This is the first time X Co.'s aggregate gross assets have exceeded $50 million. The fact that X Co.'s gross assets exceed $50 million in 2018 does not taint the stock X Co. previously issued to A, B, and C. It does, however, mean that the stock issued to D cannot qualify as QSB stock, and that no future issuance of X Co. stock will qualify as QSB stock, even if X Co.'s gross assets again drop below the $50 million threshold.

   Aggregate gross assets means the amount of cash the corporation holds plus the aggregate adjusted basis of other property the corporation holds. (16) Because this test looks to the basis of the corporation's assets, rather than the value of those assets, a corporation could have substantial self-created intangible value (such as goodwill) without running afoul of the $50 million limit.

   For purposes of Sec. 1202, the adjusted basis of any property contributed to the corporation is equal to its fair market value (FMV) on the date of contribution. (17) This prevents shareholders from circumventing the $50 million threshold by contributing low-basis/high-value property to a corporation in exchange for QSB stock. (18)

   In testing the $50 million limit, all corporations that are members of the same parent-subsidiary controlled group are treated as one corporation. (1)

   Original issuance requirement

   QSB stock must be acquired by the current holder at "original issuance. "This generally means that the stock must be acquired directly from the issuing corporation in exchange for money or other property (not including stock) or as compensation for services provided to the corporation (other than services performed as an underwriter). (20) Thus, a shareholder who acquires stock from an existing shareholder in a cross-purchase will not be treated as having received the stock at original issuance.

   The committee reports to the Revenue Reconciliation Act of 1993 clarify that stock a shareholder acquired through the exercise of options or warrants or through the conversion of convertible debt is treated as acquired at original issuance. (21)

   In certain situations, stock can be treated as having been received at original issuance even when the shareholder is not the original owner of the shares. When stock is received via a gift, at death, or as a distribution from a partnership, the stock is treated as having been received by the transferee in the same manner as the transferor. (22) Thus, if the stock was acquired by the transferor at original issuance, the transferee will be treated as having done the same. For stock distributed from a partnership to a partner to meet the definition of QSB stock in the hands of the partner, however, (1) the stock must have been QSB stock in the partnership's hands (ignoring the five-year holding period requirement); (2) the partner must have been a partner from the date the partnership acquired the stock through the date of the distribution; and (3) the partner cannot treat stock the partnership distributed as QSB stock to the extent the partner's share of the distributed stock exceeds the partner's interest in the partnership at the time the partnership acquired the stock. (23)

   Example 2: On June 1,2014, A contributes $1,000 to X Co. in exchange for stock. The stock meets all the requirements of QSB stock. On July 15,2018, A gifts the shares to B. B is treated as having acquired the stock in the same manner as A--in exchange for a transfer of cash...