Vol. 6, No. 2, Pg. 27. The Use of Qualified Small Business stock.

• Author: By Scott Y. Barnes

South Carolina Lawyer

1994.

Vol. 6, No. 2, Pg. 27.

The Use of Qualified Small Business stock

27The Use of Qualified Small Business stockBy Scott Y. BarnesBefore the Revenue Reconciliation Act of 1993 (the 1993 Act), the top individual tax rate of 31% was three points lower than the top corporate rate of 34%. As a result of the difference in maximum tax rates and the repeal of the General Utilities doctrine, tax practitioners often advised their clients to utilize S rather than C corporations. General Utilities Operating Company v. Helvering, 296 U.S. 200 (1935). The General Utilities doctrine, codified at § 311(a)(2) of the Internal Revenue Code (Code), generally provided that a corporation did not reorganize gain or loss on a distribution of appreciated or depreciated property to its shareholders for their stock. The Tax Reform Act of 1986 repealed the general nonrecognition rules of Code §§ 311(a)(2) and 336 for distributions of property by a corporation to its shareholders.

After the 1993 Act, however, the choice between the use of an S corporation or a C corporation is not so clear-cut. As a result of the 1993 Act, the top individual tax rate of 39.6% is 4% higher than the top corporate tax rate of 35%.

Code § 1202

The 1993 Act also added Code § 1202, which provides that 50% of the gain from the sale or exchange of certain "qualified small business stock" (qualified stock) held for more than five years by a taxpayer other than a corporation will be excluded from gross income. Thus, through the use of qualified stock, individuals may be able to substantially reduce the tax on the sale of certain qualifying stock.

"The enactment of Code § 1202 may provide taxpayers with new planning opportunities to exclude capital gains on certain transactions from tax. However, the apparent tax benefits of Code §1202 may prove illusory to shareholders of most closely held businesses."

The enactment of Code § 1202 may provide taxpayers with new planning opportunities to exclude capital gains on certain transactions from tax. However, as discussed below, the apparent tax benefits of Code §1202 may prove illusory to shareholders of most closely held businesses.

Qualifying for the Exclusion

The rules under Code § 1202 are quite detailed, and not all taxpayers holding stock in domestic C corporations can qualify for the exclusion...