The Amazing Section 1202

By: David Herzig

I was fortunate enough to present to the Chicago Estate Planning Council about a week ago.  I rearranged a presentation that I gave at the Notre Dame Tax and Estate Planning Institute. (As an aside, both of these forums are great sources of continuing cutting edge eduction for the practicing bar).  I spent the majority of the hour I was allotted describing section 1202 the Qualified Small Business Stock Exemption.  To my shock, most of the 300 in attendance either were not familiar with the provision or had not thought about it for a decade.  After a quick twitter exchange, I thought I would do a short post explaining the code section as well as why it should be used or at least discussed more.

First, can everyone in Silicon Valley please stop laughing. I get it. You have been using 1202 since the 1990s.  Almost every VC agreement requires the target to qualify as 1202.  For the rest of us, let me catch you up on why 1202 is maybe one the largest give aways in the tax code today.

The QBSB Election came in existence in 1993. Why was the section so forgettable?  Well, if I told you there was a tax credit if you formed a C corp that lowered your rate from 28% to 14% but still had an AMT phase-out – I probably lost you at C Corp.  Even if I had your attention, as capital rates lowered to 20%, the QSBS stayed steady at 14% so why set a C Corporation to save 6%? Yes, 6% is a large savings but, not, when the Code required that 7% of the amount excluded from gross income be treated as a “preference” item and subject to AMT.

Along came the JOBS Act which temporarily allowed non-corporate taxpayers the opportunity to exclude from gross income and the AMT up to 100% of the gain recognized from the sale or exchange of Qualified Small Business Stock (“QSBS”) purchased from and also provided that the excluded amount would not constitute AMT income. Unfortunately to pass muster under the Byrd rule,the JOBS Act had a sunset provision. To arrange a business structure with a huge benefit in a small window and then a return to a 50% exclusion level and the 7% AMT income treatment would be rather short-sided.

What makes the QSBS election worth paying attention to today, is that as part of “tax extenders” in the Protecting Americans from Tax Hikes Act of 2015 (PATH Act, Division Q of the Consolidated Appropriations Act, 2016, P.L. 114-113, enacted December 18, 2015) was a permanent extension of the 100 percent exclusion from gross income for certain gains from the disposition of QSBS.  Now the QSBS is here to stay (until the revoked in the alleged new tax code).

Why should you really care about 1202?

Let me start with the big lead:  You can exclude from capital gains taxation the GREATER of $10,000,000 or 10 times the taxpayer’s aggregate adjusted basis.  Yep, if your basis was $40,000,000, then your excludible amount is $400,000,000!  Wait, is that not good enough for you?  Can I make this better?  Sure, how about this?  First, this limitation applies on a per-issuer basis, allowing an investor to utilize the exclusion for multiple QSB stockholdings in different companies.  Second, this is a per taxpayer exclusion.  Can I stack these exclusions in the same company by, say, using multiple complex trusts?  As far, as I can tell – yes!

Assume that an individual acquires QSBS and subsequently makes a gift of QSBS to one or more irrevocable trusts. The question arises whether a non-grantor irrevocable trust may claim its own $10 million QSBS gain exclusion, separate from the grantor’s $10 million gain exclusion.  The answer is seemingly yes. Per IRC Section 1202(h)(2), the transferee of QSBS obtained by gift or bequest is treated as having acquired the stock in the same manner as the transferor and can tack the transferor’s holding period.  The same result should apply if the gift originally was made to an irrevocable trust structured as a grantor trust for income tax purposes but the grantor trust status was terminated prior to the sale of the QSBS.

What are some of the basics to qualify as a QSBS?

1.A QSBS may generally only be issued by a “qualified small business” within the meaning of 1202.  This is generally, a domestic (US) C Corp. which has aggregate gross assets which under $50MM and agrees to submit such reports to the IRS and stockholders as the IRS may require to carry out the purposes of section 1202 (To date, the IRS has yet to issue reporting requirements).

The $50MM threshold is when the corporation qualifies as a QSBS.  Not when the taxpayer sells the stock.  So, the company can grow and grow and grow!

In calculating whether a corporation meets the aggregate gross asset test, subject to certain exceptions, assets are valued at their adjusted tax bases.  As for timing, generally, for purposes of convertible stock, the aggregate gross asset test is measured at the time the convertible stock is issued to the taxpayer. For purposes of stock acquired by a taxpayer through the exercise of stock options or warrants, or through the conversion of convertible debt, the determination as to whether the gross asset test is met is made at the time of exercise or conversion, when the underlying stock is issued to the taxpayer. Restricted shares are deemed issued to the taxpayer on the date they vest unless the taxpayer submits a valid “83(b)” election with respect to the stock, in which case the stock is deemed issued on the effective date of the 83(b) election.

2.  What is a “qualified small business”?  Most technology, life sciences, and venture-backed operating companies should meet the qualified trade or business test. Banking, insurance, financing, leasing, and other businesses where the principal asset is the reputation or skill of one or more of its employees generally do not qualify.

But, who really knows what qualifies.  There is hardly any guidance on the qualifications under 1202.  For example, PLR 201436001 involved a company in the pharmaceutical industry that worked with clients to help commercialize experimental drugs. The ruling indicated that since the company’s activities involved the development of specific manufacturing assets and intellectual property assets to create value for customers, rather than offering services in the form of individual expertise, it met the definition of a qualified trade or business for purposes of Section 1202.  This makes no sense as the company business seemed to be one of  reputation or skill.  So, the lesson here is framing matters!

3.  Who can own QSBS?  Anyone but a C Corporation.  This rule seems to make little sense.  If you are going to set up a company as a C Corporation initially, then the best owner would be another C Corporation.  We could assume that the start-up venture would generate losses in early years.  Unless, the C Corporation were owned by a parent C Corporation (and could use a consolidated return) the losses would be trapped in the start-up.

Nonetheless, the rule is non-corporate taxpayer can take advantage of the QSBS exclusion. For individuals who hold shares through partnerships, S-corporations, limited liability companies taxed as partnerships, and other pass-through entities, the shares held by the entity generally may qualify as QSBS if the stock met the QSBS requirements in the hands of the pass-through entity and the individual taxpayer held an interest in the pass-through entity on the date the entity acquired the QSBS.

So, how do you maximize losses and still qualify as a QSBS?  Easy, start off as a passthrough then convert.  In PLR 201636003 a company stated as a LLC with partnership tax treatment and converted to a C Corporation.  The Service stated, “Section 1202(h) provides that in the case of a transaction described in § 351 or a reorganization described in § 368, if qualified small business stock is exchanged for other stock which would not qualify as qualified small business stock but for this subparagraph, such other stock shall be treated as qualified small business stock acquired on the date on which the exchanged stock was acquired.

Section 368(a)(1)(F) provides that the term “reorganization” means a mere change in identity, form or place of organization of one corporation, however effected.”

The Service ruled that, “[w]hile ownership of a corporation is normally tied to stock ownership, and under state law LLC owners hold a member interest and not formal stock, the term “stock” for federal tax purposes is not restricted to cases where formal stock certificates have been issued. Rather, it has been consistent Service position that for federal tax purposes stock ownership is a matter of economic substance, i.e., the right to which the owner has in management, profits, and ultimate assets of a corporation.”  The PLR was important for two purposes.  One, the tax classification is all that matters not the state law treatment.  Second, you could convert to a C Corporation after starting life as a passthrough.

Obviously, this is just a blog post about some details of 1202 and the usual disclaimers about consulting your own tax advisor apply.  But, this is a code section that should start getting more attention as the IRS rulings seem rather generous on the matter.  After all, what do tax lawyers like more than a huge hole in the tax code with little guidance.


2 thoughts on “The Amazing Section 1202

  1. I believe you misread PLR 201636003 — it appears to me that the entity in that ruling was always treated as a C corporation. The entity apparently converted to an LLC at some point after incorporating but also made an entity classification election in connection with the conversion, so it appears that there was never pass-through treatment. Do you think I am missing something?

    The following are the taxpayer’s representations in the ruling:

    “The taxpayers originally incorporated as a C corporation on Date 1 as Name 1. On Date 2, the taxpayers amended their articles of incorporation solely to change the name of the corporation from Name 1 to Name 2.

    “Effective Date 3, the taxpayers converted Name 2 to Name 3 based upon the advice of an accountant. The company made a late entity classification election to treat Name 3 as an association taxed as a C corporation.

    “On Date 4, a Certificate of Conversion from an LLC to a corporation was filed, changing the name to Corporation and converting X in Name 3 owned by the taxpayers to Y in Corporation representing all the common stock in Corporation after conversion.

    * * *

    “In Year 5, the taxpayers sold all of their common stock in Corporation as part of a sale of 100% of the company stock to an unrelated party.”


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