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Tax Geek Tuesday: Reminding You That The Gain On That Sale Of Stock May Be Tax Free

This article is more than 8 years old.

C corporations are like pit bulls and prostate exams — they carry quite the stigma,  but they’re not nearly as bad as they’re made out to be.

Long thought of as “the entity choice of last resort” — due to the corporate level tax and the resulting potential for double taxation upon distribution or liquidation — C corporations offer certain opportunities that S corporations and partnerships simply can’t match.

For example, only C corporation stock meets the definition of “qualified small business stock” under the meaning of Section 1202. And while you may not be aware you even own  qualified small business stock (QSBS), if you do, and if you acquired this qualified small business stock (QSBS) between September 27, 2010 and December 31, 2014, you will eligible to exclude the ENTIRE gain from a subsequent sale of the stock, provided it has been held for five years prior to sale. And since five years from September 27, 2010 was six weeks ago, some of these sales eligible for 100% exclusion may now be coming home to roost.

Thus, now is as appropriate time as any to crank out a Tax Geek Tuesday to point out the advantages and pitfalls of Section 1202 stock.

Section 1202, In General

Section 1202 is nothing new; it's just that until recent years, it has largely been toothless. Prior to 2010, if a noncorporate taxpayer sold QSBS that had been issued after August 10, 1993 and held for more than five years, 50% of the gain was excluded under Section 1202.  While that sounds wonderful, the remaining 50% of the gain was subject to tax at 28%, meaning the tax rate on the total gain was 14%. This offered only a 1% benefit over the long-term capital gain rate of 15% that was in place at the time. Couple this with the fact that 7% of the gain was also treated as an AMT preference item, and Section 1202 was rendered a rather useless provision.

In 2009, Section 1202 was amended to provide that for stock acquired after the date of the enactment -- and subsequently sold after being held for five years -- the exclusion rises to 75%.

The stakes were further raised with the enactment of the Creating Small Business Jobs Act of 2010, however, when Section 1202 was again amended to provide that QSBS stock acquired after September 27, 2010, and before January 1, 2014 would be eligible for a 100% exclusion, after a five-year holding period.

Sweetening the pot further, no portion of the exclusion is treated as a tax preference item for purposes of the alternative minimum tax. This presented a unique opportunity for noncorporate taxpayers to invest in Section 1202 stock between  2010 and the end of 2014 and enjoy the benefit of tax-free gain on a subsequent sale of the stock five years down the road, which at its earliest, is right now. And while the window to acquire stock eventually eligible for a 100% exclusion period technically ended on December 31, 2014, this provision is on the table to be reinstated as part of the extender package for 2015, meaning stock acquired this year may also make the cut.

In addition, assuming tax rates remain the same for the next five years, the 100% exclusion will be much more valuable that pre-2010 iterations of Section 1202 in that it will be offsetting tax rates that significantly exceed the 15% maximum rate on long-term capital gains that existed prior to 2013. Remember, after January 1, 2013, the maximum rate on such gains has increased to 23.8% for those taxpayers in the 39.6% ordinary income tax bracket who are also subject to the net investment income tax. This obviously makes the benefit of Section 1202 even more attractive, as taxpayers can now keep income otherwise taxed at 23.8% — rather than 15% — off of their tax return.

For this week's Tax Geek Tuesday, let's take a deep dive into Section 1202, in case...you know...Congress gets its act together and extends the 100% acquisition date through the end of 2015. And remember, even if it doesn't, stock acquired between September 27, 2010 and December 31, 2014 could be eligible for a 100% exclusion if the following requirements are met, meaning some of your clients may have sold stock this fall that is tax-free, subject to the limitations discussed below.

Requirements for Section 1202 Stock

QSBS is stock that satisfies three tests: the small business, original issuance, and active trade or business requirements.

"Small Business" requirement

QSBS stock must be issued by a corporation that at the date of issuance is a domestic C corporation with cash and other assets totaling $50 million or less, based on adjusted basis, at all times from August 10, 1993 to immediately after the stock is issued.

Assets when property is contributed by the shareholder

The assets are measured as the cash plus the adjusted tax basis of the other assets held by the corporation. There is one important catch, however; the basis of any property that was contributed to the corporation -- for example in a transfer by a shareholder in exchange for stock under Section 351 -- is deemed to be equal to its fair market value.

Ex: A contributes property with a basis of $1 million and a FMV of $4 million to X Co. in exchange for stock in a transfer qualifying as a tax-free Section 351 transfer. The basis of the assets to X Co., while $1 million under Section 362 for all other purposes -- will be treated as being $4 million for the purposes of the $50 million asset limit of Section 1202.

This means that when computing the shareholder's subsequent gain on the sale of the QSBS stock, the shareholder's "basis" in his stock is also considered to be equal to the FMV of the property, even though for all other tax purposes, Section 358 would dictate that the shareholder's basis is equal to his basis in the property given up.

Continuing the example above, when A sells his stock, his basis in the stock is treated as being $4 million, rather than $1 million. This way, the taxpayer can't convert the $3 million of appreciation inherent in the property prior to the contribution -- which would be taxable upon sale -- into tax-free Section 1202 gain by holding the stock for five years and then selling it.

Assets when corporation has subsidiary

In addition, all corporations which are members of the same parent-subsidiary controlled group must measure their assets on a combined basis. For these purposes, however, it requires only a 50% ownership of parent into subsidiary, as opposed to the 80% typically required under Section 1563 for consolidation.

P owns 55% of S stock. P and S are both C corporations. A contributes $1 million of cash to P in exchange for P stock. While P's assets immediately after the transfer are only $35 million, S has assets with a combined basis of $20 million. Because P owns more than 50% of the S stock, for the purposes of the $50 million asset limit under Section 1202, the assets of P and S must be combined. As a result, the combined assets are $55 million, and the P stock does not qualify as Section 1202 stock.

"Original Issuance" requirement

Stock issued for cash, assets, or services

The shareholder must acquire the Section 1202 stock in an original issue in exchange for money or other property or as compensation. Thus, a shareholder who acquires stock in a corporation via the purchase of an existing shareholder's shares will not be treated as holding QSBS stock.

Ex: A is the sole shareholder of X Co., a corporation whose stock qualifies as QSBS. B acquires all of A's stock at the beginning of 2014 in a purchase. The stock acquired by B is not QSBS, even though it was QSBS in the hands of A, because B did not acquire it via original issuance.

There are additional complexities, however, for certain tax-free reorganizations and transfers.

Stock received in a tax-free reorganization in exchange for QSBS

If a shareholder who holds previously issued stock qualifying as QSBS under Section 1202 relinquishes that stock in a tax-free reorganization --- such as a merger qualifying under Section 368(a)(1)(A) -- the stock in the surviving corporation that is received by the shareholder in the transaction will also qualify as Section 1202 stock, and the holding period of the stock received will include the holding period of any stock relinquished in the transaction.

Ex: A owns 100% of the stock of X Co., and the X Co. stock qualifies as Section 1202 QSBS stock in A's hands. X Co. merges into Y Co. in a tax-free reorganization, and in the deal, A gives up his X Co. stock in exchange for Y Co. stock. The Y Co. stock received by A is treated as QSBS stock with a holding period that includes the period A held the X Co. stock.

In addition, a shareholder can transfer QSBS to another corporation in a Section 351 transaction, and the stock received from the transferee corporation will be treated as QSBS stock, provided the transferee corporation owns more than 80% of the transferred corporation.

A transfers all of the X Co. stock, which is QSBS stock, to Y Co, in exchange for a 90% ownership of Y Co. The Y Co. stock received by A is QSBS stock because the X Co. stock was QSBS stock and Y Co. owns 100% of X Co. after the transaction.

Stock relinquished is QSBS, but stock received is not QSBS

This rule holds true even if the stock received in the merger would not qualify as QSBS stock. As you might imagine, however, any future appreciation of the stock received in the deal would not qualify for the Section 1202 exclusion.

Ex: A owns X Co stock with a basis of $1 million and a FMV of $4 million. The stock is QSBS stock. X Co. merges into Y Co. and A receives Y Co. stock, which is not QSBS stock. The Y Co. stock is treated as QSBS stock held by A, but upon a future sale of the Y Co. stock, A could only exclude a maximum of $3 million of gain. Any future appreciation in the Y Co. stock is not eligible for exclusion.

Original issuance when stock is received by a flow-through entity

In order for a partner in a partnership -- or a shareholder in an S corporation, if you'll just replace the references to partner/partnership to shareholder/corporation -- to qualify for the benefits of Section 1202 when the partnership acquires QSBS stock, holds it for five years, and then sells it, the partner must have held his interest in the partnership both at the time the partnership acquired the stock and when it sold the stock.

For the purposes of determining the partner or S corporation shareholder's basis in the stock when computing the 10X basis limitation, the partner or shareholder's basis is determined to be his proportionate share of the pass-through entity's basis in the stock.

It is also important to note, if a partner or S corporation shareholder increases his ownership interest between the time the flow-through entity acquires the stock and the time it sells the stock, the partner or shareholder's excludible Section 1202 gain is limited to his original interest in the entity.

On Ex: Jan. 1, Year 1, individual I was a 25% partner in the P partnership. On that day, P purchased stock in Corporation C for $1 million. On Jan. 1, Year 6, I is a 40% partner in P, and P sells all of its C stock, for $1.5 million. If the stock is QSBS, the amount of I's gain that is eligible for exclusion (before consideration of the dollar amount limitation), and the amount that is taken into consideration for purposes of the $10 million limitation is $125,000, i.e., 25% of P's $500,000 gain. The adjusted basis that is used for purposes of the 10-times-adjusted basis limitation is $250,000, i.e., 25% of P's $1 million basis.

Stock received via gift, death, or distribution

If a shareholder holding QSBS stock transfers the stock via gift or at death, or if a partnership holding QSBS stock distributes the stock to its partners, the recipient in all three cases will also be treated as holding QSBS stock, and his holding period will include the period the stock was held by the transferor.

A holds QSBS stock he acquired on January 1, 2012. On November 23, 2015, A gifts the property to B. B is treated as holding the stock received as QSBS stock with a holding period that began on January 1, 2012.

Active Trade or Business" requirement

To qualify as Section 1202 stock, it must be issued by a C corporation that meets an active business requirement—at least 80% of the value of the corporation’s assets must be used in a qualified trade or business during substantially all of the taxpayer’s holding period for such stock and the corporation must be an "eligible corporation."

A qualified trade or business excludes: 1. any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, etc.; 2. banking, insurance, financing, leasing, investing, or similar business; 3. farming (including the business of raising or harvesting trees); 4. the production or extraction of products subject to percentage depletion; and 5. a hotel, motel, restaurant, or similar business.

To be an "eligible corporation," the corporation must be a domestic corporation that is not:

  • a DISC,
  • a REIT or RIC,
  • a cooperative, or
  • a corporation with respect to which a Section 936 election has been made.

If a corporation owns more than 50% of the stock of a subsidiary corporation, the parent corporation is treated as conducting its ratable share of the subsidiary's business, making it more likely the parent corporation will satisfy the active business requirement.

Computational Limitations

Of course, Congress believes you can have too much of a good thing, and thus, Section 1202(b)(1) limits the exclusion for any given year to the greater of

(1) $10 million ($5 million for married taxpayers filing separately), minus any amount excluded with respect to that corporation’s stock in prior years, or

(2) ten times the aggregate basis of stock of the qualified corporation sold during the year.

The following example illustrates the operation of this limitation:

Assume that A paid $2 million for shares of qualified small business stock in 2013. In 2019, he sells the stock for $15 million, realizing a gain of $13 million. The ceiling on excluded gain is $20 million (the greater of $10 million or ten times the $2 million basis). Accordingly, the entire gain is excluded from both A’s net income and his AMT computation.

If A’s basis for the stock were only $200,000, however, the gain would be $14.8 million. Ten times the taxpayer’s basis is $2 million, which is less than $10 million. Thus, the exclusion is limited to $10 million, and $4.8 million of the gain must be included in taxable income.

Converting a Partnership Into a C Corporation to Take Advantage of the Section 1202 Rules

If the 100% exclusion gets retroactively extended through the end of 2015 or beyond, Section 1202 should clearly be given consideration by any new business forming over the next two weeks. Of course, the potential impact of Section 1202 should not drive the choice of entity decision, but it must be factored into any analysis.

Less obvious, however, is the opportunity that exists to convert an existing partnership into a C corporation with qualifying Section 1202 stock to take advantage of any potential extension of the 100% acquisition period. Provided the conversion is structured in the correct manner — and provided the C corporation stock meets the requirements discussed above to qualify as Section 1202 stock — any former noncorporate partners of the converted partnership will be entitled to sell the stock after holding it for five years free from income tax (subject to limitations, once again discussed below.)

Revenue Ruling 84-111, provides three options for a partnership-to-corporation conversion:

1. “Assets Over:” the partnership contributes its assets and liabilities to the new corporation in exchange for stock in the corporation in a tax-free transaction qualifying under Section 351, followed by a liquidation of the partnership in which the stock of the corporation is distributed to the partners in a nontaxable Section 731 transaction.

2. “Assets Up:” the partnership first liquidates, followed by a transfer by the partners of the assets of the partnership to the new corporation in a nontaxable Section 351 transaction (subject to Section 357(c)).

3. “Interests Over:” The partners transfer their partnership interests to the corporation in a nontaxable Section 351 transaction. The corporation can then “liquidate” the single-member LLC or leave it as is.

It’s important to note, however, that because Revenue Ruling 84-111 gives you the choice on how to structure a partnership incorporation, the partnership will bear the consequences of its chosen alternative. To illustrate the downside of this freedom, if the partnership chooses an Assets Over form and the liabilities of the partnership exceed the tax basis of the assets deemed contributed to the new corporation, Section 357(c) will kick in and the partnership will recognize income to the extent of the excess.

Germane to Section 1202, the manner in which a partnership is incorporated shouldn’t matter; all three options should permit the partners to hold the C corporation stock as Section 1202 stock provided all the requirements are met regarding an active trade or business and the size of assets. Options 2 and 3 pose no problem, because in both cases the partners are the original recipients of the corporate stock, and thus satisfy the “original issuance” requirement.

I wrote should in italics in the paragraph above because there is some school of thought that Option 1 – Assets Over – could be problematic, because it results in the partnership rather than the partners being the original owner of the corporation stock, thus failing to satisfy the “original issuance” requirement for Section 1202 stock. That concern should be alleviated by Section 1202(h)(2)(C), however, which provides that if a partnership transfers stock to a partner, the partner is treated as having acquired the stock in the same manner as did the partnership. Stated in another way, because the partnership received the stock in the corporation’s original issuance, that fulfilled requirement for Section 1202 should be attributed to the partners receiving the stock in the deemed liquidation of the partnership. As a firm believer of the “better safe than sorry” approach to tax planning, however,  I would recommend using Options 2 or 3 to incorporating a partnership if Section 1202 qualification is your primary goal.

 Cautions:

Understand, while the 100% exclusion exists for stock acquired from September 2010 through December 31, 2014, because of the five-year holding period requirement, the holder of stock won’t actually enjoy the benefits of the zero percent tax rate on a sale of the stock until this year at the earliest.

To benefit from Section 1202, the shareholder must eventually sell the stock of the corporation. A sale of the corporation’s assets won’t qualify. This is relevant, because most buyers prefer to purchase assets, and a buyer is likely to negotiate a lower purchase price on a stock sale than on an asset sale.

Got a idea for a Tax Geek Tuesday? Email it to anitti@withum.com or on twitter @nittiaj