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Oct 07, 2021

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BlogsQualified Small Business Stock (QSBS)Tax Law Defined™ Blog

Authors:

Scott W. Dolson

Planning for an investment home run – increasing the standard Section 1202 $10 million gain exclusion

With the corporate tax rate reduced from 35% to 21%, we have experienced a heightened awareness among business founders and investors, along with private equity groups and hedge funds, that Section 1202 potentially allows taxpayers to exclude millions of dollars of gain when QSBS is sold.[1]

High on the list of problems that are good ones to have and better ones to solve is the Section 1202’s per-issuer gain exclusion cap.  For many taxpayers, Section 1202’s standard $10 million gain exclusion cap will be more than sufficient.  But there are taxpayers whose QSBS gain far will far exceed $10 million.  For these fortunate taxpayers, advanced planning to expand the potential gain exclusion cap reaps obvious rewards when QSBS is sold.

This article assumes that the QSBS being sold qualifies for the 100% gain exclusion percentage under Section 1202(a)(4).[2] If the QSBS being sold is subject to the 50% or 75% percentage limitations, then the discussion in this article should be read to refer to the cap on the amount of gain recognized that would be eligible to apply the applicable percentage limitation against. For example, if a taxpayer sells an issuer’s fully vested founder (low basis) QSBS on November 3, 2008, for $10 million, and the taxpayer hasn’t previously sold any of that issuer’s QSBS, then under Section 1202(b)(1)(A), the applicable Section 1202 gain exclusion amount would be $10 million, and after applying the 50% percentage exclusion limitation, the taxpayer must claim a $5 million gain exclusion.[3]

This article is one of a series of blog posts addressing planning issues relating to qualified small business stock (QSBS) and the workings of Sections 1202 and 1045 of the Code.

Navigating through Section 1202’s gain exclusion rules

Section 1202(b) places a per-issuer limitation on a taxpayer’s eligible Section 1202 gain exclusion amount.  A taxpayer’s aggregate per-issuer gain exclusion for a given taxable year is generally limited to the greater of (a) $10 million (the “$10 Million Cap”), minus the aggregate prior Section 1202 gain excluded with respect to such issuer, or (b) 10 times the taxpayer’s original adjusted tax basis in the issuer’s QSBS sold during such taxable year (the “10X Basis Cap”).[4]

Section 1202(b) is a per-taxpayer, per-issuer limitation on gain exclusion.  Each taxpayer holding XYZ Corp.’s QSBS is entitled to separately take advantage of the Section 1202 gain exclusion up to the per-issuer maximum gain exclusion cap.  If XYZ Corp. has issued QSBS to 100 taxpayers, each of the 100 taxpayers has a separate Section 1202 gain exclusion cap (e.g., each has a standard $10 Million Cap).  If John Smith holds QSBS of 10 different issuers, he has a separate standard $10 Million Cap and separate 10X Basis Cap for each of the 10 QSBS issuers.  Each partner in a partnership holding XYZ Corp’s QSBS and each shareholder of an S corporation holding XYZ Corp.’s QSBS will be treated as a separate taxpayer, with each partner or shareholder entitled to take advantage of a separate per-issuer standard $10 Million Cap and the 10X Basis Cap.

For purposes of the 10X Basis Cap, a taxpayer’s capital contribution is the amount of cash initially paid for QSBS, the fair market value of property exchanged for QSBS, or if the QSBS is issued in exchange for services, the value of the QSBS for Section 83 purposes (when issued if not subject to vesting or if a Section 83(b) election is made, or when it vests if it is subject to vesting).  Since capital contributions with respect to already issued QSBS are ignored for purposes of calculating the 10X Basis Cap, additional shares of QSBS should be issued in exchange for each cash contribution, assuming the issuer is still eligible to issue QSBS.

If all of John Smith’s QSBS is sold during one taxable year, the critical factor will be whether his aggregate adjusted tax basis in the QSBS exceeds $1 million.  If so, then the gain exclusion based on the 10X Basis Cap will exceed the $10 million gain exclusion resulting from applying the standard $10 Million Cap.

Section 1202(b) determines gain exclusion for a specific taxable year.  The aggregate Section 1202 gain excluded in prior years with respect to XYZ Corp. QSBS reduces the $10 Million Cap exclusion amount for this year’s XYZ Corp. gain exclusion.  Once a taxpayer has excluded $10 million of XYZ Corp. gain, there will be no additional gain exclusion amount available based on the $10 Million Cap.  But gain exclusion in prior taxable years does not reduce the gain exclusion available in the current year applying the 10X Basis Cap, as the exclusion amount is determined based solely on the adjusted tax basis of the QSBS being sold in the current taxable year.   So if John Smith excludes $10 million of XYZ Corp. Section 1202 gain in 2019, and he sells for $1 million additional shares of XYZ Corp. QSBS in 2020 with an aggregate tax basis of $1,000, he will be entitled to a Section 1202 gain exclusion of $10,000 (10 X $1,000 basis), as he will have used his entire $10 Million Cap for such issuer in 2019.  The balance of John Smith’s gain will be taxed at the 20% long-term capital gains rate.[5]

Calculating the gain exclusion cap under Section 1202(b)

Section 1202(b) determines the available gain exclusion for a taxable year during which QSBS is sold.   If John Smith sells all of his XYZ Corp. QSBS in a single taxable year, the gain exclusion is the greater of (A) $10 million, or (B) the 10X Basis Cap.   If John Smith sells all of his XYZ Corp. QSBS in single taxable year, the standard $10 Million Cap will apply unless he has an adjusted tax basis in his QSBS greater than $1 million.  If John Smith’s aggregate tax basis exceeds $1 million, then the Section 1202 gain exclusion cap will be 10 times the aggregate tax basis of his QSBS.  For example, if John Smith’s basis in XYZ Corp. QSBS is $2 million, then his Section 1202 gain exclusion cap will be $20 million.

If John Smith holds some shares of an issuer’s QSBS that have an adjusted tax basis and some shares that have little or no tax basis, he may be able to maximize his aggregate Section 1202 gain exclusion by selling the low basis QSBS in year one and the high basis QSBS in year two.  The plan would be for John Smith to take maximum advantage of the 10X Basis Cap in year two.  For example, assuming John Smith holds 250,000 shares of common QSBS with a tax basis of zero and a market value of $10 million, and 50,000 shares of convertible preferred QSBS with a tax basis of $500,000 and a market value of $2 million, he can exclude both the $10 million in gain triggered by a sale during 2020 of the 250,000 shares of common QSBS and the $2 million in gain triggered by the sale during 2021 of the 50,000 shares of convertible preferred QSBS.  The available exclusion cap for the 50,000 shares of convertible preferred QSBS would be $5 million (10 x $500,000 = $5,000,000).

If John Smith pays cash for QSBS, his tax basis for purposes of the 10X Basis Cap will be the amount paid.  If John Smith contributes appreciated property in exchange for QSBS, his tax basis for purposes of the 10X Basis Cap will be the fair market value of the property at the time of contribution.  If John Smith exchanges services for QSBS, his tax basis for purposes of the 10X Basis Cap will be any amount he paid for the QSBS, plus the amount of any taxable income triggered under Section 83 with respect to the QSBS.  John Smith can have a different tax basis in different blocks of an issuer’s QSBS.  If John Smith was initially issued penny stock and later acquired preferred stock during a capital raise, he would have a different tax basis in his two blocks of QSBS.

Section 1202(b)(1)(B) provides that for purposes of the 10X Basis Cap, “the adjusted basis of any stock shall be determined without regard to any addition to basis after the date on which such stock was originally issued.”   Section 1202(i)(2) provides, however, that “[i]f the adjusted basis of any qualified small business stock is adjusted by reason of any contribution to capital after the date on which such stock was originally issued, in determining the amount of the adjustment by reason of such contribution, the basis of the contributed property shall in no event be treated as less than its fair market value on the date of the contribution.”  It is unclear how to reconcile these two provisions.  What is the point of the second rule if contributions to capital don’t affect the 10X Basis Cap computation?  The main takeaway from these two provisions should nevertheless be that you should never make capital contributions with respect to QSBS, instead, you should always acquire additional shares of QSBS in exchange for additional capital.  Section 1202(b)(1)(B) clearly establishes the rule for purposes of the functioning of the 10X Basis Cap., and the rule doesn’t work favorably for those who make additional capital contributions.

How the Section 1202 gain exclusion cap functions for married couples

Section 1202(b)(1) provides that if a “taxpayer” has eligible gain, that gain is subject to the gain exclusion caps discussed elsewhere in this article.  There is no question that spouses filing a joint return are each a separate “taxpayer” under the Internal Revenue Code.[6]   This combination of reference to “taxpayer” in Section 1202 and the status of spouses as separate taxpayers for certain purposes under the Internal Revenue Code provides support for the argument that each spouse should be treated as a separate taxpayer for Section 1202 purposes, with each spouse having his or her own separate gain exclusion caps (i.e., the spouses would each have a separate $10 Million Cap).  Section 1202(b)(1)(A), which provides that the $10 Million Cap is a $5 million gain exclusion cap per spouse for a married couple filing separately, can be cited to refute this argument, although it could be argued that Congress may have intended to limit the aggregate Section 1202 gain exclusion cap for spouses filing jointly to a single $10 Million Cap, but failed to address that intention in the language of Section 1202.

If the issue were litigated, married couples could argue that the US Supreme Court has held that when Congress passes a statute whose plain text gives a taxpayer the benefit of a “double windfall”, the statute should nevertheless be given effect, in spite of the IRS’s arguments to the contrary.[7]   The IRS might argue that the adoption of the separate “taxpayer” argument would give married couples an unintended windfall.     Probably both taxpayers and the IRS would agree that reading Section 1202 to limit married couples to a single gain exclusion cap would be one of the largest marriage penalties found in the Internal Revenue Code.[8]  There are no tax authorities expressly addressing this issue in the context of Section 1202.

One case that might shed some light on how the courts would view the Section 1202 marriage penalty issue is Marvin L. Levy, 46 BTA 1145 (1942).    In that case, a married couple argued that each spouse should be entitled to a separate net capital loss limit, instead of one combined net capital loss limit.  The Board of Tax Appeals (predecessor to the Tax Court) concluded that the reason for filing a joint return is to amalgamate tax items of two spouses, potentially resulting in offsets unavailable in individual returns.  The Board of Tax Appeals believes that with a joint return, there are no longer two individuals with their own rights to deductions, but an integrated whole, including an integrated (single) capital loss limitation.  In Judge Kern’s dissent, he made the same argument that could be made today with respect to Section 1202’s gain exclusion cap — that spouses are separate taxpayers with separate net capital loss limits.  Judge Kern discussed the Supreme Court cases cited by the majority and noted that he could find no justification in those cases or the statute supporting the majority’s conclusions.  The Levy decision suggests that a taxpayer would have an uphill battle in Tax Court making the separate taxpayer argument, but Judge Kern’s dissenting opinion provides a roadmap for making the contrary argument and some hope.   In our opinion, taxpayers are more likely to have a better chance of succeeding in their efforts to maximize Section1202’s gain exclusion by exploring other planning options addressed in this article.

How the Section 1202 gain exclusion cap functions for a partnership or S corporation holding QSBS

From a planning standpoint, holding QSBS through a fund taxed as a limited partnership or limited liability company (“LLC”) presents an opportunity to dramatically increase the aggregate Section 1202 gain exclusion amount.  If a partnership or S corporation holds an issuer’s QSBS, each partner or shareholder is treated as a separate taxpayer with his own standard $10 Million Cap and separate 10X Basis Cap.  There are specific rules governing how Section 1202 gain flowing through the pass-thru entities are allocated among partners and S corporation shareholders.  There are potential limitations on the amount of Section 1202 gain and corresponding sale proceeds that can be allocated to partners holding carried interests that are beyond the scope of this article.

How the Section 1202 gain exclusion cap applies to QSBS issued in connection with a partnership’s incorporation[9]

In most cases, the aggregate consideration paid by a taxpayer for an issuer’s QSBS won’t exceed $1 million, so the 10X Basis Cap won’t effectively increase the taxpayer’s aggregate exclusion amount beyond the $10 Million Cap.  But the enterprise value (which includes goodwill value) of start-ups can increase dramatically during the early years of operation.  This creates a potential planning opportunity involving operating a start-up as a partnership for several years and then incorporating the partnership and in the process, issuing QSBS to the partners in exchange for their partnership interests.  Both a partnership’s assets and partnership interests qualify as a property that can be contributed by a partnership or LLC to a C corporation (generally in a Section 351 exchange) in exchange for QSBS.

The planning opportunity afforded through the incorporation of a partnership arises out of the fact that for Section 1202 gain exclusion purposes, the tax basis of property contributed in exchange for QSBS is deemed to be the fair market value of the property at the time of contribution.  If a partnership is incorporated, the enterprise value of the partnership’s business would generally be treated as the fair market value of the contributed property.  So, if the owners of a business decide to operate a start-up through an LLC or limited partnership and incorporate the business only after the enterprise value has increased substantially, the 10X Basis Cap could substantially increase the owners’ aggregate gain exclusion.

Section 1202 also provides that when appreciated property is contributed in exchange for QSBS, the difference between the tax basis of the property and its fair market value for Section 1202 purposes does not qualify for the gain exclusion when the QSBS is eventually sold.

Here is an example of how the 10X Basis Cap works when a partnership is converted to a C corporation and QSBS is issued to the partners.  If John Smith and Susan Jones operate their business as equal owners in the early years through XYZ LLC, and incorporate the business when the fair market value of XYZ LLC’s business is $25 million, each of them will have a $112.5 million (10 x $12.5 million – $12.5 million) gain exclusion under Section 1202 when they sell their XYZ Corp. QSBS after five years.  Contrast this result with an example where John Smith and Susan Jones each initially capitalize XYZ Corp. with $50,000 and sell their QSBS for $250 million after seven years.  In this second example, each of John Smith and Susan Jones gain exclusion would be limited to the standard $10 Million Cap.

In addition to the increased gain exclusion cap, there may be additional benefits associated with operating a business in partnership form during its start-up years that are not addressed in this article, including tax loss pass-through to the business’ owners.[10] One downside of waiting to incorporate a business after its enterprise value has increased while operated through a partnership is that the five year holding period for Section 1202 purposes doesn’t start until the QSBS is issued in connection with the incorporation of the business.

Planning techniques for increasing the Section 1202 gain exclusion amount.

Taking advantage of the 10X Basis Cap (packing the corporation with contributed property). 

If a taxpayer has Section 1202 tax basis in shares of QSBS, taking advantage of the 10X Basis Cap can result in an aggregate gain exclusion of more than $10 million.[11]   For example, if a taxpayer has some shares of QSBS with no tax basis and some shares of QSBS with Section 1202 tax basis, the taxpayer could sells shares with low or no tax basis in year one, and then sell higher tax basis QSBS in subsequent years.  If the numbers work, this approach can result in an aggregate gain exclusion far exceeding $10 million.

If it makes sense to operate a business in the early start-up years as a partnership, incorporating the business when the enterprise value attributable to the taxpayer’s shares exceeds $1 million, but before the aggregate enterprise value of the business exceeds $50 million, will also increase the taxpayer’s overall potential gain exclusion amount above the standard $10 Million Cap.

On a more aggressive planning note, in some cases stockholders (particularly founders and early-stage contributors) can position themselves to take advantage of the 10X Basis Cap down the road by “packing” a qualified small business with intellectual property and other assets contributed in exchange for QSBS.   “Packing” is accomplished by contributing property to a qualified small business in exchange for QSBS and assigning value (Section 1202 tax basis) to the contributed property in the exchange.  Any Section 1202 tax basis credit awarded a taxpayer should be supported whenever possible with contemporaneous valuations of the property, and the position should be consistent with Section 409A valuations and valuations placed on stock for investor/financing purposes.  For example, if a founder is credited with contributing $1 million worth of intellectual property at the same time $1 million is invested in the company, the founder and the investors should receive the same equity interests.  If founders are credited with contributing $1 million in intellectual property for Section 1202 purposes, the same equity interest can’t be valued at $100,000 for Section 409A purposes.

Section 1202(b)(1)(B) defines the 10X Basis Cap as “10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year.”  This definition doesn’t distinguish between shares of QSBS held for five years and shares of QSBS held for less than five years (i.e., shares when sold would not be eligible for Section 1202’s gain exclusion).   Particularly for stockholders holding low basis founder stock, the absence of a direct tie-in between the shares of QSBS sold and application of the gain exclusion cap suggests that an additional planning technique might be to purchase high basis QSBS near in time to a sale event.  Thereafter, when the stockholder’s QSBS is sold in a single sale event (e.g., both founder stock and Series B Preferred Stock), the 10X Basis Cap amount attributable to the sale of the Series B Preferred Stock could be applied to increase the amount of gain excluded with respect to the stockholder’s founder stock (which in this example has been held for at least five years).  For example, if a stockholder has held founder shares worth $30 million for more than five years, the founder might acquire $3 million of Series B preferred stock 18 months prior to the company’s sale.  If the founder sells his stock for $33 million, he would have gain of $30 million ($33 million – $3 million = $30 million), allowing the founder to claim a $30 million Section 1202 gain exclusion applying the 10X Basis Cap (10 x $3 million = $30 million).  There must be bona fide business purposes for infusing $3 million into the corporation beyond the income tax benefits associated with the benefits of Section 1202’s 10X Basis Cap in order to avoid the potential application of the IRS’ business purpose doctrine.

Dividing an issuer’s QSBS among multiple “taxpayers.”  

The potential aggregate Section 1202 gain exclusion can be substantially increased if an issuer’s QSBS is spread over a two or more “taxpayers,” each with a separate standard $10 Million Cap and $10X Basis Cap.  Since the Internal Revenue Code defines a “taxpayer” as “any person subject to any internal revenue tax,” this fact opens the door for several planning steps focused on increasing the aggregate Section 1202 gain exclusion cap.

Founders can structure the ownership of QSBS to include a spouse, adult children and other family members.  Likewise, investors purchasing preferred stock can make their investment individually, through spouses, adult children, non-grantor trusts, limited partnerships, LLCs and S corporations.  Aggressive planning to increase the exclusion cap can also be undertaken by employing non-grantor trusts and family entities.[12] These entities may also have the benefit of helping to deal with transfer restrictions, governance and asset protection planning issues.

In many instances, an investor or business owner doesn’t plan at the outset to deal with the Section 1202 exclusion cap because of the odds against an investment in QSBS outstripping the standard $10 Million Cap.  In those cases where it turns out that an investment in QSBS is a home run and is likely to exceed the $10 Million Cap[13], there are several tools available for increasing a taxpayer’s aggregate Section 1202 exclusion cap.  Gifting QSBS is permissible under Section 1202 as an exception to the general rule that the original holder must sell the QSBS in order to take advantage of the Section 1202 gain exclusion.  QSBS may be gifted to an unlimited number of separate taxpayers, each of whom will have the taxpayer’s own $10 Million Cap and 10X Basis Cap.

Gifting QSBS to non-grantor trusts has increased in popularity in recent years as more founders and investor look for ways to use Section 1202 planning in their start-up and venture financing planning.  The intent, purpose and terms of a trust agreement and the timing of gifts to trusts must be carefully considered.  Founders and investors utilize non-grantor trusts for a variety of mixed tax, business and personal reasons.  Trusts can be a useful vehicle through which to engage in asset protection planning, shielding assets from beneficiaries or protecting assets from poor investment decisions through the use of professional asset management.  Trusts are also a useful tool for advanced estate and gift tax and non-tax planning (for example, trust planning often centers around taking advantage of more favorable state laws for the administration of trusts).  At least in theory, if a taxpayer creates multiple non-grantor trusts, each non-grantor trust will be treated as a separate taxpayer with its own standard $10 Million Cap and 10X Basis Cap, regardless of whether there are multiple irrevocable trusts with overlapping or identical beneficiaries.[14]

To the extent possible, QSBS should be gifted when the value of the gifted shares is as low as possible and hopefully well before the QSBS is sold.  Completed gifts of QSBS will be subject to the gift tax rules and gift tax return reporting requirements.  Holders of QSBS can take advantage of annual gifting and the lifetime unified gift and estate tax exemption ($11.4 million for 2019), or structure the terms of the trust so that it is a non-grantor trust for income tax purposes but not a completed gift for gift and estate tax purposes.  A taxpayer engaged in Section 1202 planning need to carefully consider not only federal gift and estate tax consequences in the context of the taxpayer’s estate plan, but also how the planning steps will be treated for state tax purposes.

If a taxpayer is gifting QSBS to an irrevocable trust, consideration should be given to reserving a special limited power to appoint the trust principal to beneficiaries other than the grantor.  This transfer of assets to a trust would be structured as a gift of QSBS for Section 1202 purposes but would be treated as an incomplete gift for gift tax purposes.  The taxpayer would not pay gift taxes or file or a gift tax return, but here again, the assets of the trust would be included in the taxpayer’s estate.[15]

Another way to potentially expand the exclusion cap is to leave QSBS to two or more beneficiaries, as transfers at death are also permitted under Section 1202.

Taxpayers should take into consideration how their state of residence treats these various planning ideas for state income, gift and estate tax purposes.  Not all states follow the federal treatment of QSBS and certainly not all states track the federal gift and estate tax rules and exclusion limits.

As discussed below, there are sound arguments based on applicable tax authorities that married couples filing jointly each have a separate $10 Million Cap and 10X Basis Cap, based on the conclusion that each spouse is a separate taxpayer for Section 1202 purposes.  But the potential exists for the IRS to take a contrary position.

Using multiple corporations for Section 1202 planning; Engaging in separate business activities through separate corporations. 

A taxpayer’s gain exclusion cap is determined separately for each issuer of QSBS.  There is no provision in Section 1202 that aggregates the QSBS of brother-sister corporations for purposes of limiting gain exclusion.  These facts suggest that there is an opportunity to operate businesses through multiple C corporations, which should work so long as each of the corporations is engaged in a stand-alone qualified small business. Operating a unified business through several corporations most likely won’t work to increase the gain exclusion because each of the corporations independently won’t function as a stand-alone qualified small business.[16]

It does make sense for several reasons to separate discrete businesses into separate C corporations from an overall Section 1202 planning standpoint.  An important planning goal should be to make it easy from a transaction structuring standpoint to sell QSBS after the five-year holding period requirement is satisfied.  Owning two businesses in one C corporation might complicate the owners’ ability to sell the holding company’s QSBS and take advantage of the Section 1202 gain exclusion.   Also, as discussed above, multiple corporate issuers function to increase the potential aggregate Section 1202 gain exclusion.

Reinvesting Section 1202 gain in multiple issuers. 

Section 1045 allows holders of QSBS who have not reached the required five-year holding period to sell their QSBS and reinvest the proceeds in other QSBS.  One issue that doesn’t appear to have a clear answer is whether proceeds of the sale of QSBS rolled over into other QSBS investments under Section 1045 retains its original “identity” for the gain exclusion cap purposes, or whether it is possible to expand the gain exclusion cap by reinvesting the proceeds of one issuer’s QSBS into multiple QSBS investments.  Given that Section 1045 refers to a taxpayer reinvesting Section 1202 proceeds in QSBS, a reasonable conclusion is that, except for Section 1202 holding period purposes and Section 1045’s gain deferral, Section 1045 treats the transaction as a new investment in QSBS.  If that is correct, then there seems to be no reason why a taxpayer can’t reinvest Section 1202 proceeds in multiple QSBS issuers, each with a separate $10 Million Cap and 10X Basis Cap.  There certainly is nothing in the language of Section 1202 or Section 1045 that expressly prohibits the taking of this position or suggesting that a contrary interpretation of the functioning of the Section 1045 rollover should be adopted.

Closing remarks

Engaging in one or more of the planning ideas outlined above to increase a taxpayer’s potential Section 1202 gain exclusion can have the collateral consequence of significantly affecting the ownership and governance structure of business start-ups and a founder’s or investor’s estate planning.   Transferring QSBS to family members and utilizing non-grantor trusts and other family wealth transfer vehicles often has a significant impact on the taxpayer and family social and economic relationships.  Taxpayers and advisors should not lose sight of these issues when considering the potentially significant tax benefits generated by Section 1202 planning.   Finally, Section 1202 planning may also significantly affect a taxpayer’s overall federal and state income, gift and estate taxes, and all of these consequences should be taken into account as part of the planning process.  States are not uniform in adopting Section 1202 and how a taxpayer’s state of residence handles gift and estate taxes will impact the planning process to expand the Section 1202 exclusion amount through gifts and other techniques discussed in this article.

The details of advanced Section 1202 planning are not commonly understood.  Founders, investors, advisors, and return preparers engaging in advanced planning should consider seeking the advice of tax professionals who regularly handle QSBS issues.  In particular, taxpayers and other participants in the planning process should want to know whether there is substantial authority for tax return positions.  Finally, taxpayers and other participants in the planning process should also seek advice regarding potential penalties and the IRS’s disclosure rules.

More resources

In spite of the potential for significant tax savings, many experienced tax advisors are not familiar with Sections 1202 and 1045 planning. Venture capitalists, founders and investors who want to learn more about Sections 1202 and 1045 and related planning opportunities are directed to several articles on the Frost Brown Todd website:

Contact Scott Dolson if you want to discuss QSBS issues by telephone or video conference.

[1] This article addresses federal income taxes.  Many, but not all, states follow the federal Section 1202 gain exclusion.  References to Sections are to Sections of the Internal Revenue Code.

[2] Subject to satisfying all of Section 1202’s eligibility requirements, Section 1202 excludes from gross income 50% of gain recognized on the sale of QSBS for stock issued on or after August 1 1, 1993, through February 17, 2009, 75% of gain recognized for QSBS issued from February 18, 2009, through September 27, 2010, and 100% of gain recognized for QSBS issued after September 27, 2010.

[3] For QSBS issued prior to September 28, 2010, (i) the portion of the gain that is excluded from the benefit of Section 1202 due to the percentage limitations is subject to a 28% tax rate under Section 1(h)(7) and the 3.8% net investment income tax, and (ii) 7% of the portion of the gain excluded under Section 1202 is a preference item for alternative minimum tax purposes.

[4] (b) Per-issuer limitation on taxpayer’s eligible gain.

(1) In general.  If the taxpayer has eligible gain for the taxable year from 1 or more dispositions of stock issued by any corporation, the aggregate amount of such gain from dispositions of stock issued by such corporation which may be taken into account under subsection (a) for the taxable year shall not exceed the greater of—

(A) $10,000,000 reduced by the aggregate amount of eligible gain taken into account by the taxpayer under subsection (a) for prior taxable years and attributable to dispositions of stock issued by such corporation, or

(B) 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year. For purposes of subparagraph (B), the adjusted basis of any stock shall be determined without regard to any addition to basis after the date on which such stock was originally issued.

(2) Eligible gain.  For purposes of this subsection, the term “eligible gain” means any gain from the sale or exchange of qualified small business stock held for more than 5 years.

(3) Treatment of married individuals.

(A) Separate returns. In the case of a separate return by a married individual, paragraph (1)(A) shall be applied by substituting “$5,000,000” for “$10,000,000.”

(B) Allocation of exclusion.  In the case of any joint return, the amount of gain taken into account under subsection (a) shall be allocated equally between the spouses for purposes of applying this subsection to subsequent taxable years.

(C) Marital status.  For purposes of this subsection, marital status shall be determined under section 7703.

[5] Plus, potentially the 3.8% surtax and applicable state income taxes.

[6]  A husband and wife filing a joint return are persons who are jointly and severally subject to a tax, and therefore, each is a taxpayer within the meaning of the Internal Revenue Code.  Section 7701(a)(14) defines a taxpayer to be “any person subject to any internal revenue tax” and that under Section 6013(d)(3), each spouse has joint and several liability for the tax shown on a joint return.

[7] Gitlitz v. Commissioner, 531 U.S. 206 (2001).

[8] A marriage penalty occurs in situations where two persons filing as single filers would be entitled to separate tax benefits, but if they marry, then they would only be entitled to a single benefit.   In the context of Section 1202, if you are single, you have a $10 Million Cap with respect to the sale of XYZ Corp QSBS, and so does your significant other  But if you marry your significant other, then as a married couple, you would only be entitled to a single $10 Million Cap with respect to XYZ Corp QSBS.

[9] The discussion of partnership in this section generally would include a limited liability company taxed as a partnership, along with a limited partnership.

[10] See these articles on the Frost Brown Todd website:  [Revisiting the Choice of Entity Decision for the Closely Held Business] and [The Choice of Entity Decision for VC Financed Start-ups.]

[11] A taxpayer could have tax basis for Section 1202 by contributing cash or property to the issuing corporation in exchange for QSBS.

[12] If the trust is a grantor trust, the “taxpayer” is the grantor and is treated as the owner of the QSBS for Section 1202 purposes.  If the trust is a non-grantor trust, the “taxpayer” is the trust, and the trust is treated as the owner of the QSBS for Section 1202 purposes.

[13] The assumption here is that the 10X Basis Cap under Section 1202(b)(1)(B) isn’t helpful because of the modest initial amount paid for the QSBS.

[14] Referred to by some as “stacking” (multiplying) trusts for Federal income tax planning purposes.  There are no tax authorities addressing the use of non-grantor trusts in connection with Section 1202 tax planning, but see Treasury Regulation § 1.199A-6(d)(3)(vii) which provides that that a trust formed with a principal purpose of avoiding, or of using more than one, threshold amount for purposes of calculating the deduction under Section 199A will not be respected as a separate trust for purposes of determining the threshold amount for purposes of Section 199A and Treasury Regulation § 1.643(f)-1 which provides that “two or more trusts will be aggregated and treated as a single trust if such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and if a principal purpose for establishing one or more of such trusts or for contributing additional cash or other property to such trusts is the avoidance of Federal income tax.  For purposes of this rule, spouses will be treated as one person.”

[15] This incomplete gift, non-grantor trust is referred to generally as an ING (a DING in Delaware).

[16] Section 1202(k) provides that the IRS may issue regulations to prevent “the avoidance of the purposes of [Section 1202] through split-ups, shell corporations, partnerships, or otherwise.”  To date, the IRS hasn’t addressed Section 1202 income tax avoidance schemes through regulations, but the potential focus on “shell corporations” is there.