Understanding the Gain Exclusion under Section 1202
Brief History of U.S. Federal Taxation of Virtual Currency
This article will be first in a series of blog posts that address federal income tax planning issues and opportunities for qualified small business stock (QSBS), including the relationship between Sections 1202 and 1045.
Generally, Section 1202 provides certain shareholders of a C corporation the ability to claim a federal income tax gain exclusion of $10 million annually in connection with each shareholder’s sale of QSBS that has been held for more than five years. Section 1202’s gain exclusion is an extremely attractive federal income tax benefit to founders, certain employees, and venture capitalists. Although Congress passed the Build Back Better Act and the Inflation Reduction Act, the proposed provisions that would have reduced Section 1202’s benefits were omitted, thus improving the prospect that QSBS will qualify for Section 1202’s gain exclusion until 2027 and potentially beyond such tax year. Furthermore, based upon Congress’ passage of the Tax Cuts and Jobs Act in 2017, which reduced the federal corporate income tax rate from 35% to 21%, there has been an increase in the use of C corporations as the entity of choice for startups.
Qualifying for the gain exclusion under Section 1202
Section 1202 has several eligibility requirements that apply to both the issuing C corporation and each shareholder, all of which must be satisfied to claim Section 1202’s gain exclusion and are as follows:
- Stock must be acquired directly from a domestic (US) C corporation.
- Stock is not QSBS unless acquired from a C corporation and sold while the issuer is a C corporation. Additionally, the C corporation’s status should be maintained from the date of issuance to the date of sale.
- The gain exclusion under Section 1202 cannot be claimed by a corporate shareholder; however, individuals, trusts, and pass-through entities such as partnerships, including limited partnerships, limited liability companies (LLCs) classified as partnerships for federal income tax purposes, and S corporations may qualify for Section 1202’s gain exclusion.
- QSBS must be acquired directly from the C corporation for cash, property, or services.
- With certain exceptions, QSBS must be held by the recipient for more than five years, which will be discussed in more detail below. If QSBS is sold before a shareholder achieves a five-year holding period, it is possible to reinvest the proceeds in replacement QSBS under Section 1045.
- QSBS must be “stock” for federal income tax purposes, which can be common stock (voting or nonvoting) or preferred stock; however, nonvested stock, i.e., stock that is subject to a substantial risk of forfeiture under Section 83, is not treated as “stock” until it vests, unless the recipient makes a timely Section 83(b) election, which subject is further discussed in an upcoming blog post.
- For federal income tax purposes, QSBS must be sold to take advantage of the gain exclusion under Section 1202. With certain exceptions, the shareholder originally issued QSBS must also be the seller of the QSBS.
- For an issuance of stock to qualify as QSBS, the issuing corporation:
- Must not have “aggregate gross assets” in excess of $50 million ($50 Million Test) at any time prior to or immediately after the issuance of the stock, discussed further below under section II;
- Must use at least 80% of the corporation’s assets (by value) in a qualified trade or business, and the corporation’s shareholders must own “substantially all” of the eligible QSBS for the applicable holding period discussed further below in section III; and
- Meets either the $10 million gain exclusion cap or the 10x gain exclusion cap discussed further below in section IV.
The $50 Million Test
The corporation must meet the $50 Million Test immediately after the issuance of the QSBS, considering the cash or other property contributed to the corporation in exchange for the stock included in the applicable issuance. Therefore, the issuing corporation must not have “aggregate gross assets” in excess of $50 million at any time before or immediately after the issuance of QSBS. Generally, the definition of “aggregate gross assets” means the amount of cash plus the adjusted tax basis of other assets on a corporation’s balance sheet, which should include any transfer of assets in or out of the corporation in connection with the same transaction.
The 80% Assets Test
A significant issue associated with QSBS planning is the determination of whether a corporation engages in a qualified trade or business (80% Test). Albeit, if the corporation’s principal activities clearly qualify under Section 1202, it is still necessary to ensure that the corporation continuously satisfies the 80% Test, which requires monitoring that at least 80% of the corporation’s assets (by value) are used in qualified business activities and excluding assets used in non-qualifying activities, investment assets, non-qualifying real estate, and cash not required for working capital needs.13 The activities of a majority-owned subsidiary are included in the 80% Test. Although Section 1202 is silent on the issue, it is more likely than not that the activities of at least majority-owned joint ventures, the pro rata ownership of LLCs and LPs, would also be used in calculating the 80% Test. Although Section 1202 requires that the corporation issuing QSBS be a domestic, i.e., a US, C corporation, there is no corresponding limitation with respect to the ownership of a non-domestic (or foreign) subsidiary.
The $10 Million Gain Exclusion and the 10x Gain Exclusion Caps
Section 1202 limits the amount of gain that a taxpayer may exclude in a given tax year to a minimum of $10 million for gain triggered by the sale of QSBS ($10M Exclusion). The same taxpayer can also have a gain exclusion cap that exceeds $10 million if the taxpayer paid cash or contributed property in exchange for the QSBS. The “10x gain exclusion cap” provides that a taxpayer’s gain exclusion cap equals a multiple of 10 times the amount of cash or the value of property contributed to the corporation in exchange for QSBS. As just one example, if an LLC that owns assets with a fair market value of $20 million converts to a corporation, when the QSBS issued in the conversion sells for $250 million, some or all of the first $25 million would be subject to long-term capital gains tax and the balance of $225 million would be eligible for Section 1202’s gain exclusion. Additionally, if a taxpayer held common stock with a $0.001 tax basis per share and preferred stock with a $2,000 tax basis per share, the taxpayer would have the ability to sell a portion of the common stock in year one for $10 million, which would exhaust the first $10 million gain exclusion cap, but also can take advantage of the 10x gain exclusion cap by selling the preferred stock in later tax years. For shareholders with insufficient tax basis to take advantage of the 10x gain exclusion cap but anticipate that their QSBS will sell for more than $10 million, it is possible to expand the aggregate gain exclusion beyond $10 million through carefully structuring gifts to trusts or individuals.
Furthermore, many shareholders mistakenly believe that the $10 million and 10x gain exclusion caps are mutually exclusive. However, it is possible to take advantage of both gain exclusion caps through the ordering of the sale of a shareholder’s QSBS over more than one tax year. That said, once the $10 million gain exclusion has been used, the 10x gain exclusion may be used in subsequent years.
CONCLUSION
The above discussion sets forth the requirements for certain equity to qualify as QSBS. Future blog posts will discuss the many other requirements of obtaining and qualifying for the federal tax benefits of QSBS and planning opportunities. For more information, please contact Laura.
