Qualified Small Business Stock Update

Take-Away: As small business owners seek to avoid capital gains when they decide to sell their business, they first need to determine if their stock qualifies as small business stock, as the tax savings can be significant.

Background: The Tax Code contains a provision that creates an incredible opportunity to avoid capital gain recognition for some shareholders . IRC 1202 provides for the full, or partial, exclusion of capital gains that are realized on the sale of what is technically described as qualified small business stock, or QSBS. This Tax Code section is intended to incent non-corporate taxpayers to invest in small businesses.  However, this statute contains several conditions before stock can meet the QSBS definition, e.g. only C corporations qualified; capitalization ceilings are imposed; only a trade-or-business can qualify etc. An earlier missive (written back in 2017) summarized the conditions that must be satisfied before the owner can claim that their stock is QSBS.

IRC 1202 Requirements: Qualifying for the IRC 1202 capital gain exclusion is a bit like trying to thread a needle, as there are multiple conditions that must be met. Those conditions include the following:

1. The stock was issued by a domestic C corporation. Consequently, this requirement excludes S corporations from the  IRC 1202 exclusion. In addition, a former DISC, a RIC, a REIT, a REMIC, and stock in a cooperative do not qualify for the IRC 1202 gain exclusion.
2. The stock was originally issued after August 10, 1993 in exchange for money, property not including stocks, or as compensation for services rendered. In addition, to assure this original issue requirement, certain redemptions of stock by the issuing corporation will result in thee shareholder’s stock not being QSBS.
3. On the date of the stock issue and immediately after the issuing the stock, the issuing corporation had $50 million or less in assets. Once this $50 million asset-test for a stock issue is met, the corporation does not need to retain its assets below $50 million (unless it plans to make another QSBS issue.) In short, the QSB does not have to always remain small.
4. The use of at least 80% of the corporation’s aggregate gross assets is for the active conduct of one or more qualified businesses. Aggregate gross assets means the amount of cash and the aggregate adjusted bases of other property held by the corporation. A special rule provides that the basis of property contributed to the corporation in-kind will equal the fair market value of such property at the time of its contribution to the business.
5. The issuing corporation does not purchase any of the stock from the taxpayer during a four-year holding period beginning two years before the issue date; and
6. The issuing corporation does not significantly redeem its stock within a two-year period beginning one year before the issue date. A significant stock redemption is redeeming an aggregate value of stock that exceeds 5% of the total value of the company’s stock.

Excluded Amount: If the closely held business stock meets the definition of a qualified small business  (akin to threading a needle) the excluded capital gain is an amount equal to the greater of (i) $10 million, or (ii) an annual exclusion of 10 times the owner’s basis in the stock sold, i.e. for an exclusion amount up to $500 million!  Both of these limitations apply on a per-issuer and per-shareholder/taxpayer basis.

Planning Tip: In the earlier missive I noted that the per-taxpayer opportunity could be exploited by the QSB stockholder  transferring some of his/her QSBS to irrevocable trusts, as each trust could then claim up to $10 million of exclusion from capital gain recognition on the subsequent liquidity event.

Example 1: Claudia owns C corporate stock. Claudia was one of the founding shareholders in Claudco, Inc. in October, 2010. Claudia’s income tax basis in her Claudco stock is $0.00, as the stock in Claudco was awarded to her for her services. In 2022, Claudia is ready to retire; she plans to sell her Claudco stock to Claudco’s controller for $10 million. Claudia will pay no federal income tax if Claudco qualifies as a qualified trade or business. However, if Claudco is not a qualified trade or business, then Claudia will owe federal incomes taxes of roughly $2.38 million, or a 23.8% tax on the $10 million in gross sales proceeds she receives on the sale of her stock.

Example 2: The same facts, except Claudia’s investment in Claudco is worth $21 million. If Claudia sells her stock in Claudo for $21 million, only $10 million will be exempt, and $11 million will be subject to a capital gains tax of $2,618,000. Assume, however, that Claudia creates three irrevocable trusts, one for each of her three children. Claudia transfers $7,000,000 to each trust for each of her children. Claudia’s husband agrees to split the gift with her. Claudia. No federal  gift tax is owed. Claudia, and each of the three irrevocable trusts, can avoid paying capital gain tax on the sale of her or its QSBS, resulting in no capital gain taxes incurred when $21 million of Claudco stock is sold or redeemed. Because the Claudco stock held by each of the trusts was originally issued to Claudia, that classification passes onto the three trusts, thus enabling each trust to qualify for the IRC 1202 gain exclusion up to $10 million.

Well, the Exclusion Not Quite that Simple: There is a growing scale as to the amount of the excluded capital gain when QSBS is sold. In the case of an individual other than a corporation, gross income does not include 50% of any gain from the sale or exchange in QSBS held for no more than 5 years. [IRC 1202(a)(1).] In the case of QSBS acquired after 2/17/2009 and before 9/27/2010, the QSBS exclusion is 75%. [IRC 1202(a)(3).] If the QSBS stock was acquired after 9/27/2010 the QSBS exclusion is 100%.

Qualified Trade or Business: As noted, one of the key conditions that must be met is that the business must be a qualified trade or business, which often leads to a ‘facts and circumstances’ analysis whether IRC 1202 applies to an anticipated sale of stock. In fact, the statute goes to great lengths to say that it applies to “any trade or business, other than the following excluded businesses.” Then, a long list is provided of the types of businesses that will not be eligible for the capital gain exclusion, even if they meet all of the other eligibility criteria. Those excluded businesses not entitled to claim the IRC 1202 exclusion of capital gain include the following:

1. Any trade or business that involves the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees;
2. Any banking, insurance, financing, leasing, investing, or similar business;

2. Any farming business (including the business of raising or harvesting trees;)
3. Any business that involves the production or extraction of products of a character with respect to which a tax deduction is allowed under IRC 613 and IRC 613A; and
4. Any business of operating a hotel, motel, restaurant, or similar business (would an RV dealership be a similar business?)

Because the opportunity to avoid substantial capital gain taxation is so attractive, it is not then surprising that most  inquiries focus on whether the shareholder who faces a potential liquidity event qualifies as a non-excluded qualified trade or business. In March 2022, the IRS provided its most recent discussion of what constitutes a QSBS trade or business in connection with the health exclusion.

Aside: As I was reading this Private Letter Ruling I was thinking about Lance Armstrong. Apparently back in 2008 Lance invested $100,000 in a start-up company that later became known as Uber. It is believed that Lance’s initial investment in that company is now worth about $20 million. I would suspect that if Lance were to sell his Uber today stock it would not qualify as QSBS since that business essentially provides a service. Then again, maybe I am wrong.

Private Letter Ruling 202221006, March 3, 2022

Facts: The shareholder who sought this private letter ruling was the owner of stock in a pharmaceutical distributor that engaged in the retail sale of a limited number of drugs. Specifically, the corporation entered into exclusive distribution agreements with the manufacturers of the drugs;  the corporation did not manufacture any drugs on its own. The corporation employed licensed pharmacists that dispensed drugs through the mail, and other non-licensed individuals  coordinated insurance coverage with respect to the prescriptions. In addition, the non-licensed employees periodically contacted patients to inquire about the side-effects of their prescriptions and to schedule prescription refills. Thus, there was no interaction between these employees and physicians other than with regard to receiving the prescriptions. The pharmacists interacted with patients only to answer their questions, but they did not engage in the diagnosis, treatment, or management of medical care. Consequently, the interactions by the pharmacists with patients was limited to filling prescriptions and the maintenance of prescriptions as ordered by physicians.

Not an Excluded Trade or Business: The IRS found that the shareholder’s corporation was not engaged in the field of health because it is not engaged in the provision of medical services to patients and its employees are not certified healthcare providers. “It merely fills prescriptions and its interactions with patients are incidental to ensuring receipt of prescriptions and answering questions about prescriptions.” Another key fact was that  all of the corporation’s revenues were generated by the sale of drugs- not rendering services. The IRS glossed  over any findings whether the business’ principal asset was not the reputation or skill of one or more of its employees.

Observation: Why this Private Letter Ruling is important is twofold: (i) First, the IRS built upon earlier guidance that it has provided that narrows the scope of the health exclusion as a trade or business under IRC 1202; and (ii) Second, despite the proposed sale of stock transaction, the IRS provided a PLR; the IRS will often refuse to give guidance on a proposed stock sale since it is a hypothetical sale at the time the ruling is requested. Note, however, that the requested PLR from the IRS carried with it a $38,000 user fee along with the professional fees of the tax preparer to prepare and submit the ruling request. The IRS acknowledged that “the shareholders are in the process of negotiating the sale of their stock … to an unrelated third party.” For shareholders who are looking for certainty in the sale of their closely held business stock, this is good news- if the shareholder is willing to pay a user fee to the IRS of $38,000!

Conclusion: Anecdotally, many small business owners now currently explore the sale of their business. They would like to know the tax consequences of that anticipated sale, especially when they are negotiating the price for their stock.  If that is the case, then they should take a close look at IRC 1202 to confirm if their business meets the definition of a qualified small business. And as demonstrated by the fairly recent Private Letter Ruling, what may initially appear to be an excluded trade or business, e.g. health, might nonetheless still qualify as a qualified small business. If enough wealth is at stake, even paying a $38,000 IRS user fee might be warranted to determine if QSBS is to be sold.