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George F. Bearup, J.D. Senior Legal Trust Advisor

10-Nov-21

Qualified Small Business Stock

Take-Away: The incredible tax benefits that are associated with the sale of qualified small business stock would be substantially curtailed if the House Ways and Means Committee’s proposals becomes law under the HR 5376 bill.

Background: We’ve covered qualified small business stock in the past, so what follows is a bit of a ‘refresher.’ The Tax Code gives a tremendous capital gains tax ‘break’ for the owners of a qualified small business stock.  This tax benefit started back in 1993 and over the years it has been periodically improved. IRC 1202 is designed to encourage the flow of capital to small businesses. In addition, the way the rule is written, it is intended to prompt ‘patient capital equity’ by delaying the tax benefits to investors in small businesses for a period of time designed to assure that the corporation will have sufficient time in which to earn a profit.

IRC 1202: In general, before getting into the conditions and restrictions on meeting the qualified business ‘test’, IRC 1202 stock provides a benefit that shelters from capital gains taxes the greater of $10 million or ten (10) times the basis in that 1202 stock. Accordingly, for example, if 1202 stock was acquired after September 28, 2010 by a founder of the corporation, an executive of the corporation, or an investor in the corporation, there is a 100% exclusion from income of either $10 million or 10 times the basis in the 1202 stock when it is sold. In addition, there is no exposure to either the alternative minimum tax or the 3.8% net investment income surtax [IRC 1411.] Note: There is no filing requirement in order for a shareholder to avail themselves of the benefits under IRC 1202. Many may not even know that it exists.

Qualifications: Several qualifications must be met before the sale of 1202 stock can avoid capital gains, which include the following:

  • C corporation: The corporation must be a C corporation  under the Tax Code. It is possible, though for LLCs, partnerships,  and a few S corporations to convert to a C corporation and thus also meet this requirement.
  • Directly Received 1202 Stock : The 1202 shareholder must receive the 1202 stock directly from the issuing C corporation. The intent of IRC 1202 is to induce capital investments by investors in the early stages of the C corporation. Accordingly, an individual could not purchase the initially invested 1202 stock and enjoy the tax benefits intended for the initial investor under IRC 1202. However, 1202 stock can be gifted or inherited and continue to enjoy the tax benefits.
  • Small Business- Maximum Gross Assets: The gross assets of the corporation cannot exceed $50 million through the time that the investor actually receives the 1202 stock (to the time the stock was issued.) For example,  if an executive in the start-up C corporation possessed stock options, at the time the stock option is exercised, the gross assets of the corporation must be below $50 million. In addition, the corporation must use 80% of its assets to actively conduct a trade or business. Some active trades or businesses are also expressly excluded as a qualified small business, including: banking, finance, insurance; farming; mining; restaurants; and professional services like physicians, attorneys, or accountants.
  • Minimum Holding Period: The holding period for the 1202 stock much be at least 5 years to obtain the full benefit of the $10 million/or 10 times basis, tax benefit. However, the time period of the initial 1202 shareholder can be tacked onto the next holder to reach the minimum 5-year holding period. For example, if an initial shareholder in a 1202 qualified business gifted 1202 stock to a non-grantor trust after holding the stock for 3 years, the trust, if it held the 1202 stock for another 2 years before selling the stock,  would meet the minimum 5-year holding period and could thus enjoy the exemption from capital gains on its sale of the 1202 stock.
  • Rollover: If 1202 stock is sold prior to the 5-year holding period, it is possible for the initial investor to rollover the sales proceeds to a new qualified small business corporation and continue to avoid the immediate capital gains tax. [IRC 1045.]
  • No Formal Notice: There is no filing requirement in order for shareholders to avail themselves of the benefits under IRC 1202. No notice to the IRS nor any formal ‘election’ that needs to be timely made. As a result, it is possible that many shareholders of a qualified small business corporation might benefit from IRC 1202 without even knowing that they are eligible to exclude their gain from taxation.

Trusts: As was reported in the earlier missive on qualified small business stock, a 1202 shareholder could transfer by gift their 1202 stock to multiple non-grantor trusts, and each trust would be eligible to claim the ‘larger of the’ $10 million/10 times basis exclusion from taxable income. If the trusts were set up in Delaware (or one of the other favored tax-haven states) the trust would not have to pay any state income taxes either. While the temptation would be to create multiple trusts to hold the 1202 stock, aka stacking 1202 stock in multiple trust, each enjoying their own $10 million exemption, recall that there is the fairly new Tax Code provision that is intended to address perceived tax abuses with regard to using multiple trusts. [IRC 643(f).] That Tax Code section will treat two or more trusts as one trust if  the same settlor and beneficiaries of the trusts are substantially the same and the principal purpose in using the trusts is tax avoidance. More to the point, the IRS refuses to issue any private letter rulings on stacking multiple trusts.

Proposed Change to IRC 1202: The Ways and Means Committee’s proposed change to IRC 1202 under HR 5376, [found on page 2,213 of page 2,466 if anyone is so inclined to want to read it] provides that:

  • after September 13, 2021, the tax benefits derived under IRC 1202 would be only 50% of the benefit, not 100% of the gain exclusion the current statute provides. This translates into about a 14% tax on the greater of the $10 million/10 times basis exclusion when 1202 stock is sold.
  • In addition, the 50%  taxable amount would also be exposed to the AMT tax since that amount is added back as a tax preference.
  • The 8% net investment income surtax, and possibly the newly proposed 3% surtax faced by high earners would apply.

According to many sources, why IRC 1202 is targeted by this proposed legislation is because: (i) if the existing tax benefit was cut in half, the projected increase in revenues for 2021 alone would be $1.8 billion; (ii) the perception is that IRC 1202 only benefits wealthy venture capitalists who earn more than $400,000 a year and who can afford to make risky investments; and (iii) based upon early IRS studies, it is inconclusive whether the existence of IRC 1202 actually induces individuals to assume the risks of investing in small business corporations.

Conclusion: Like much of the House Committee’s proposed tax legislation, it is unclear whether this proposed change to IRC 1202 will become law. If, in fact, the change would produce over $1.8 billion in new revenues just in this year alone, there is no doubt that IRC 1202 will receive considerable attention when the details of the proposed new tax law starts to be debated in earnest.