There is a generous tax benefit that only select taxpayers qualify for. Not well known, it is called ‘‘qualified small business stock,’’ or QSBS for short, and is found in Section 1202 of the Internal Revenue Code. Titled the “Partial Exclusion for Gain from Certain Small Business Stock,” it allows taxpayers to exclude gain from certain stock.
The original language of the section allowed taxpayers to not include 50% of any gain from sale or exchange of qualified small business stock held more than five years from gross income.
This section has been amended by the Creating Small Business Jobs Act of 2010 so that for qualified small business stock acquired between 2009 and 2010, 75% shall be substituted for 50% in § 1202(a)(1). (§ 1202(a)(3)).
In the case of qualified small business stock acquired in 2010 and beyond, 100% shall be substituted for 50% in § 1202(a)(1). (§ 1202(a)(4)).
This section was implemented to help small businesses enjoy some of the benefits that big corporations get. When used, it can help jump start small businesses and is a huge benefit to taxpayers.
This exclusion is applicable for “certain small business stock.” The small business stock factors include:
- issued by a C corporation with no more than $50 million of gross assets at the time of issuance.
- of a corporation that uses at least 80 percent of the asset value in an active trade or business, other than in the fields of personal services, finance, farming, restaurants or hotels, and so on.
- issued after August 10, 1993.
- held by a non-corporate taxpayer (meaning any taxpayer other than a corporation).
- acquired by the taxpayer on original issuance (although there are exceptions to that rule); and
- held for more than six months (to be eligible for a tax-free rollover under § 1045) and more than five years to qualify for a 50% gain exclusion.
Pursuant to Section 1202(c), “‘qualified small business stock’ means any stock in a C corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993.” Additionally, § 1202(c)(1)(A) says that it must be a C corporation “as of the date of issuance.” Therefore, the threshold question for whether or not a taxpayer will receive exclusion under Section 1202 is, whether or not the issuing company is a C corporation.
Notwithstanding, this means that S corporations, Partnerships, or any other entities will not be able to partake in this exclusion. As mentioned previously, entity status is not the only element required to obtain this exclusion. The corporation must also be of a size to warrant as a qualified small business.
According to Section 1202(d) to qualify as such, a small business can be any domestic corporation which is a C corporation if the aggregate gross assets of such corporation before and after the issuance did not exceeds $50,000,000. This is referred to as The $50 Million Capitalization Test.
To calculate aggregate gross assets under the $50 million capitalization test, you simply take the amount of cash and the aggregate adjusted basis of property held by the corporation and add them together. (§ 1202(d)(2)(A)). The aggregate adjusted basis of property held by a corporation is the fair market value at the time of the contribution of the property to the corporation. (§ 1202(d)(2)(B)).
One additional fact to keep in mind – once the $50 million capitalization test is satisfied, the corporation can never again issue qualified small business stock.
Finally, there is the third corporation element – it must be engaged in an active qualified trade or business. (§ 1202(e)). A qualified trade or business means any trade other than “any trade or business involving 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 business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.” (§ 1202(e)(3)(A)).
Additionally, banking, insurance, and farming are not considered qualified trades or businesses for purposes of Section 1202. (§ 1202(e)(3)(B)-(C)).
According to an IRS Private Letter Ruling, “the thrust of Section 1202(e)(3) is that businesses are not qualified trades or businesses if they offer value to customers primarily in the form of services, whether those services are the providing of hotel rooms, for example, or in the form of individual expertise (law firm partners).
In the earlier private-letter-ruling case, the company’s activities involved the deployment of specific manufacturing and intellectual property assets, creating value for customers.
The company, “works with clients to help commercialize experimental drugs . . . its business activities include research, development, manufacture and commercialization.”
However, the IRS said this is allowed for Section 1202(e)(3) purposes. “Essentially, Company is a pharmaceutical industry analogue of a parts manufacturer in the automobile industry.”
The IRS goes on to say, “thus, although Company works primarily in the pharmaceutical industry, which is certainly a component of the health industry, Company does not perform services in the health industry within the meaning of § 1202(e)(3).”
For the purposes of subsection (e) of § 1202, the company was ruled to be within the exclusion of Section 1202. As you can imagine, it is a fine line.
Five Years Plus Possible Complications
I mentioned that Section 1202 has a five-year holding period requirement. On its face, it seems like a simple benchmark to hit, but it gets more nuanced and complicated when options are involved.
In Natkunanathan v. Commissioner (2010), the United States Tax Court addressed this issue of stock options and Section 1202. In that case, the petitioner claimed that Intel Corp. stock was qualified business stock because, the stock originally came from options in a company called Cogent.
Petitioner held these options until after Cogent merged with Intel, when petitioner then exercised his options. On that same day, petitioner sold the Intel stock that he had received for a gain of $295,285.
Petitioner sold the stock the same day he got it but previously held the options for a long time. Does the holding period of these options count towards the holding period of the stock?
The Tax Court cited Gantner v. Commissioner (1988) in saying, “options to purchase stock are not ‘shares’ of ‘stock or securities’ under the plain language of Section 1091, which was amended to explicitly provide otherwise.”
The Tax Court takes the plain meaning approach to Section 1202 and decides that “stock” does not cover options to acquire stock. The Court goes on to cite the legislative history of Section 1202, which says, “‘stock acquired by the taxpayer through the exercise of options * * * is treated as acquired at original issue.
The determination whether the gross assets test is met is made at the time of exercise * * * and the holding period of such stock is treated as beginning at that time.’”
Therefore, in addition to all other tests that the stock needs to meet, if the taxpayer wants a stock option to be excluded under Section 1202, it must be after the five-year holding period from the date of exercise.
The Tax Court convened with: “this conclusion seems appropriate since both the application of the gross assets test and the commencement of the holding period would occur at the time of such exercise.”
A Bonanza of Sorts
“It behooves every investor, lawyer, and accountant to know the basics of this bonanza, particularly since so many taxpayers seem to be ignorant of the provision,” wrote Robert Wood. “Moreover, it turns out that for those taxpayers who do claim tax benefits under this provision, audit rates appear to be high. This means you need to know not only enough to claim the deduction or exclusion, but also enough to later defend it."
Section 1202 can be very useful for taxpayers, but they need to understand the many hurdles it throws up. The tax code is long, especially this particular section.
If you have taken the deduction and are now being audited, or if it is of serious interest and you would like some assistance navigating the code, please contact us at Brotman Law. Our tax attorneys and staff are here to help.