Qualified Small Business Stock: Some Interesting Questions

Thank you to the authors, Raj Tanden and Jacob I. Davis, for their hard work in creating this article.

Section 1202¹ is a once-obscure tax saving provision that has come into prominence in the last few years. Originally passed in 1993 as a 50% capital gain exclusion, it has been amended several times since. In its current iteration, Section 1202 allows for a 100% capital gain exclusion for the sale of qualified small business (QSB) stock (QSBS), if its requirements are met, and subject to caps.

One important requirement is that the issuing company must be a domestic C corporation. After the 2017 Tax Act, which substantially cut the U.S. federal corporate tax rate to 21% (from 35%), using a C corporation for a new business has become far more popular. In sum, the current tax climate can making an investment in a C corporation very tax efficient if the investment is in QSBS.

We consider some issues to consider regarding the qualification.

Can Section 1202 be used to buy out another company, and even a foreign company?

Section 1202 requires that the issuing corporation be incorporated domestically,² and for it to be actively engaged in a qualified trade or business,³ among other requirements. For this purpose, the statute allows the issuing corporation to look-through to a corporate subsidiary to meet this active trade or business requirement, as long as the parent owns at least 50% of the subsidiary.⁴

While Section 1202 was enacted to provide a tax incentive to seed small, growing U.S. companies, the statute doesn’t seem to preclude raising money in a new C corporation that uses the money to buy-out another C corporation.⁵ The acquired C corporation would meet the subsidiary test as long as the new C corporation acquires at least 50% of the stock of this other “target” C corporation. Further, it would appear that such target C corporation could be a foreign corporation.

However, considering the intent of Section 1202, it is possible the IRS would attack using a purported QSB as an acquisition vehicle.

Can the active business of a partnership subsidiary be attributed to the QSB?

While Section 1202 specifies when a subsidiary corporation can be “looked through” for the parent’s active trade or business test, the statute is unclear on when a parent corporation can look through a partnership (such as multi-member LLC that has not elected to be taxed as a corporation). Until the IRS provides guidance, a taxpayer may wish to consider one of these alternatives:

• Apply the “corporate” look-through rule: the parent corporation must own at least 50% of the capital and profits of a partnership to look through the partnership.
• Apply the “continuity of business enterprise” test regarding partnerships: the parent corporation must own at least 1/3 of the partnership’s capital and profits if it doesn’t manage the partnership and at least 20% where it does.⁶
• Treat any partnership as an “aggregate” of its partners and allow a look-through regardless of the percentage owned by the parent corporation.

Disqualifying redemptions

Section 1202 requires that the stock be originally issued by the corporation.⁷ If the corporation makes a disqualifying stock redemption, the issuance will be disallowed QSBS status in whole or in part. A redemption is disqualifying if it occurs in either (a) a 4-year period beginning two years before the stock issuance and stock of certain related parties (such as a founder who owns significant stock in the company) is redeemed, or (b) in a 2-year period beginning one year before the stock issuance and more than 5% of the aggregate value of all outstanding stock is redeemed.⁸

New investors should investigate whether the company has made any disqualifying redemptions preceding their investment and should seek covenants that it won’t do so in the future.

If an existing shareholder wishers to sell his or her stock and he or she or she knows that new investors may seek QSBS status, the shareholder should sell his or her stock to a purchaser and not the company. However, the purchaser cannot use the QSBS exemption, as it requires an original stock issuance.

Can ownership of a carried interests qualify for QSBS treatment?

QSBS benefits are only eligible for non-corporate shareholders, including partnerships, LLCs taxed as partnerships, and S corporations.⁹ Among other requirements, the partners include the portion of the QSBS gain proportionate to their share of the partnership’s adjusted basis in the QSBS on their individual tax returns.¹⁰

Because many QSBs are financed by venture capital funds formed as partnerships, sponsors often ask whether their carried interest can qualify for the QSBS exclusion.

Regulations under Section 1045 (which governs rollover of QSBS) preclude the holder of a carried interest from qualification for purposes of that statute. Specifically, the regulations refer to a partner’s capital,¹¹ and a carried interest is a share of partnership profits and not capital.

While these regulations do not expressly apply to Section 1202, we think that they make it very difficult to claim that a holder of a carried interest can exclude gain allocated to him or her from a fund that holds QSBS.