07/22/2024 | Press release | Distributed by Public on 07/22/2024 07:18
Jul 22, 2024
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Section 1202 provides for a substantial exclusion of gain from federal income taxes if a stockholder transfers qualified small business stock (QSBS) in a taxable sale or exchange.[1] But this gain exclusion is available only if each of Section 1202's eligibility requirements are satisfied. A useful rule of thumb is that Section 1202's gain exclusion is only applicable if a stockholder is reporting capital gain resulting from a taxable sale or exchange of qualified small business stock (QSBS).[2]
This article focuses on Section 1202's critical "sale or exchange" requirement. In addition to transfers of QSBS that qualify as a taxable sale, redemptions of QSBS and partial and complete corporate liquidations can also trigger a stockholder's right to claim Section 1202's gain exclusion. The tax rules governing these various transfers must be understood in order to ensure that stockholders benefit from the best possible tax treatment in secondary sales and corporate M&A transactions.
This article is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045.
The C corporation has gained favor since 2017 as an entity of choice because of the 21% corporate tax rate and the potential for benefiting from Section 1202's gain exclusion. Additional information regarding Section 1202's eligibility requirements and Section 1202 and Section 1045 tax planning can be found in our QSBS library.
The right to claim Section 1202's gain exclusion is generally triggered when there is taxable gain arising out of a "sale or exchange" of QSBS. A good rule of thumb is that Section 1202's gain exclusion applies when a sale or exchange results in the reporting of gain on a stockholder's Schedule D (Capital Gains and Losses).[4] Not all amounts paid with respect to QSBS qualify for Section 1202's gain exclusion. A payment treated as a dividend does not qualify and any portion of the consideration that is characterized as compensation income does not qualify.
In addition to sales of QSBS to third parties, transfers that can trigger the right to claim Section 1202's gain exclusion include redemptions, partial liquidations and complete liquidations. Those transactions are discussed below.
A "redemption" of stock occurs when an issuing corporation purchases shares of its own stock.[13] Distributions in redemption of stock under Section 302, in connection with a partial liquidation under Section 302(b)(4), and in connection with a complete liquidation of a corporation under Section 331 can be treated as payments in exchange for QSBS, thereby triggering the right to claim Section 1202's gain exclusion. The portion of any sale or exchange consideration treated as a dividend is generally taxed at capital gains rates but is not eligible for Section 1202's gain exclusion.[14]
Section 302 governs whether the redemption consideration is treated as a dividend or as a payment in exchange for the redeemed stock. Under Section 302, a redemption is treated as a distribution in part or full payment for QSBS if:
Whether there has been a "meaningful reduction" of a stockholder's proportionate interest in the corporation is the key test for determining whether a distribution qualifies for dividend or exchange treatment. In Himmel v. Commissioner, which is referred to as the leading authority for the identification of the specific rights which arise from owning stock in a corporation that are relevant in testing a redemption for dividend equivalence, the Second Circuit stated that "ownership of stock can involve three important rights: (1) to vote and thereby exercise control, (2) to participate in current earnings and accumulated surplus, and (3) to share in net assets on liquidation."[16] The IRS has taken the position that a change in a stockholder's voting interest is a "key factor" in determining the applicability of Section 302(b)(1).[17] The Sixth and Eighth Circuit Court of Appeals have held that a loss of supermajority control warrants sale treatment.[18] In contrast, the IRS has declined to allow for sale treatment where the redeemed stockholder continued to own more than half of the voting stock.[19] In contrast, the IRS has ruled in favor of sale treatment once a stockholder's vote drops to 50% and his ability to control the corporation is adversely affected.[20] In most cases, a stockholder whose pre-redemption percentage interest is below 50% will be accorded sale (exchange) treatment even with a small reduction in percentage interest, but tax authorities addressing the treatment under Section 302(b)(1) of these redemptions are not entirely consistent.[21] A stockholder who intends to rely on Section 302(b)(1) to support sale (exchange) treatment should have the surrounding facts carefully reviewed by competent tax advisors. Perhaps the best advice is to rely, if possible, on Section 302(b)(2)'s mechanical test or Section 302(b)(3)'s complete redemption safe harbor rather than relying on the position that the redemption payment was not substantially equivalent to a dividend.
A question that occasionally comes up during the planning process is whether it possible to trigger Section 1202's gain exclusion by selling QSBS to family members or their affiliated entities. One concern being addressed by triggering a taxable sale or exchange is the issue of whether Congress or the IRS will take future steps to eliminate or reduce the benefits of claiming Section 1202's gain exclusion. A stumbling block associated with having family members purchase stock is that when QSBS is sold within the family, the stock will not be QSBS in the hands of the purchaser. A suggested workaround for this problem has been to form a corporation to purchase the related party's stock with the hope that the newco corporation could issue QSBS and rely on Section 1202's parent-subsidiary look-thru rules to meet Section 1202's eligibility requirements. The problem with this plan is that it runs afoul of Section 304, which provides that if two corporation's have related ownership, the purchase of stock of Corporation A by Corporation B will result in dividend treatment for the consideration paid to the stockholders of Corporation A. Related party transactions should be carefully vetted for the potential application of Section 304.
If there is a redemption of QSBS preferred stock, any portion of the redemption proceeds representing payment for declared dividends would not be included in the redemption consideration eligible for claiming Section 1202's gain exclusion against.[22]
A basic principle of Section 1202 planning is to avoid engaging in multiple activities within a single QSBS issuer if there is a foreseeable possibility that a purchaser might be interested in acquiring only one activity. If this occurs, the distribution of unwanted assets out of a corporation prior to a stock sale will trigger a deemed sale of those assets subject to the 21% corporate income tax. Also, corporate-level sale treatment along with the corporate income tax would apply to an actual sale of assets by the corporation. The subsequent distribution by the corporation of net sales proceeds generally results in a second level of tax at the stockholder level. But if the sale of assets by a corporation and distribution of proceeds qualifies as a "partial liquidation" under Section 302(b)(4), the distribution of sales proceeds can qualify as a redemption payment that can be offset by Section 1202's gain exclusion. Likewise, a distribution of unwanted assets in conjunction with a stock sale can potentially qualify as a partial liquidation under Section 302(b)(4). A partial liquidation generally occurs when a corporation engaged in multiple activities adopts a plan of partial liquidation, sells the assets of associated with one of the corporation's activities, and distributes the net proceeds within the taxable year in which the plan was adopted or the succeeding taxable year.[23]
Section 302(e)(1) provides that a distribution is to be treated as in partial liquidation if "(i) the distribution is not essentially equivalent to a dividend (determined at the corporate level rather than the shareholder level), and (ii) the distribution is pursuant to a plan that occurs within the taxable year in with the plan is adopted or within the succeeding taxable year." Section 302(e)(2) provides that a distribution will be treated as meeting the requirements of Section 302(e)(1) if (i) the distribution is attributable to a corporation ceasing to conduct, or consists of the assets, of a qualified trade or business, and (ii) immediately after the distribution, the corporation continues to be actively engaged in the conduct of a qualified trade or business. Section 302(e)(3) provides that the term "qualified trade or business" means a business which (A) was actively conducted throughout the 5-year period on the date of the redemption, and (B) was not acquired by the corporation within such period in a transaction in which gain or loss was recognized in whole or in part.
In order for a distribution to qualify as a partial liquidating distribution rather than a dividend, (i) the distribution must, as provided in Section 302(e)(1)(B), be attributable to a plan, (ii) must be attributable to a corporate contraction, or to fit within the Section 302(e)(2) safe harbor, must be attributable to the sale of an "activity," with the corporation continuing to operate another "activity" post-sale, and (iii) the proceeds attributable to the partial liquidation must be distributed by the corporation to its stockholders either in the year the plan of partial liquidation is adopted or in the subsequent year. The corporation should file an IRS Form 966 in connection with the adoption of the plan of partial liquidation.
Sections 302(b)(4) and 302(e)(1) provide that in order to qualify as a partial liquidation rather than a dividend, a distribution must be a redemption and must result from a contraction of the business. In spite of the "redemption" requirement, IRS concluded in Revenue Ruling 90-13 that the actual surrender of stock is unnecessary for a pro rata distribution in partial liquidation to qualify as a redemption under Sections 302(b)(4) and 302(e).[24] The IRS also concluded in Revenue Ruling 79-184 that a distribution arising out of sale of a subsidiary's stock is not eligible for partial liquidation treatment.[25] The workaround for this technical issue would be a deemed liquidation of the subsidiary (e.g., conversion to single-member LLC treated as a disregarded entity for federal tax purposes) governed by Sections 332(a) and 381(a), undertaken before the sale of the subsidiary's equity. Also, based on the language of Revenue Ruling 79-184, a sale of a subsidiary's assets followed by the liquidation of the subsidiary and distribution of the liquidation proceeds from the parent corporation in partial liquidation of the parent corporation should also work.
Section 346(b) was the predecessor to the partial liquidation provision now found at Section 302(b)(4). Treasury Regulation Section 1.346-1 and Proposed Regulation Section 1.346-1 provides that the determination of whether the assets sold constitute an "activity" for purposes of the partial liquidation activity safe harbor (i.e., that the sale of assets rises to the level of an "activity" and therefore is a sufficient corporate contraction to qualify for exchange treatment when the proceeds are distributed by the corporation) has the meaning provided in Treasury Regulation Section 1.355-3(b)(2). Section 355 and its regulations address the concept of "activity" in connection with corporate spin-offs. Section 355 provides generally that the determination of whether the assets involved constitute an "activity" is made from all of the facts and circumstances. The Section 355 regulations refer to the requirement that the activity includes active and substantial management and operational functions, the upshot being that the case would need to be made that the assets sold (i.e., the "activity") included management and operational functions. Section 355's regulations and proposed regulations, along with other tax authorities interpreting Section 355, include a significant body of materials providing guidance regarding what would be considered an activity that should translate into guidance regarding whether a sale of assets qualifies as a partial liquidation for purposes of Section 302(e)(1).[26]
Section 331(a) provides that "amounts received by a stockholder in a distribution in complete liquidation of a corporation shall be treated as full payment in exchange for the stock." Section 331(b) further provides that Section 301, which specifies possible dividend treatment for corporate distributions, does not apply to a distribution of property in complete liquidation of a corporation. So even where the distributing corporation has earnings and profits (E&P), the final distribution from the corporation will not be characterized as being sourced from E&P. A stockholder who receives distributions in exchange for his QSBS in connection with a complete liquidation is eligible to claim Section 1202's gain exclusion.[27]
Many sale transactions are structured as asset sales in spite of the fact that a stock sale is optimal when a corporation's stockholders are holding QSBS. An asset sale is often preferred by buyers because it allows for a step-up cost basis in the purchased assets, and can be structured to avoid stepping into shoes of the historic target company with respect to known or contingent liabilities. In other cases, the buyer might want to acquire only part of the target corporation's assets. Whatever the reason, the target corporation will have a corporate level tax on any gain triggered by the asset sale. After the asset sale (or sale of subsidiary stock), the target corporation may continue its business activities or undertake a complete liquidation "when the corporation ceases to be a going concern and its activities are merely for the purposes of winding up its affair, paying its debts, and distributing any remaining balance to its stockholders."[28]
Distributions made without the adoption of a formal plan of dissolution can still be treated as payments in exchange for a stockholder's stock, allowing for the claiming of Section 1202's gain exclusion. But in particular where the dissolution will occur over time and include potentially multiple distributions, the corporation's board should adopt a plan of complete dissolution and file IRS Form 966 prior to making the first liquidating distribution.[29] One method often used to complete a corporation's dissolution is to convert the corporation into a partnership or disregarded entity for tax purposes, which can be accomplished several ways depending on the state law status of the corporation: by converting the corporation into a LLC under state law, via a check-the-box election on IRS Form 8832, or through merger of the corporation into the LLC, with the LLC as the surviving entity in the merger.
A stockholder who receives an installment obligation (which can include rights to future payments in the form of escrowed funds, deferred purchase consideration and earn-outs) that meets the requirements of Section 453(h) can defer the recognition of gain until receipt of the installment payments. A stockholder should consider electing out of installment sale treatment of a distributed installment obligation if the stockholder has sufficient Section 1202 gain exclusion available to offset the gain accelerated as a result of the election.[30] This strategy can lock in the gain exclusion and avoid the potential impact of future changes to Section 1202 or the impact of tax authorities affecting the section.
Any portion of distribution in a partial or complete liquidation attributable to declared dividends would not be treated as exchange proceeds eligible for claiming for Section 1202's gain exclusion.[31]
Despite the potential for extraordinary tax savings, many experienced tax advisors are not familiar with QSBS planning. Venture capitalists, founders and investors who want to learn more about Sections 1202 and 1045 planning opportunities are directed to several articles on the Frost Brown Todd website, or reach out to the author, Scott Dolson, of Frost Brown Todd's Tax Practice.
[1] References to "Section" are to sections of the Internal Revenue Code of 1986, as amended. This article addresses federal income tax issues. The treatment of QSBS at the state and local level differs from jurisdiction to jurisdiction and is not addressed in this article but should certainly be taken into consideration in the planning process.
[2] Section 1202(a) provides "in the case of a taxpayer other than a corporation, gross income shall not include 50 percent [increased to 100% by Section 1202(a)(4)] of any gain from the sale or exchange of qualified small business stock held for more than 5 years." Section 1202(b)(2) provides that "the term 'eligible gain' means any gain from the sale or exchange of qualified small business stock held for more than 5 years."
[3] A commonly seen acquisition structure is to organize an acquiring C corporation to issue what is assumed to be QSBS, and thereafter purchase 100% of the stock of a target qualified small business.
[4] A direct sale of QSBS by a taxpayer will be reported on Form 8949 (Sales and Other Dispositions of Capital Assets) or pass-through to the taxpayer on a Schedule K-1 if the QSBS was sold by a partnership or S corporation.
[5] There are few useful tax authorities addressing this issue. See Technical Advice Memorandum (TAM) 83-37-012 (May 25, 1983); Azar Nut Co. v. Commissioner, 94 T.C. 455 (1990), aff'd 931 F.2d 314 (5th Cir. 1991); Revenue Ruling 58-614, 1958-2 CB 920.
[6] The price for the common stock is often the price set forth a contemporaneous issuance of preferred stock or some discount reflecting the different rights of the preferred and common stock.
[7] See TAM 83-37-012 and Azar Nut Co. In spite of the limitations associated with 409A valuations, corporations routinely use the 409A value when determining what portion, if any, of the consideration paid to selling of preferred stock should be treated as compensation. Tax articles written by tax professionals who work regularly with Silicon Valley companies merely note this fact without challenge. See Tax Issues Related to Startup Secondary Sales authored by Marshall Mort, Hans Andersson, and Shawn Lampron, attorneys at Fenwick & West LLP and Are the Proceeds from a Secondary Sale Taxed as Compensation or Capital Gains? authored by Christopher M. DeMayo, partner at Withum.
[8] Revenue Ruling 59-60, 1959-1 CB 237.
[9]See Sections 301(c), 316(c) and 356(a). If the target corporation doesn't have E&P, then the boot would be return of capital to the extent of tax basis and then "gain" against which Section 1202's gain exclusion could be claimed.
[10] Under Section 1202(h)(4), if QSBS is exchanged for stock in a Section 351 nonrecognition exchange or Section 368 tax-free reorganization, Section 1202's gain exclusion can be claimed in connection with the sale of the replacement stock. If the corporation issuing the replacement QSBS failed to meet Section 1202's "$50 million test" at the time of issuance, the amount of Section 1202 gain exclusion will be limited by Section 1202(h)(4)(B).
[11] See Section 1202(h)(4). The eventual results differ if the stock received in the exchange is QSBS or "quasi-QSBS." Section 1202(h)(4)(B) provides for a limited Section 1202 gain exclusion when the replacement QSBS is eventually sold if the issuing corporation did not qualify as an issuer of QSBS at the time of the exchange of original QSBS for replacement QSBS.
[12] A stockholder might want to trigger a taxable transfer for the purpose of claiming Section 1202's gain exclusion because of a fear that Section 1202 might be amended or revoked.
[13] Section 317(b) provides that "stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock."
[14] Treasury Regulation Section 1.316-1(c) provides as follows: "the term 'dividend' includes any distribution of property to shareholders to the extent made out of accumulated or current earnings and profits. See, however, section 331 (relating to distributions in complete or partial liquidation), section 301(e) (relating to distributions by personal service corporations), section 302(b) (relating to redemptions treated as amounts received from the sale or exchange of stock), and section 303 (relating to distributions in redemption of stock to pay death taxes)."
[15]United States v. Davis, 397 US 301 (1970).
[16]Himmel v. Commissioner, 338 F.2d 815 (2d Cir. 1964).
[17] See Revenue Ruling 85-106, 1985-2 CB 116. In CCA 200409001, the Chief Counsel's Office advised that the right of control is a key right in determining if a redemption substantially reduces a stockholder's interest in a corporation.
[18]Patterson Trust v. United States, 729 F.2d 1089 (6th Cir. 1984) and Wright v. United States, 482 F.2d 600 (8th Cir. 1973).
[19] Revenue Ruling 77-218, 1977-1 CB 81 (dividend treatment where reduction was from 60% to 55%).
[20] Revenue Ruling 75-502, 1975-2 CB 111 (exchange treatment where reduction was from 57% to 50%).
[21] In Revenue Ruling 84-111, 1984-2 CB 90 and Revenue Ruling 76-364, 1976-2 CB 91, the IRS ruled for sale treatment in voting reductions from 29% to 23% and 27% to 22% that were accompanied by loss of concerted control. Where there is no possibility of control by a minority stockholder, even a small vote reduction generally results in sale treatment. See Revenue Ruling 75-512, 1975-2 CB 112 (drop from 27% to 22% was not a dividend where stockholder took no part in management); Revenue Ruling 56-183, 1956-1 161 (reduction in group's ownership of common stock from 11% to 9% not equivalent to a dividend).
[22] See Private Letter Ruling 91110760 (holding 8) (12/21/90); Revenue Ruling 69-130, 1969-1 CB 93; and Revenue Ruling 69-131, 1969-1 CB 94.
[23] See Treasury Regulation Section 1.346-1(a)(2).
[24] Revenue Ruling 1990-1 CB 65.
[25] Revenue Ruling 79-184, 1979-143. An actual redemption of stock may make sense if a stockholder intends to take advantage of Section 1202's 10X gain exclusion cap. There are no tax authorities providing actionable guidance on this issue.
[26] A corporation should be engaged in two activities if it operates a software development and licensing business and manufactures widgets. If a corporation has multiple store locations, it is possible that each store could qualify as separate activities. Finally, the marketing and manufacturing divisions of the sale business could potentially qualify as separate activities.
[27] Subject, of course, to satisfying all of Section 1202's eligibility requirements.
[28] Treasury Regulation Section 1.332-2(c).
[29] An example of a situation where there might be multiple distributions would be where the corporation sells its assets and the purchase agreement includes an up-front payment, escrows of purchase consideration and an earn-out. One strategy would be to keep the corporation "alive" while the payments play out rather than triggering a distribution of both of the up-front cash and the value of the contract rights to the deferred payments by completing the liquidation of the corporation (including by converting the corporation to an LLC taxed as a partnership or disregarded entity).
[30] This decision will depend on a stockholder's personal facts and circumstances, including the amount of available Section 1202 gain exclusion, taking into account the applicable gain exclusion caps, and the stockholder's state of residence (i.e., whether the state follow the federal treatment of QSBS or like California, doesn't recognize Section 1202).
[31] See footnote 21.