Time to Consider Item 1202 Stock | Trout pepper

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As has been widely discussed, the Treasury Department has released “General Explanations of Revenue Proposals for the Tax Administration for Fiscal Year 2022,” which include a potential increase in long-term capital gains rates for taxpayers meeting certain annual income thresholds. While the outcome of this tax proposal is unclear, taxpayers should consider taking advantage of the favorable tax treatment of Qualified Business Actions (QSBS) under Section 1202. [1] Section 1202 provides a framework for pre-existing and newly incorporated corporations to attract capital investment because of its attractive federal tax benefits. Generally, an unincorporated shareholder can exclude up to 100% of the gain recognized on the sale of QSBS held for more than five years, capped at the greater of $ 10 million or 10 times their tax base. initial investment. [2] It should be noted that this limitation applies per company and per shareholder.

The shares of a company may qualify as QSBS if the following conditions are met:

  • the share is issued to an unincorporated shareholder (individuals, trusts, estates and, in certain circumstances, persons owning QSBS through a partnership, LLC imposed as a partnership or S-corporations);

  • the issuer is a C company;

  • shares are acquired directly from the company upon initial issuance in exchange for money or other property (excluding shares) or in compensation for services;

  • the total gross assets of the small business from inception to the date of issue of the share (including the proceeds received in exchange for the share) is $ 50,000,000 or less. Aggregate gross assets are generally equal to the amount of cash and the aggregate adjusted basis of assets held by the company; [3] and

  • for most of the time the shareholder owns the shares, the small business is engaged in a qualified trade or business and uses 80% (by value) of its assets in the active conduct of one or more trades or qualified companies.

The use of Section 1202 shares is a relatively new phenomenon in the world of tax planning. As such, the IRS has issued little guidance to address the uncertainty of some of the QSBS requirements. For example, the IRS Tax Code defines a “qualified trade or business” as any trade or business other than: (i) any trade or business involving the provision of services in certain areas, including, but not limited to, accounting, engineering, consulting, financial services, brokerage services, law, health or any other trade or business, where the main asset is the reputation or competence of one or more of its employees ; (ii) any banking, insurance, financing, leasing, investment or similar activity; (iii) any agricultural enterprise; (iv) any mining, oil or gas company; and (v) any business operating a hotel, motel, restaurant or similar business. While the definition of services may seem straightforward, the activities of many business organizations may be uncertain when applying this rule. The IRS has issued a handful of private letter rulings on the matter. For example, the IRS ruled that a company that provided research to pharmaceutical companies was not considered a service company because it did not offer services in the form of individual expertise. [4] The IRS recently issued a ruling by private letter, addressing what constitutes brokerage services since it is not defined in section 1202. [5] After noting the definition of broker in the Merriam Webster dictionary, the IRS ruled that a broker is a business that simply acts as an intermediary. The open questions in this area are important. If taxpayers are concerned about meeting the business or business exclusions of Section 1202, they may choose to review the Section 199A regulations to determine how the IRS may interpret their trade or business for Section 1202 purposes.

In particular, special rules concerning redemptions linked to the issue of QSBS and tax-free transactions may apply. Another useful feature of QSBS shares is that an elective shareholder can sell the original QSBS as part of an otherwise taxable transaction and buy new QSBS within 60 days of the sale without generating a gain if the QSBS shares have been held for at least six months as long as the proceeds of the sale do not exceed the amount invested in the replacement QSBS. [6]

Under the right set of facts, QSBS shares can have significant tax advantages for investors to eliminate 100% of capital gains. Future federal legislation increasing capital gains rates could make this even more attractive in the future.


[1] Unless otherwise indicated, all references to the “Section” are to the Internal Revenue Code of 1986, as amended, and all references to the “Regulation” or “Treas. Reg. Are in the Treasury Regulations promulgated by virtue thereof. This article does not discuss the state and local tax treatment of Section 1202 actions, which may vary.

[2] QSBS shares issued from August 11, 1993 to February 17, 2009 are eligible for a 50% federal income exclusion. QSBS shares issued from February 18, 2009 to September 27, 2010 are eligible for a federal income exclusion of 75%. QSBS shares issued after September 27, 2010 are eligible for a 100% exclusion, the current QSBS gain is also 100% excluded from the alternative minimum tax and net investment income tax of 3, 8%.

[3] See Section 1202 (d) (2) (B), which provides that the adjusted base is equal to its fair market value at the time of assessment. Fair market value is measured for the purposes of the $ 50,000,000 threshold, regardless of whether the property was contributed in connection with a section 351 transaction that currently requires a deferral of the asset for the property. made for other tax purposes. There is also no tally of the holding period of assets contributed to QSBS to measure the five-year holding period requirement.

[4] PLR 201436001 (September 5, 2014). See also PLR 201717010 (April 28, 2017) (the company that provided medical test results without diagnosis and treatment was not a service provider).

[5] PLR 202114002 (January 13, 2021).

[6] See Article 1045.


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