All posts tagged Qualified Small Business Stock

Section 1202: Original Issuance

Section 1202 Original Issuance

Question

I am a small business owner and investor who read your informative blog post “Section 1202, Qualified Small Business Stock.”  However, I would like to ask for your clarification of an important requirement for the small business stock capital gain exclusion.

Concerning the “original issuance” requirement, you stated that “QSB stock means any stock acquired on original issuance by the taxpayer from a domestic C corporation…”

My understanding of the meaning of “original issuance,” is that it is stock issued by a corporation at the time of its incorporation, and does not include new stock subsequently authorized and issued by the corporation at a later time.  Practically speaking, this would mean that QSB “original issue” stock could be purchased from a new startup, but not from a corporation that had been in existence for a year, whose directors opted to raise capital by authorizing and offering a new issue.

Alternatively, does “original issue” simply mean stock an investor purchased directly from the issuing C corporation (or through its underwriter), as opposed to acquiring the stock from another investor, or from a broker?  Must an investor desiring the benefit of the gain exclusion provided under Section 1202 purchase only from a startup at its time of incorporation?

Short Answer

The short answer:  Section 1202 can cover shares issued at any time and from time to time after the incorporation of the Company, provided the various requirements of Section 1202 are met at the time the shares are issued and throughout the time the shares are held.

Not-So-Short Answer

Internal Revenue Code section 1202 defines “qualified small business stock” as any stock in a C corporation which is “originally issued” after the date of the enactment of the Revenue Reconciliation Act of 1993, if:

(a) as of the date of the issuance, the corporation is a “qualified small business,” and

(b) except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its “original issue” (directly or through an underwriter) –

(i) in exchange for money or other property (not including stock), or

(ii)as compensation for services provided to such corporation (other than services performed as underwriter of such stock).

The statute does not define “originally issued” or “original issue.”  But a plain English reading of the phrase would mean to me, as a lawyer, that the shares are supposed to come directly from the company – not purchased from another shareholder.  In other words, shares purchased on the secondary market wouldn’t qualify.

Nowhere does the statute say that the stock has to be issued at the time of incorporation.  If Congress had wanted to say that Section 1202 only worked for shares issued as part of the incorporation process, it could have easily done so.

Plus, there is language in the statute which would be completely incongruous with the meaning of “original issue” being  only at the time of incorporation.  For example, the reference to an “underwriter.”  Underwriters aren’t typically present at incorporation.  Similarly, Section 1202 (c)(3) says that stock acquired by the taxpayer will not be treated as qualified small business stock if at any time during the 4-year period beginning on the date 2 years before the issuance of the stock, the corporation issuing the stock purchased any of its stock from the taxpayer or a person related to the taxpayer.  If the statute only covered shares issued at incorporation, the inclusion of the 2year look back language wouldn’t make sense.

There are a number of things that have to happen in order for stock to be “qualified small business stock,” but none of them is that the stock has to be issued on the incorporation or in connection with the incorporation of the company.

In other words, stock issued several years after the incorporation of the company can qualify, if the various requirements are satisfied.

To give you a sense of some of the things that are required:

  1. The aggregate gross assets of the corporation before and after the issuance of the shares cannot exceed $50,000,000;
  2. The corporation must be a domestic C corporation;
  3. The corporation must be engaged in an active trade or business; and
  4. The corporation’s business must be a “qualified trade or business.”

So, to answer your question, there is no requirement in Section 1202 or the regulations under Section 1202 limiting the benefits solely to stock issuance at the time of incorporation.

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Going, Going, Gone: Qualified Small Business Stock

QSBS

You may or may not be aware of this, but come December 31, 2013, one of the most exciting tax incentives for investing in startups is going to expire.  What am I talking about?  The 100% exclusion from tax for investing in qualified small business stock.  This benefit expires on December 31, 2013, and it is unclear whether Congress will renew it.  What I mean by this benefit expiring is, if you want to set yourself up to take advantage of this benefit down the road (you have to hold the stock for 5 years to avail yourself of the tax break), you have to acquire the qualified small business stock before the end of this year.

What does the 100% exclusion entitle you to?

Up to $10M in capital gains can be entirely excluded from tax, including the alternative minimum tax.  What you generally have to do to qualify for exclusion is:

  • Form or invest in a C corporation before the end of this year.
  • Have that C corporation start actively conducting a business this year.  (Under IRC Section 1202, stock is not treated as qualified small business stock unless, during substantially all of the taxpayer’s holding period for such stock, the corporation was engaged in an active trade or business.)  What this means is it is not good enough to simply incorporate this year; the new corporation has to do business this year as well.  Obtain your business licenses, open your bank accounts, and do business.
  • Have that business qualify as a “qualified small business.”  For example, software and Internet companies typically qualify.

For a more thorough discussion, check out my post on Section 1202.

What should you consider doing?

  • If you are pondering an investment in a C corporation that you could close either this year or next year, you may want to close it this year, so that you can potentially take advantage of this tax benefit down the road.
  • If you have an LLC that you have been considering converting to a C corporation, you might want to do it before year end.
  • If you formed a C corporation this year, and you were thinking you made a mistake and should have been doing business as an LLC, this information may provide you with an additional reason  to remain a C corporation.

Call your tax lawyer or tax accountant if you are on the fence about what to do.

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Can An S Corporation Issue Qualified Small Business Stock?

Q&AI am the founder of a company.  If I formed my startup as an S corporation, can I convert it to a C corporation before the end of this year and still get 1202 status for my founder stock?

Answer:

Section 1202 stock is entitled to a special tax break if held for five years. If acquired between 9/27/10 and 12/31/13 – the break is 100% (subject to a generous cap).*

No.  “Qualified small business stock” means stock in a C corporation, if “at the date of issuance, such corporation is a ‘qualified small business.’”  A “qualified small business” means a C corporation.

What this means is that if you initially formed your company as an S corporation and you terminate your S election before the end of this year, your founder shares will not qualify for the 1202 stock benefit (because you will have not received them when the company was a C corporation).

If you convert to a C corporation, subsequent investors may obtain the 1202 benefit, however.  The reason for this?  Because IRC Section 1202 (c)(1) says: “as of the date of issuance, such corporation is a qualified small business.”  But shares received while the company was an S corporation cannot qualify.

The answer is different if you are currently an LLC and you incorporate.  If you incorporate an LLC, your founder shares can qualify for the Section 1202 benefit.

* For more information on Section 1202 generally, please see this blog post:  startuplawblog.com/section-1202-qualified-small-business-stock 

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