All posts tagged 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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Where Do I File My 83(b) Election?

Where Do I File My 83(b) ElectionIf you have never filed a Section 83(b) election before, you might not know where to file it.

Increasingly, founders come to me who have been filing their Forms 1040 electronically. Many of these founders have never filed paper returns, and when I tell them they have to file the 83(b) election with the office of the IRS at which they file their returns, they don’t know what I am talking about. Because they haven’t been mailing in their Forms 1040, they don’t know where to file a Section 83(b) election.

They say to me: “I have e-filed the last few years so I actually don’t have an address when I look at my returns.”

The IRS Regulations make clear where you are required to file the 83(b) election.  They provide as follows:

“The election referred to in paragraph (a) of this section is made by filing one copy of a written statement with the internal revenue office with whom the person who performed the services files his return.”

If you don’t know where to find the physical address, you can refer to the instructions in Form 1040.

You can find these instructions at www.irs.gov/pub/irs-pdf/i1040.pdf. At the time of this blog post, the places to file were found on page 104.

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Is the QSB Stock Tax Exclusion Even Worth It?

QSB stock tax exclusion1In the throes of the end of last year, when people were trying to figure out whether to incorporate a C Corporation before year end to try to set themselves up to qualify for the Section 1202, qualified small business stock 100% exclusion from tax benefit (subject to a $10M cap), I heard the following claim made:

“You can only exclude 10x your basis in your stock. Thus, if you are a founder, and your basis in your stock is very, very low–the exclusion isn’t worth much.”

If the above statement was true, the Section 1202 exclusion for qualified small business stock would indeed not be much of a benefit for founders, who typically don’t have a large cost basis in their shares.

Most founders might pay just a few thousand dollars for their founder shares. If a founder paid $2,000 for his or her shares, and the most they could exclude from tax was 10x that, the exclusion would only shelter potentially up to $20,000 in income from tax.

If you could only exclude 10x your basis in your shares from tax, Section 1202 would indeed be a meager prize.

But is the above statement true?

No.

Section 1202 reads as follows:

(b) Per-issuer limitation on taxpayer’s eligible gain

(1) In general

If the taxpayer has eligible gain for the taxable year from 1 or more dispositions of stock issued by any corporation, the aggregate amount of such gain from dispositions of stock issued by such corporation which may be taken into account under subsection (a) for the taxable year shall not exceed the greater of—

(A) $10,000,000 reduced by the aggregate amount of eligible gain taken into account by the taxpayer under subsection (a) for prior taxable years and attributable to dispositions of stock issued by such corporation, or

(B) 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year.

For purposes of subparagraph (B), the adjusted basis of any stock shall be determined without regard to any addition to basis after the date on which such stock was originally issued.

Thus, you get the greater of 10x or $10M. Rest assured founders, the benefit is ample if you qualify.

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