On-Demand: Section 1202 Capital Gains Exclusion

It's a per issuer limit, which means that it's per companies so a person can technically claim exclusion on a variety of different unrelated qualified small businesses to be claimed over and over If a person has the luck to and the great fortune to have invested in qualified small business stock.

Keep in mind there's $10 million lifetime limit exclusion per company. The code specifically says that if they file their personal tax return, filing separately because that's where its claimed. This claims on a personal 1040. The exclusion is $5 million per spouse and then since the code specifically calls this out on, the general consensus is if that a person files their 1040, jointly the $10 million limit is not doubled, it's sold $10 million in total. It's not $10 million per spouse, it's $10 million in total.

This exclusion is from federal capital gains tax and the net investment income tax, The 3.8 net investment tax. So if a person benefits from this exclusion, they could save 23.8% tax. So for every dollar exclusion under Section 1202, they're saving 23.8%. This net investment income tax was enacted back in 2013 as part of the Affordable Care Act. Due to time constraints were not going to go deep into Section 1045. 1045 is a related code section of 1202, it's a deferral provision.

What 1045 allows is a person that holds qualified small business stock for more than six months. And what happens if they have to sell their stock before the five-year holding period is up? A person can have qualified small business stock for five years. They get an offer they can't refuse to sell the stock of the company. They're not going to be able to ask the buyers to hold off for another year until they sell.

So what 1045 allows is if a person holds it for more than six months and they sell it for five years, if within 60 days of the sale, they sell that stock, if they sell that stock and then they identify within 60 days another qualified small business, they can defer that gain and reinvest that proceeds in another qualified small business. It's important to note that 1045 is an election. You actually have to affirmatively elect into 1045 whereas 1202 is strictly an exclusion.

In order to understand why Section 1202 has largely been ignored for the first 20 plus years it was enacted and why it's become so relevant now, this chart really illustrates and drives home those two scenarios. If you look from August 11, 1993 through February 17, '09, the exclusion ratio, the amount eligible for exclusion is 50% up to the ceiling I mentioned of $10 million or 10 times the basis. And then from February 18th, the stock is acquired from February 18, 2009 through September 27, 2010. The exclusion ratio is 75%.

And the best case scenario if the stock is acquired from September 28, 2010 going forward, the exclusion is 100%. If you look at the different columns on top, at the 50 and 75% exclusion, for the amount that's not excluded, this is of course in 1202. So if you're in the 50% exclusion bucket and you have a $100,000 gain, 50 of that is excluded. So 50,000 you're excluding. The other $50,000 that is tax is taxed at 28%. And whatever is excluded additionally, so you've excluded $50,000 and you're paying tax on $50,000, whatever is excluded is also, there's a 7% alternative minimum tax add-back.

So the reason why 1202 was largely ignored for the first 20-plus years is from 2003 until 2012, capital gains rates were 15%. Now, they're 20% but for almost a decade, they were 15%. So if you were in the 50% exclusion bucket, and so you're paying 28% tax on the amount that's not excluded, your effective tax rate is 14%. So if capital gains rates are 15% and then your effective tax rate is 14%, in Section 1202, it really was not worth going through all the requirements and clearing all the hurdles for 1202.

So a couple of things happened along the way. In 2012, the capital gains rates were increased to 20% and then a year later the net investment income tax was brought in which was 3.8%. So essentially, the top tax rate on capital gains rates in a matter of a couple years, went from 15% to 23.8%. That's a big difference if you have a large gain.

The other reason why 1202 is so relevant now is you see from September 28, 2010 going forward, the exclusion ratio was 100%. But that was temporary. The congress would extend it every year. There'd be some back and forth whether they're going to send 100% exclusion. And then finally in 2015, they made this exclusion ratio permanent for 100% exclusion. So you also have to hold it for five years. So from 2015, when it was made permanent until 2020, now people that have held their stock since that time, they're thinking about selling, they think about exiting and we're getting significantly more activity in 1202 than we've ever gotten.

When I first got involved in Section 1202, when our co-practice leader asked me to get involved in Section 1202 almost a decade ago, it was a sleepy provision that no one really talked about and now this is one of the hottest areas of taxation.

So we're going to walk through all the requirements of 1202. This is at a high level and we'll go into detail on each requirement. Number one, the stock must be issued by a domestic C-corporation with less than 50 million in assets at the time of and immediately after issuance. It must be issued by a corporation that uses at least 80% of its assets and the active trader business other than a personal service services.

Number three, it must be held by a non-corporate taxpayer. So it could be held by an individual. It could be held by partnership. An LLC tax is a partnership. An LLP, it could be held by an S-corporation. It just cannot be held by another C-corporation. Number four, it must be acquired by the taxpayer on original issuance. Number five, it must be held by the taxpayer for more than five years.

So at the outset it looks pretty simple. Just meet these five requirements and then I'm eligible for 1202. There are a lot of rabbit holes with 1202, so that's what we're going to talk about today. Some additional qualifications. Qualified small business stock, like I mentioned does not apply to an equity interest, in a pass-through entity such as a partnership or an S-corporation. It only applies to C-corporation stock. However, qualified small business stock can be held by a partnership or an S-corporation. However, the partner or the S-corporation shareholder must have held their interest in the partnership at the time the qualified small business stock was acquired and they must be in that S-corporation and that partnership the entire time until the qualified small business stock is sold.

So those are the things to keep in mind if qualified small business stock is held by a pass-through entry not directly by an individual. Additionally, the amount that's eligible for exclusion is what their ownership ratio was at the time that the entity held purchased the qualified small business stock. So if a person's a 10% partner in the partnership when the ABC partnership acquires qualified small business stock, and then let's say two years later, their ownership percentage goes up to 20%. And then four years later the partnership sells the qualified small business stock.

That original partner, their gain eligible for inclusion is that 10% ratio. It's not the 20% ratio. So there's a lot of tracking that needs to be going and Kayla will be talking about that in a little bit.

Now, let's talk about the aggregate gross asset test. This is one of the key tests and the magic number is $50 million. And this is based on tax basis, the tax basis of the assets plus the fair market value of property contributed at the time of contribution, the fair market value. And Kayla will go into deeper detail as far as property contributions.

So if at any point during its existence, the corporation exceeds $50 million in assets. It can no longer issue qualified small business stock. However, any stock that's issued prior to that threshold being breached would not be tainted. So let's say for example, two stockholders contribute two million dollars into a corporation at inception and then four years later, they're very successful, they have a capital raise bringing additional investors and cash into the company, they bring in $60 million.

So any stock issued during that raise would not be eligible for 1202. However, those original shareholders, those two shareholders that put $2 million four years before that, that would be eligible for 1202. And all the other requirements that we're going to talk about today will need to be met for 1202. Corporations that are part of a parent subsidiary control group.

So if the parent company has more than a 50% owned subsidiary, then those assets get included with this $50 million test. And this is something that needs to be tracked the entire time throughout the company's existence. So if you have multiple issuances of stock, if you want to track to see if the stock is eligible for 1202, this $50 million threshold needs to be tracked closely.

A possible planning technique is electing a bonus depreciation or Section 179 expensing on fixed assets as that reduces the company's tax basis in this fixed assets. So you've met these other requirements, I've mentioned. Now, the company must meet the active business requirement. So at least 80% of the assets by value must be used by the corporation, the act of conduct or one or more qualified businesses. And we'll talk about on the next slide what a qualified small business is.

There are exceptions to this and the reason for this rule is that when the congress drafted this code section, 1202, they didn't want companies just holding companies just sitting on a pile of cash. They're not really an active business. So there are exceptions for reasonable working capital needs. The code doesn't spell out what reasonable working capital needs are. There's some speculation that may be enough cash for the next operating cycle. If the cash is held for research and development expenses and for startup expenses, those three items if the cash is held for them, they're subject to certain limits. But if they're held for those three activities, they would not violate the active business requirement.

There are two more requirements for the active business threshold. No more than 10% of the company's assets by value can be portfolio securities and no more than 10% of the corporations, assets can be in real estate holdings. And for purposes of 1202 rental real estate and similar businesses are not considered an active trader business.

So what is a qualified trader business? So the way tax code spells it out, it doesn't tell us what are the qualified trade businesses, it tells us what qualified trade business is not. And you'll see a theme here where it's more personal services type companies that aren't eligible. They were looking to spur investment in companies that are making things, making widgets whereas accounting firm and yes, we're making tax returns and financial statements, but that's not what they were looking to spur investment in.

So any trade of business involving the performance of services in the fields of healthcare, law, engineering, architecture, accounting and financial services. So for this example, for healthcare. A doctor's office would not be eligible for Section 1202. But what about a company that's in the same field? So a medical diagnostics company. Think of Quest Diagnostics, a company like that obviously would have to be a lot smaller, but they're taking blood test and they're conveying the results to the doctors.

The doctors are making the actual diagnosis. The people in the lab are literally just processing it and they're sending the results over the doctor. So the IRS has ruled that a medical diagnostics company, even though they're in the health field would be eligible for Section 1202.

The next one, any trader business with a principal asset of such trade or business is the reputation or skill of one or more employees. This is very vague. It can probably catch a lot of businesses, but Section 1202 does not really provide any guidance on this, but we could theoretically look at Section 199A which talks about the 20% pass-through deduction while not binding on 1202. It could give us some guidance to the thinking of how the IRS would think as far as this trader business.

In 199A, it talks about if you have a celebrity chef and they're endorsing a pasta sauce in the supermarket. So something like that where that's really the driving factor of those sales is the chef's face on the pasta sauce. So something like that. It's a very narrow definition within 199A, which parallels to 1202, so we might be able to look to that to see some guidance there.

Some additional ineligible businesses are banking, insurance, financing, leasing, investing in similar businesses, farming businesses. Any business eligible to claim depletion deduction. So think of oil and gas companies, businesses operating in the hospitality business such as hotels, motels and similar type businesses. And again, this 199A is qualified business deduction that passed a few years ago unrelated to 1202. They actually cut and pasted a lot of this to show which businesses are ineligible to claim that deduction as well.

So this may sound familiar to some of you. So what is an eligible corporation? For 1202, in order to be eligible for qualified small business stock, it must have been a domestic C-corporation so it must be incorporated in America, in the United States at the time of issuance, at the time of sale and for substantially all the holding period. Again, the tax code does not say what it says what it cannot be. So it cannot be a DISC which is a domestic international sales corporation, a regulated investment company, a real estate investment trust or also known as a REIT. It cannot be a real estate mortgage investment conduit and it cannot be a cooperative.

And with that, I will turn it over to Kayla to discuss the original issuance requirement.

Kayla Konovitch:Thanks, Ben. Okay. All right. So another requirement is that the stock, the qualified small business stock must be acquired at original issuance. So what does original issuance mean? That means it has to be directly purchased and the shares issued directly by the corporation or it could actually be done through an underwriter, but again, it has to be originally issued by the company and it has to be that it's an exchange for money, for property other than stock or as compensation for services that were provided to the corporation.

So I mean it seems straight up, but honestly it could get complex in this area. And with any provision there's always some exceptions. If you had let's say transfers, let's say gifting or inheritance or certain tax free organizations, that could actually still qualify as original issuance and we'll get into that a little bit later. So just to go over more simple examples of what we're talking about by original issuance, in our first example, "Adam acquired 100 shares of X Corporation directly from X, directly from the corporation in exchange for cash."

So in this scenario, I mean, that's really the classic plain vanilla that's clearly original issuance that would qualify. In the second example, Adam acquired 100 shares of X Corporation directly from the corporation, but here it's in exchange for 100 shares that Adam owned in Y Corporation. In this scenario that would actually not qualify, because again we said one of the requirements is that it could be in exchange for property, but not other than stock.

So in this scenario it would not be considered original issuance and it would not qualify for this exclusion. In the third scenario, Adam acquired 100 shares of X corporation from Sam in exchange for cash. In this case, we're illustrating that he did not buy it directly from the corporation. It was from his friend, Sam, and in this case it would not qualify as original issuance.

In the fourth example here, Adam was issued restricted stock of Corporation X in exchange for services that he provided to the corporation. In such a scenario, if Adam also made a Section 83B election for this stock, would it actually be considered original issuance? And the answer is yes. We said that it could be in exchange for compensation of services. We'll get into the 83B election a little bit later.

But overall, again, it is requirement that it does need to be original issuance. Okay. So over here we put together a scenario that we just wanted to bring up and just something to consider. This is actually a pretty standard scenario that we see sometimes in private equity. It could be growth equity or leverage buyout funds. We do see this coming up sometimes and it's just a question really if such a scenario would qualify as original issuance.

So before we go through it, I'll tell you that just to give you a little organizational structure of what the shapes actually mean. If it's a circle where it's a general partnership GP or LP, that actually means that that's an individual. If it's a triangle where it says private equity fund, that's a partnership structure. And the two boxes below, the squares there are actually our corporations.

So in this scenario, the private equity fund wants to purchase the stock of their target Puppy Pooch Inc. They want to purchase that company. Puppy Pooch is a manufacturer of puppy apparel. Their assets are way under their tax base. So their assets are way under 50 million. They're good in a good active trade or business. They want to purchase the stock from the founders.

Now, the question becomes, well, if they purchase it directly from the target, from the founders, clearly, I mean that's not an original issuance and that would not qualify. So the question becomes, well, if the private equity fund formed this new co-holdings company, a brand new formed corporation where they got original issue stock in exchange for money that they put into this corporation, is that considered original issuance that would qualify here? And by the way, there there may be a number of business reasons that they may structure it like this in private equity.

This can be used as the platform acquisition where later on they may purchase additional lines of businesses and added to this parent as a subsidiary. So there could be business reasons that you may structure it like this. So the question becomes, well, is the new co-holdings stock, would that qualify as original issuance. Again, I'm bringing this up because it's something to think about. The actual Section 1202 rules are very brief. They're ambiguous and it doesn't go into a lot of detail and there's no regulations or any legislative history on this.

So there's just a lot of questions surrounding this. In addition, I'm throwing this out there, something to consider, but at the same time there's also a provision. Although, at the end of 1202, it's 1202K and it does actually say that the IRS can come in and they can issue regulations to prevent any sort of anti-abuse. So just keep that in mind. Anti-abuse, obviously, what does it mean? They mentioned maybe split ups or shell corporations and partnerships.

So again, there is this question. But I do want to point out that these code section was enacted August 10, 1993, which is over 27 years ago and there has not been any regulations that were issued. So again, just bringing it up as something to think about.

Okay. So in this structure, again, it's the same shapes, right? The circles mean an individual, the partnership is a triangle and the square there illustrates that that's a corporation. So in this scenario, this is a what we call a blocker entity with a pass-through investment. What we mean by a blocker entity, we use that term a lot in private equity.

A blocker entity is typically set up so that one of the uses may be so that if you're investing in a partnership that has operating activity, the income doesn't flow straight up to the fund which can impact the foreign investors or tax exempt investors. And in those situations, they may form what they call a blocker corporation so that if the fund, they're directly investing in stock and not through a partnership interest with activity.

So in this scenario, the private equity fund wants to purchase Tile Home LLC, their target company which is a partnership. In doing so, again there could be business reasons, other tax reasons that they want to form. In the acquisition, they form this new co-holdings company. What we're going to focus on now is not that original issuance question, we're going to focus on well, what if in certain circumstances, would Newco Holdings qualify and meet the active business requirement test when it's actually conducted through a partnership?

So Tile Home LLC, that's a partnership that's owned by this corporation in our case, it's owned 90%. So before Ben mentioned that there's this parent subsidiary control test when you're looking at the active business requirement that you can attribute the subsidiaries activity to the parent if they control it more than 50%. So the question becomes, "Can that activity be attributed to Newco Holdings so that it would meet the active business requirement.

Again, this code section doesn't parallel anything or bring up the partnership structure or something like this. So it is silent and that just was another question if such a structure would actually be possible to get a benefit here. So we're just mentioning that as just something to think about.

Okay. So another requirement is that the qualified small business stock has to be held for five years. How is that measured? That would be measured on the date of issuance. When that stock is issued, that's when you measure the holding period. Now, in certain situations, if you have a tax-free transaction or a reorganization, under certain provisions, under Section 351 or in the 368, basically, the holding period can actually tack on. So that's actually a good fact.

But I do want to say that there is a limitation. If you have a qualified small business, that was a good eligible business and then they did a tax free restructuring under an exchange under Section 351, and that business no longer, the new exchange stock is no longer a qualified small business stock, then you have to measure there's this unrealized built-in gain up to the date of that restructuring where it would sort of freeze in place. It would only be that amount that has potential to be excluded from gain.

Anything subsequent to this restructuring would not actually be eligible for this exclusion when you sell it. Now, of course if you had qualified small business stock that was good eligible stock, and you had a tax-free restructuring in this exchange, you would actually, and it would still would qualify as qualified small business stock. So if the original stock and exchange stock all would qualify, then there wouldn't necessarily be a limitation and the full amount potentially can be excluded.

Okay. So Ben mentioned before Section 1045 that's that rollover provision. If you owned a qualified small business stock for at least six months and you sold it before you actually held it for the full five year period, then you can actually within 60 days, you roll over those proceeds into a new qualified a small business stock investment, if that's the case, then the holding period would actually tack.

So if you held it for two months prior and then roll the proceeds into another good qualified small business stock, you'd only need just another three years in order to qualify and meet the five-year holding period.

Okay. So we get a lot of questions. This comes up in the venture capital all the time. They want to know do the stock options, do the warrants, does the convertible debt, do these financial instruments itself do they qualify as qualified small business stock? So the answer is that these instruments itself do not qualify. However, when you actually exercise or convert them, if you have its options or warrants and you actually exercise them, it's the date that you exercise that you need to test that it meets the needs of the qualified small business stock provisions and the holding period would begin.

So if you have incentive stock options, the holding period would begin on the date of exercise. If you have restricted stock, where you did not make an 83B election, that would be on the date of vesting is when the holding period would begin. And if you have restricted stock where you did actually make an 83B election, then the holding period would begin on the date of election.

So just to give you a little background the 83B election, that's where you have restricted stock and the vesting, it's not fully vested but you could make this election to pick up the fair value of this stock and actually pay taxes now on it. If you did make such an election, the holding period will begin on the date of election. And by the way, you have to think about if you do want to make election or not, there's various implications that we're not going to get into here, but again if you did make the election, the holding period will begin on the date of election.

So it's really important to look at these rules. I just had a question that came up yesterday. Somebody asked me, they had a client that they had convertible debt and they converted it into equity and they now sold out this equity position and they were looking at the holding period and they realized that because you have to measure this, the holding begins on the date of exercise.

They actually end up missing this exclusion provision because of a few days. So just be careful when you're going to these investments that you're monitoring and tracking that holding period, and again it's from the date of exercise and the date of conversion. In addition, if you have convertible preferred stock and you convert it to common stock, the holding period would tack as well.

Okay. So one of the original issuance requirements, we said that it has to be in exchange for money, it could be an exchange for property other than stock. So in such a scenario where you have property that you're exchanging for this stock, the holding period for this stock that you're now acquiring begins on the date of the exchange. It doesn't take the holding period of your original property.

So it's from the date of the exchange. In addition, the basis of that stock is not going to be less than the fear market value of the property that's exchanged. Now again, this provision is if this is a statement that's just for the Section 1202 when you're looking at the gain in terms of what amount would be excluded. So what would happen is that if you had property that you then contributed, exchange for qualified small business stock, that property you would have to measure and see what's the built-in gain at that date on that property?

And that built-in gain, that unrealized built-in gain would have to be recognized when you actually later sell the stock. That amount is not eligible for this exclusion. Any post appreciation on that qualified small business stock after you exchange it, that post appreciation could actually be eligible for the game. This happens when you may have an LLC that converts to a C-corporation and I do want to point out that it is really important to get evaluation done.

The valuation is important because you have to measure and see what the unrealized built-in gain is at that time. In addition, it's actually a benefit for determining the amount that's excludable for this exclusion. One of the provisions that I've mentioned before is that you can get to exclude either the greater of 10 times your basis or $10 million. So if the basis now is that fair market value, that's a higher amount than 10 times the basis that actually can be a very nice deduction that you can benefit from here. And we're going to have an example a little bit later in this session to go over a scenario like this with a property exchange.

All right. Let's talk about carried interest for a few minutes. I know there's a lot of questions in this area, a lot of discussion and generally so Ben mentioned before that if you are a partner in a partnership, you have to be in the partnership at the time the partnership acquired of that qualified small business stock and throughout the holding period and when they ultimately sell the stock.

So the question is with carried interest. Carried interest is like a special profits interest essentially. We see this a lot in private equity and venture capital funds. This is when part of the fee arrangement is that the general partner can be entitled to a, let's say a 20% carried interest, I'll say the capital gains. Let's say 20% of the capital gains if they hit certain thresholds and hurdles. So potentially it's a profit interest allocation of capital gain that the GP can receive.

So the question is with 1202 is a carried interest eligible for this 1202 exclusion, right? So the big question is the GP deemed to have held the stock in that partnership, the qualified small business stock when you're looking through in the partnership for the five-year period if the carried interest maybe only kicks in at a later date, when this is it sort of actually kick in. So it is a big question.

I'm actually not here to give you the answer yes or no, I'm here to just bring up issues and why there's issues on both sides and why some people think that it is or it isn't and what you need to consider in analyzing this. So again, there's some commentators that say, "Yes, this would be eligible." Some say that it would not. There's issues on both sides. And part of that is because there's differences in the partnership interest rules when it talks about it in the Section 1202, in the actual code where it's not very elaborated and there's no meaningful regulations or legislative history.

Then there's the sort of related provision under Section 1045 where there are treasury regulations and it says something else in that section. So it becomes a question of how do you analyze this. What does it actually mean if it's somewhat ambiguous. So in order to take a position on a tax return without actually disclosing it, you would need to have substantial authority.

So what is substantial authority? Substantial authority is when you have approximately a 40% chance of success based on its merits. So you need to determine is there a basis to take a position? At what level does it come up to, to actually take this position? And we really tell our clients, "It's something you need to discuss between a client and their tax advisor and to see what sort of position and what you're comfortable doing." But it's really a discussion item and not something outright. It depends on the facts and circumstances of each case.

In addition, you could actually sign the tax return if there's a reasonable basis. You could sign a tax return but you also need to disclose it. So again just something to think about and we'll actually spend a moment just to go into 1202 and 1045 and see why there's this ambiguity. So the question becomes the partnership interest has to have been held at the time that the partnership acquired, the qualified small business stock and through the date of sell, otherwise it would not qualify for this exclusion.

So in 1202, it actually says that there is a limitation on the interest that it's your interest that's held on the date of acquisition, which what does that mean? That's very ambiguous. Is that looked at as what the general partner would be entitled to based on the limited partnership agreement. This is something that they know from the start that if you hit certain thresholds and measurements you can actually be entitled to this carry. So is it something that you would get? What's the effective carry that you would have been allocated at the time or really is it just your your smallest percentage interest in the partnership throughout the holding period? So again, it's unclear here and that's why there's so much discussion on this point.

Now, if we look at the Section 1045, that's the related provision for the non-recognition role where you can have the rollover the qualified small business stock. So the treasury regulations here, they actually specifically say that only a capital interest is taken into account and it's your smallest percentage interest that you're holding during that holding period. So this seems to say something a little bit different or more specific than 1202.

So again, there's a lot of questions here or could we argue and say that this is what the GP would have been entitled to or had the rights to, initially that they should be able to exclude this or do you say that you can just take the smallest percentage throughout the year and that's what would be eligible. And again, there's also questions on carrying just waivers. That's a little bit more questionable.

So there's certainly a case there is something to be made on each side and it's something that we really encourage every client to discuss with their tax advisor to look into this and see what position they're comfortable taking. I'm also just mentioning over here that the tax advisor has an article. I put a link on this page to a really great article that talks about substantial authority and specifically the 1202 as it pertains to carried interest.

Okay. Now, we have a lot of clients, they said, "Okay. Well, we know we have qualified small business stock. Well, now, what do we do? What's documentation? How do we pass this along to investors? So in the section itself, it doesn't actually give us any guidance or reporting requirements, but we do have some you know best practices of what we tell our clients and what you really should be doing. So what I want to say is that at the time of issuance, you're actually making that acquisition. You should get the balance sheet that shows the total assets and the tax basis of the assets and it should have an analysis that kind of shows you that you need the gross assets test.

You should also have some documentation or schedule showing the percentage of assets that are used in an active trade or business. You should get proof of a C-corporation status like the copy of the 1120, the articles of incorporation. Those would be very helpful. And even more so, we really push this and say that it's really the corporation that needs to come and say that this is good qualified small business stock.

So it's recommended you really should get an affidavit from an officer of the company basically stating that they do not fall to any of the disqualified trades or businesses and that they're not an ineligible corporation. So it's important documentation to have and I'll say that this is important at the time of acquisition that you get this documentation. A lot of times where we're now selling and we bring up the question, is this good 1202? And then you have to go backwards and it's just a little bit more difficult to get that info. So it's certainly something to do on initial acquisition.

Okay. So now, what if I'm a partner in a partnership and the partnership is holding qualified small business stock? First of all, I'm going to tell you that the partnership itself, you're going to get the gain reported on your Schedule K-1. However, you need to note that the partnership does not exclude the gain. It's the individual partner or any non-corporate taxpayer that needs to analyze and make sure they're qualified and they take the exclusion of their own tax return. It's not the partnership, but the partnership itself should be passing along the information necessary that you need to take the exclusion.

So in our firm what we like to do is if we do have a gain that may be eligible for this exclusion, we like to put this on line 11I of the Schedule K-1 on the other income line instead of the line 9A, just so it stands out more and people are more prone than to looking at the footnotes which are super important. And in the footnotes, we're going to give you a description of the stock. We'll, put the date of acquisition, the date that the partnership acquired this qualified small business stock, which is really important because each partner needs to determine themselves if they're eligible and they had original issuance.

Were they in the partnership at the time that the partnership made this acquisition? Many times especially in the fund world, people are selling their interests to an outside party. So you have to be careful with that. We'll put in the sell date, your pro rata share of the proceeds and provide a share of the cost and the gain. We always put a recommendation to consult your tax advisor to determine if you're eligible for this exclusion.

Kayla Konovitch:Ben, I'm going to turn it over you.

Ben Aspir:Thank you, Kayla. So we've gone through the requirements of 1202, some best practices. Kayla talked about some of the ambiguity in 1202 regarding different structures, carried interests. So what about if there's an asset sale instead of a stock sale, right? Because 1202 talks about on the sale of qualified small business stock, not qualified small business assets.

A lot of times the sale of a company is treated as an asset sale at the urge of the purchasers. They prefer asset sales. So with C-corporations, there's two level of tax. We say there's double taxation on C-corps where the entity pays tax and then when dividends are paid out or proceeds distributed out, the shareholders pay another level of tax at the personal level.

So 1202 actually still applies to a certain effect with a corporate asset sale, not on the corporate level gain. So when the company sells assets, the corporate tax rate is 21%, so the actual entity will pay 21% tax on the gain of the sale of the assets. However, if the corporation completely liquidates after it sells its assets and distributes out the proceeds, the tax code still treats that as if they exchange it in the sale of stock.

So 1202 can still apply at that second level of gain and you could potentially exclude that gain at the shareholder level. It's a common misconception that people assume, "Oh, it structures an asset sale 1202. It does not apply at all." It applies just not as well as if it was a stock sale where potentially the entire gain could be excluded subject to limits. A question we often get in relation to 1202 is with S-corporations. Can we be an S-corporation and terminate our election and then become a C-corp and then hold the stock for five years and then be eligible for 1202?

So it's important like Kayla said when you do terminate. You have to be aware of the fair market value at the time determination because any gain that's inherent prior to that conversion is not eligible for 1202. So if the S-corporation is worth $5 million at the time of termination that first $5 million a gain at the time of sale eventually five years later, 10 years later down the line, it would not be eligible.

Also, when the S-corporation terminates its election, it's also important that the newly formed C-corp to issue shares in the C-corporation because that S-corp stock since when the stock was originally issued was not C-corp stock, it was S-corp stock so it would violate like Kayla talked about with the original issuance requirement so that's something to be cognizant of.

If you are thinking about terminating an S-election and there are other tax effects regarding that S-corp terminations. But just to be aware that new stock needs to be issued in order to benefit from 1202 in the new C-corporation.

Additional considerations. So Kayla talked about the holding period. So for stock in qualified small business stock can be gifted, can be inherited and also it can be distributed from a partnership or an S-corporation and it'll maintain its status and the holding period if a person holds the stock for three years, they decide to gift it to their daughter and the daughter holds it for another two years, that would meet the five-year holding period.

There's also planning techniques with gifting to an individual or a non-grant or trust so there's a state plan that could be done around it as far as like I mentioned this $10 million exclusion is per person. So if I decide to give shares of 1202, half my shares of 1202 to my son, he also gets a $10 million exclusion. If a person wants to gift it to a variety of different people, it's $10 million per person. So we call that stacking of the exclusions. So there's definitely planning that could be done around if a person is thinking about gifting or doing estate planning around Section 1202 stock.

Conversions to a C-corporation. Just as Kayla mentioned, you must have a valuation in order to value the fair market value of the assets. Timing of the sale of qualified small business stocks. So let's say you have multiple tranches of stock, you have low basis shares, you have high basis shares. If you're able to time it, sometimes it's all sold at once, but you can actually try and optimize the $10 million exclusion on the 10 times basis inclusion.

So you may want to first sell the low basis shares, because you're obviously going to have a higher gain and then use up the $10 million solution, and then in the subsequent year sell those high basis shares and benefit from the 10 times basis exclusion. And then there may be instances where it may be just beneficial if you have just high basis shares to sell it all at once.

So that's an analysis that needs to be done when selling qualified small business stock. There's also this anti-abuse rule with Section 1202. So let's say I have stock issued in 1202 in qualified small business. The corporation was formed in 1985 and it's the only stock I've received. Well, the shares must be issued after 1993. So even though it might meet the other requirements, those shares wouldn't be eligible for 1202.

If I'm about to sell my company and I wasn't properly consulted on 1202 then that new shares should be issued. Let's say right before a sale, why don't I just have the corporation redeem out my shares and give me new shares right before the sale. So 1202 has an anti-abuse provision that there's a look-back period. Two years before and two years after the stock is issued more than 2% and $10,000 of shares by value is redeemed in that time and that testing period, those shares that I receive are not eligible for 1202.

Then there's another anti-abuse provision as far as if this was called significant redemptions in the corporation or repurchases. So if more than 5% of all the shares are redeemed in a two-year period, one year before and one year after, that could actually taint all the stock that's issued in that two-year testing period. Another planning technique or you want to call it just a caveat that if someone is investing in an existing qualified small business, they may want to ask the existing corporation to certify that they have not run a foul, this anti-abuse rule that they haven't had a significant amount of redemptions.

Not even trying to go around the rules, but just not even being aware of it if they redeemed out a major shareholder so that they could not be aware they could buy into this company with the purpose of investing in a qualified business stock and not be aware. Additionally, there's a rule against hedging or shorting the qualified small business stock and the tax code says, "If the transaction you're engaging in substantially reduces your risk of loss, then it may affect your 1202 status. So if you're shorting the stock and if the stock was not held for at least five years before that transaction that's the shorting or hedging transaction is executed, it could terminate and ruin the 1202 status.

And last but not least, we have state adoption 1202. I noticed also in the Q&A some people had asked that. So up until now, we're just strictly federal taxation. It varies from state to state. I can tell you my home state, New Jersey does not recognize 1202, so in theory I could have a gain that's excluded at the federal level on my 1040 and then play full tax at the New Jersey state tax for the gain on the sale. However, 20, 25 miles away in New York and New York does recognize 1202. It really varies from state to state. It has to be analyzed again to determine state taxation of 1202. It is not automatic.

Now we'll walk through a couple examples and Kayla is going to walk us through the first one.

Kayla Konovitch:Okay. So in this example, we have on July 1st, 2013, David invested 40 cents to buy 200,000 shares of ABC Corp. So note that he made this purchase in 2013. During that year, you could be eligible for 100% exclusion. Now, six years later on July 1st, 2019, David sold all 200,000 shares for $22 million. So here we compute the gain. There's practically no basis. There's 40 cents. So we have a $22 million dollar long-term capital gain.

So the question is in this example, "Well, what amount of the gain is eligible for the exclusion?" So first off is that there is 100% eligibility here. And second is that we need to look. Well, let's look at this, right? You can get the greater of 10 times your basis or $10 million. 10 times your basis would be $4 or you can take $10 million, up to 10 million. So in this case of course, we'd opt for up to 10 million.

So what would happen is David on this 2019 tax return, he'll exclude $10 million per this exemption and the amount above, the extra 12 million, he's going to actually have to pay taxes on in addition to the 3.8% net investment income tax. On the 10 million that he's excluded like Ben mentioned earlier, if you get the exclusion because of this 1202, you won't either pay the 3.8% that investment income tax on it. Okay. All right.

Okay. Ben, you want to take example two?

Ben Aspir:Sure. So our second example, we're going to talk about property contributions. Kayla went through the requirements earlier. So on July 1st, 2008, Mia contributes a million and a half of assets which is measured, remember, at fair market value for purposes of 1202 with no tax basis. She exchanges it for 200,000 shares in ABC Corp. Now, as I mentioned early on in our webcast, if the stock is acquired in 2008, it's the 50% exclusion bucket. So just keep that in the back of your mind. It's the date of acquisition for determining the exclusion ratio.

It's been determined that ABC Corp is a qualified small business on the 1202 and then 11 years later, July 1st, 2019, Mia sells half her share, so 100,000 shares for $30 million. That's a pretty good return on investment. So what are tax results? Without apps in 1202, Mia would realize a $30 million long-term capital gain, paid 23.8% tax on the entire thing and again, remember state tax treatment varies. And then the ceiling is on 1202 on the gain exclusion is the greater of. Remember the greater of $10 million or 10 times the basis.

You multiply $10 million times the 50 exclusion ratio. So 50% of 10 million is $5 million or 10 times Mia's basis. So we use the fair market value here. So originally it was a million and a half and she sold half her shares. So half of a million and a half is $750,000. 10 times that is $7.5 million. So applying the 50% exclusion ratio. 50% of 7.5 million is 3.75 million. By my calculations, $5 million is higher than 3.75 million. So Mia is going to exclude $5 million of the entire gain. So there was a $30 million original gain.

So the $5 million is included on her 1040, on her personal tax return and the remaining 25 million is taxed. It's important to note that under the rules of 1202, the amount that's not excluded is taxed at 28%, but that's only of the 5 million. So of the remaining 25 million, 5 million is taxed at 28% and the remaining 20 million is taxed at a regular capital gains rates.

So now in year two, Mia wants to sell her remaining shares. Again, a hundred thousand shares. She had in total in the beginning 200,000 shares. She sells the second half for $30 million. Option 1202 should be recognizing a $30 million long-term capital gain and paying 23.8% tax on it.

Now, going back to this rule of $10 million and it's a lifetime limit per per company. So per person per company. Since she's already exhausted her $10 million exclusion rate, she cannot claim that. However, she can claim the 10 times basis exclusion. So original basis, which is a fair market value for purposes of 1202 is 1.5 million. So half of that is $750,000. So we applied 10 times that, which is 7.5 million and MIA can exclude in year two, $3.75 million from capital gains.

So on her personal tax return in 2020, she'll exclude 3.75 and the remainder. So $30 million less the 3.75 million. 26.25 million is taxed. And keep in mind that of the 26.25, 3.75 is taxed at 28%. So the remainder, 26.25 minus 3.75 will be taxed at regular capital gain rates. So I will turn it now over to Kayla to discuss entity choice with regard to Section 1202.

Kayla Konovitch:Okay. So obviously there's a tremendous benefit if you could be eligible for this exclusion. So we're going to go through an example which again it's an ideal situation and it clearly illustrates if you could get this benefit that it's certainly the worthwhile route to structure and you'll see that the difference in tax savings that you get here.

So if you invest either in a pass-through entity versus a C-corporation. So in the first five years if you have taxable income of a million dollars in a pass-through scenario, the income is passed through up to the partner and he's going to pay taxes of 296,000 on a million dollars of income. That's at the 37% highest tax rate. In addition, there's also the qualified business income deduction that's at 20% Section 199A, a pass-through deduction. So with that benefit, you'd be paying $296,000 of tax.

Now, if you're a shareholder and in the corporation, the corporation had a million dollars of taxable income, you'd be paying a flat 21% tax rate which means you'd be paying $210,000 of tax. Okay. So here clearly, so far the pass-through is paying more tax given that they reduced the tax rate and tax reform effective in 2018.

Well, what happens now if they want to give a distribution of the earnings to the individual or to the stockholder? Well, what would happen is that in a partnership structure, you're building up your tax basis. So they already pay tax on the first million dollars of income. In that scenario, if you distributed out a million dollars of income, the individual would have basis to take that distribution and there would be no additional tax at that time.

However, for a C-corporation, there's actually two layers of tax. So if the corporation is profitable and you make a distribution, first of all note, you don't have a million dollars available to distribute because the entity first had to pay $210,000 of income tax. So if you distribute out that $790,000 of income and this earnings and profits in the company, that distribution is going to become a taxable dividend to the stockholder.

So that stockholder is going to pay a tax rate on the dividend, a qualified dividend of 20% plus an additional 3.8% for net investment income tax. He'd be paying another $188,000 of tax. So at this moment, pass-through is paying total of 296,000, the individual and the partner and through a corporate structure, they're paying $398,000. So clearly with the double layer of tax, a corporation was paying more at this point in time.

However, now, you want to get out of the business, get out of this investment and you want to sell your partnership interest or the stock of the company. If you're going to sell it for $3 million where you have $100,000 of basis, you'd have a $2.9 million gain. In that scenario as a pass through, that would be a long-term capital gain to you at a rate of 20% and if you're active in the company, you don't have to pay the net invested income tax. You'd be paying $580,000 of tax and in a C-corporation, if you sell that stock and that stock was again good qualifying small business stock and you could either do 10 times your basis. Your basis was 100,000, so your exclusion can be either a million or the greater of $10 million.

So in this case, you're going to ask for the 10 million exclusions. That means that the full 2.9 million, you do not have to pay taxes. So from the initial year one through exit, you can see that from a pass-through, an individual partner would be paying $876,000 of tax versus if this was a corporate stock, they would only be paying $398,000. Again, this is a very drastic example, but clearly there's a tremendous tax savings if you could be eligible for this qualified small business stock.

I do want to say that there's a number of things you need to consider when making a choice of how to structure what type of acquisition, what your exit strategy is. If you're selling a stock, you don't get a step up, you might want to sell assets, but then the consideration style may differ. If you're throwing off losses in the first few years, you might want to be in a pass-through structure. So there's a lot of different things to think through, but this scenario ultimately, it would actually show you what the benefit potentially can be in 1202 getting this exclusion.

Okay. So just some final thoughts. In closing, obviously everybody is talking about the election and what if, what's going to happen if the senate is controlled by Democrats, the senate is controlled by Republicans. So obviously, at this point it is not certain yet. If the Republicans control the senate, chances are, there won't be much tax reform. If the democrats do control the senate, then there is more chance of something going through, but Biden does need to focus on obviously the economy and COVID-19 recovery. So tax reform might not be that first thing that happens, so there may be some time.

If there are some changes, there has been talk of increasing the corporate income tax rate, limiting the Section 199A 20% pass-through deduction. In a more extreme case, they actually increase the capital gains tax rate. They may actually think about, "Well, do we want to put this big exclusion provision under Section 1202. But again, there has been no conversation." This has not been brought up by either party, this specific provision. So for this time it's definitely a really great planning opportunity.

So I hope that there are a number of things they were able to learn throughout the session, but I do have a few takeaways that I really I think are very important. One is that really the best practice is that when you're actually making that purchase, that original acquisition, it's at that time that you should make sure either structure it or make sure that you identify and you know if this investment actually qualifies for this exclusion and it's really important that you track it so that you know you will qualify and continue to qualify for this exclusion.

That would be best practice when you're making the purchase. If you haven't done so, I really urge you. I'd recommend that you go through your portfolio now to identify if there are any investments that may qualify. We've seen sometimes that a client could have been unaware that it originally qualified and somehow they restructured something that later disqualified the investment from qualifying and it's not a great place to be because there's a lot of potential tax savings here.

So again, it's important to analyze your portfolio. Documentation is key. We mentioned that earlier and what I'd like to say is you need to tag them and track them because you need to make sure. Instead of when you have time, you're selling to go back and re-figure this out, it's better to know it originally and track and make sure it continuously qualifies throughout the holding period. So that's really our recommendation.

In addition, Ben and I put together 1202 qualified small business tax guide. It's just a high-level guide to use when you're actually going into an investment or looking at your portfolio just to check and see, "Well, do you have something that may qualify?" It's just a starting point so it's good to use and analyze, and that’s like the first phase and then there's more questions to be asked to still make sure that it qualifies because it's not just a simple provision.

Again, there's a lot of ambiguity in this code. There's no treasury regulations or legislative history here. Again, that opens up for opportunity, but that also opens up for a lot of questions and interpretation. So that's essentially my final thought and takeaway. Ben, if you have anything you wanted to add to that.

Ben Aspir:Sure. We have a couple of questions that we can get to. We have a couple minutes. Someone asked the question regarding, let's say a partnership distributes out to its five partners qualified small business stocks. So each partner gets a $10 million gain exclusion. It's not a total in the aggregate, it's every single person gets the $10 million gain exclusion. Someone asked about, they heard me mention a 28% tax rate. So that's only the amount.

If you're in the 50 or 75% tax bucket, the amount is not excluded up to - so let's say you have a like a $10 million gain and you exclude $5 million, the other 5 million is taxed at 28%, not 20. But whatever remaining gain, if the company sold for $100 million, that remaining $90 million is not taxed at 20%. It's only that first 10 million where you're excluding five and you're not excluding the other five is taxed at 28% or the remainder is taxed at 20%.

If you inherit shares, someone asked, yes that does qualify. Someone mentioned that there are many areas not clear for Section 1202. Is there any pending guidance expected? I'm not aware of any in the pipeline. I hope one day there will be. I think part of the reason why there is a lack of guidance is because this code section was ignored for so long. As I mentioned at the beginning of the webcast, many people weren't taking benefit from it.

So the IRS really did not have any impetus to issue much guidance on it. I mean, now, it's become so popular and Kayla and I are getting dozens of questions a week on this and many people are claiming it. Hopefully that'll light a fire under the IRS to actually issue guidance on it. Let's see. There's one more question.

Kayla Konovitch:There's a question here how does it work with a partnership? Is it the partnership or the individual? How does it work? So the answer is that if you're a partner in the partnership and the partnership purchases the qualified small business stock, and you were in the partnership at the time through the holding period and exit, you potentially can qualify. The way it's recorded is that the partnership actually picks up the full gain, passes on your piece of the gain on to your K1 and then you on your personal tax return, when you're filling out your schedule D, there's a special code.

I think it's code Q that you actually fill out and you show the amount that you're excluding so you pay less gain on your personal tax return. So it's something that's done on the individual return and that's where you take the exclusion and you just need to use the correct code to show that you're getting this benefit and you won't pay tax on that.

Thank you, everyone.

Ben Aspir:Thank you. If you have any questions, feel free to reach out to Kayla and I.

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