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Q4 2020 - The Most Overlooked Tax Break for Long-Term Investors: IRC Section 1202 Exclusion of Gain from Qualified Small Business Stock

Dec 9, 2020

General Overview

What is the exclusion of gain from qualified small business stock (“QSBS”)? Can my fund and investor base take advantage of this exclusion? Let’s explore…

Currently, the general rule is that gain from the sale or exchange of stock held more than one year is treated as long-term capital gain, taxed at a maximum federal tax rate of 20% plus an additional 3.8% for the Net Investment Income Tax (“NIIT”). 

However, Congress wanted to encourage investors to invest in small businesses. Their belief was that investors who risk their funds in new ventures, small businesses, and specialized small business investment companies should be entitled to some relief -- a full or partial exclusion of gain. This relief should encourage the flow of capital to small businesses, many of which have difficulty attracting equity financing.

Therefore, IRC Sec. 1202, enacted on August 10, 1993, generally permits a non-corporate taxpayer who holds QSBS for more than five years to exclude up to 100% of any gain on the sale or exchange of the stock. The amount of gain eligible for the exclusion is limited to the greater of 1) ten times the taxpayer's basis in the stock (annual limit) or 2)  $10 million gain ($5 million, if married filing separately) from stock in that corporation (lifetime limit). This is a per issuer limitation on eligible gain.

In order to qualify for the QSBS exclusion, a few requirements must be met:

  • Stock must be issued by a domestic C corporation after August 10, 1993;
  • Aggregate assets of the corporation do not exceed $50 million before and immediately after the issuance;
  • The stock is issued by a corporation that uses at least 80% of its assets in an active trade or business (certain trades or businesses are specifically excluded from IRC Sec. 1202);
  • The stock is held by a non-corporate taxpayer (partnerships, LLCs, S corporations – underlying partners, individuals);
  • Stock is original issue stock acquired in exchange for:
    • Money or other property (not including stock), or
    • As compensation for services provided to such corporation (other than services performed as an underwriter of such stock);
  • Stock is held for more than five years.

Keep in mind that the QSBS qualifications mentioned above can be complex based upon each criteria. In addition, the statute provides restrictions governing redemptions.

The capital gain exclusion percentage depends on the purchase date of the QSBS. The following chart depicts the applicable exclusion rate at either 50%, 75% or 100% exclusion.

IRC Sec. 1202 Stock Acquired Capital Gain Exclusion AMT addback Tax rate on gain not excluded
8/11/93 - 2/17/09 50% 7% 28%
2/18/09 - 09/27/10 75% 7% 28%
9/28/10 - Present 100% 0% n/a

Another perk is that QSBS gains that are excluded for regular tax purposes would also be excluded for the 3.8% NIIT. That generates a 23.8% federal tax savings on the excluded gain. However, when it comes to states, each state has its own set of rules in conforming or decoupling from the federal rule. Note that New York State follows federal rules for this exclusion provision. New Jersey currently has a bill pending approval of the QSBS exclusion with its own criteria, and Pennsylvania does not allow QSBS exclusion of gain. Investors are encouraged to reach out to their tax advisors in determining other state rules.

IRC Sec. 1045 Rollover of Gain from QSBS

In cases where stock was held for over six months but not more than five years, there is a non-recognition rule that follows IRC Sec. 1202. IRC Sec. 1045 allows a taxpayer to potentially rollover gain from the sale of QSBS that has been held for more than six months. In order to do so, the taxpayer must purchase new QSBS within sixty days of sale and make an election on their tax return. The holding period of QSBS acquired in an IRC Sec. 1045 rollover transaction generally tacks on. This means, QSBS held for less than five years when sold still has opportunity to rollover proceeds into new QSBS stock with a tacked on holding period.

Options, Warrants, and Convertible Debt

A question that comes up often in venture capital is whether convertible debt, options, or warrants qualify for the exclusion. The instrument itself does not qualify. However, once the instrument is exercised or converted to original issue stock, it may qualify. It is important to measure each QSBS criteria on the date of conversion or exercise. The five-year holding period begins on the date of conversion or exercise.

Acquisition date for stock-based compensation:

  • Incentive stock options: date of exercise;
  • Restricted stock no IRC Sec. 83(b) election: date of vesting;
  • Restricted stock IRC Sec. 83(b) election: date of election.

Opportunities in QSBS

There are a lot of wrinkles in determining QSBS status which leads to opportunities. Firms need to think expansively when applying this code section. The statute and regulations of IRC Sec. 1202 are not robust. This has allowed for broader application and interpretation. So it is important to think beyond the standard venture capital startup company acquisition. In particular, growth equity funds and leveraged buyout funds may enjoy tremendous benefits in this provision as well.

Let’s walk through some examples that have surfaced recently:   

Example 1

Private Equity Fund LP (“Fund”) wishes to purchase the stock of Puppy Pooch Inc. (“PP Inc.”), a domestic C corporation that manufactures puppy apparel, for $35M with an adjusted tax basis of assets of $12M. In order to facilitate the acquisition, the Fund forms Newco Holdings, Inc. (“Holdings”), a domestic C corporation, to purchase PP Inc. as a platform acquisition. The Fund pays cash for newly issued stock in Holdings. Holdings then immediately purchases the stock of PP Inc. (structure below).

Example 1-01.jpg

In this scenario, if the Fund holds the stock of Holdings for over five years prior to sale, would the gain on the sale of Holdings stock qualify for the QSBS exclusion? Is this considered to be good original issue stock? Intuitively, one may think that PP Inc. didn’t issue new stock and the Fund effectively purchased existing stock from the founder, the seller. However, there were business reasons to create Holdings which in turn issued original issue stock in exchange for cash. In addition, the active trade or business requirement for Holdings should be met because of the parent-subsidiary look-through rule of IRC Sec. 1202 (attribute the assets and activities of a 50%-or-greater-owned subsidiary to the parent). Based on a reading of the rules and regulations, there doesn’t seem to be anything that addresses this specifically precluding this transaction from qualifying. We should give thought to a structure like this in determining eligibility.

To add a curveball here, there is a provision at the end of IRC Sec. 1202 that authorizes the IRS to issue anti-abuse rules; specifically, to include regulations to prevent split-ups, shell corporations, partnerships, or otherwise. As stated above, IRC Sec. 1202 was enacted on August 10, 1993 -- more than 27 years ago. The IRS has yet to issue these regulations.

Example 2

Private Equity Fund LP (“Fund”) forms a new corporation, Newco Holdings Inc. (“Holdings”), to acquire Tile Home LLC (“TH”), a domestic partnership that distributes tiles (structure below). Our question, here, is if the business activity below the corporation is conducted in partnership form, does the business activity of the partnership qualify and get attributed to the corporation, so that Holdings would qualify as QSBS?

Example 2-01.jpg

IRC Sec. 1202 specifically addresses this issue in a corporate parent-subsidiary structure with a look-through approach for 50% corporate subsidiaries. The Internal Revenue Code is silent as to businesses conducted through partnerships. On the flip side, one may argue that the Code does not explicitly allow for a qualified trade or business to be operated through a partnership either. But, it appears there is no compelling reason to exclude the operation of active trades or businesses through partnerships, given the policy behind IRC Sec. 1202, to encourage investment in small businesses and given that pass-through entities are commonly utilized in structuring business operations. It is still possible that Treasury could issue regulations to limit the ability to operate an active business through a partnership; but, again, it has been 27 years with no guidance issued. This is an open question but certainly worth considering.


Another scenario that may come up, and more so now in the current environment, is when a Chapter 11 bankruptcy is filed, and the federal court appoints a committee tasked with developing a reorganization plan. Occasionally after reorganization, a company will issue new stock that is considered different from the pre-reorganization stock. In doing so, the old stock will usually be considered worthless when the new stock is issued. If a taxpayer purchases this newly issued post-reorganization stock, can it qualify as QSBS? Another question to consider.

Carried Interest

Another often-debated topic is whether carried interest or a special profits interest is eligible for the IRC Sec. 1202 exclusion of gain. Is the GP deemed to have held the stock through the partnership for the five-year period if there is a crystallization of carried interest only when the QSBS is sold? It’s a good question! Some commentators say “no” and some say “yes.” There is an argument to be made on either side.

Let’s take a look into this. IRC Sec. 1202 states that a partnership interest must be held both on the date the partnership acquired the QSBS stock and through the date of sale in order to qualify. However, the provision provides a limitation that requires that the excluded gain be limited to that which is allocable to the interest held at the time the partnership acquires the stock. Note the reference in IRC. Sec. 1202 is the interest held on the date of acquisition. That is ambiguous; what does that mean? Could this be interpreted to include the rights that the GP has at day one (i.e., 20% of future profits)? Or, is it the smallest interest held throughout the holding period? There are no meaningful regulations or legislative history under IRC Sec. 1202 to answer this question.

However, the Treasury Regulations under IRC Sec. 1045 state that if a partner’s interest in the partnership varies during the five-year holding period, only the smallest “capital interest” percentage held during the QSBS "holding period" is to be used. This rule ensures that the partner can defer recognition of only the gain that relates to the partner's continuous economic interest in the QSBS that was sold. While the IRC Sec. 1045 regulations are not directly applicable to transactions governed solely by IRC Sec. 1202, it is not clear whether the Treasury and the IRS might argue that the IRC Sec. 1045 interpretation should apply for purposes of carried interests under IRC Sec. 1202 and only capital interests should be measured.  There is ambiguity in the Code with no clarifying regulations or legislative history. Is there a tax position to take here?

Choice of Entity

Should one invest in a pass-through entity (LLC or partnership) or a C corporation? It depends. There are multiple facets to consider that relate to tax, legal, and general business issues. Here are a few considerations:

  • Current tax rates;
  • Single taxation vs. double taxation;
  • IRC Sec. 199A qualified business income, 20% pass-through deduction;
  • Losses: If the business is going to throw off tax losses in the earlier years, one may want to consider a pass-through vehicle to potentially reduce taxes sooner. Losses in a corporation will sit unutilized until there is taxable income in the future and are not passed through to the stockholder;
  • Liability: Liability coverage varies in different entity forms;
  • Step-up in basis: It is important to think about the exit strategy. A purchaser of C corporation stock does not receive a step-up in basis of the assets. Therefore, consideration will vary for a stock sale vs. an asset sale or sale of partnership interest. There are multiple items to consider; consideration is based on the specific facts and circumstances.

Here’s an ideal example that starkly contrasts the taxation of a pass-through vs. a C corporation. This example reflects tax savings utilizing a corporation that is a QSB where the stockholder receives the QSBS exclusion.

Taxation as passthrough-01.png Qualified small business stock gets more attractive

1A) $1M x 37% tax rate less 20% IRC Sec. 199A QBI deduction = $296,000 (assumes active in business so no NIIT)

1B) $1M x 21% = $210,000

2A) No tax on distribution from a partnership if there is sufficient tax basis. $1M of income increases tax basis. Already paid tax on the $1M, single layer of tax on partnership income.

2B) Distribution of $790,000 (net of corporate income tax) x 23.8% qualified dividend rate + NIIT = $188,020. Double layer of tax on corporation. 

3A) $2.9M gain x 20% = $580,000 (assumes active in business so no NIIT)

3B) No tax on sale of stock that is QSBS held for over five years. 100% exclusion if purchased after September 28, 2010.

Closing Thoughts

Firms should liaise with their respective deal team. They should be aware of the benefits of this provision when seeking deals as it directly translates to tax savings and additional cash. Best practice is to identify transactions that may qualify during the acquisition process, then tag them and track them, from initial purchase through date of sale, to ensure qualifications have been met throughout the holding period.  Unfortunately, there have been occurrences where good original issue QSBS disqualified upon a restructuring, so identifying, tagging and tracking the investment is key.

If firms have not identified the investments in their portfolio that may qualify, it’s not too late. They can look over their portfolios immediately, then tag them and track them. To assist with this exercise, see our QSBS guideline to get started on identifying investments that may qualify.


What's on Your Mind?

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Kayla Konovitch

Kayla is a Partner in the Financial Services Group with over 10 years of experience in public accounting. She provides tax consulting services, including advising on tax strategy, transactions, and accounting matters to clients. Kayla specializes in working with private equity funds, venture capital funds, hedge funds, family offices, and management companies.

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