Too Good to be True? Ensuring Capital Gains Treatment of Qualified Small Business Stock is Upheld

IRC Sec. 1202 allows holders of qualified small business stock (“QSBS”) to exclude up to 100% of capital gains on the sale of QSBS from federal income, provided the stock meets certain criteria.  

With the recent increase in IRS funding under the Inflation Reduction Act, the IRS has focused resources on increasing audits of high-income, high-wealth individuals. With this increase in exams comes more IRS scrutiny into taxpayers’ exclusion of gain from the sale of QSBS. Therefore, it is imperative that taxpayers maintain records throughout their stock ownership period to monitor whether their stock qualifies as QSBS. 

QSBS Gain Exclusion Requirements 

The issuing corporation and the shareholder must both meet certain requirements for the stock to qualify for the QSBS gain exclusion under IRC Sec. 1202.  

Corporate Requirements 

1. Issuance: The stock must be issued after August 10, 1993, by a domestic C corporation; 
2. $50 Million Asset Test: At the time of issuance to the individual taxpayer, and immediately after, the corporation must not have more than $50 million of gross assets;
3. 80% Active Business Test: Stock must be issued by a corporation that uses at least 80% of its assets (by value) in an active trade or business, other than in certain personal service types of businesses. The corporation must satisfy these requirements for “substantially all” of the holding period for the applicable QSBS;
4. Qualified Trade or Business: The corporation’s activities must not be one involving the following: 
   1. Performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial or brokerage services, or any trade or business where the principal asset is the reputation or skill of one or more of its employees,
   2. Banking, insurance, financing, leasing, investing, or similar business,
   3. Any farming business,
   4. Any business involving production or extraction of products that are allowed a deduction under IRC Sec. 613 or 613A, or
   5. Operating a hotel, motel, restaurant, or similar business. 
5. No Redemption from Taxpayer or Related Person: The issuing corporation must not purchase more than a de minimis amount of the stock from the taxpayer (or a person related to the taxpayer) during a four-year period beginning two years before the issue date; and
6. No Significant Redemption: The issuing corporation cannot significantly redeem its stock within a two-year period beginning one year before the issue date. A significant stock redemption is redeeming an aggregate value of stocks that exceed 5% of the total value of the company’s stock. 

Stockholder Requirements 

1. Original Issuance: Stock must be acquired by the stockholder on original issuance. Partners of a partnership qualify as acquiring stock on original issuance if the stockholder was a partner at the time the QSBS was acquired by the partnership; 
2. Stockholder Entity: Stock must be held by a non-corporate taxpayer. Any type of stockholder other than a C corporation can qualify for Sec. 1202 gain exclusion, including individuals, trusts, and pass-through entities such as partnerships and S corporations;
3. Holding Period: Stockholder must hold the QSBS for more than five years; and
4. Sale of Stock: Stockholder must sell the QSBS (for federal income tax purposes) to take advantage of Sec. 1202’s gain exclusion. 

Common Pitfalls of QSBS Ownership 

Stockholders seeking to exclude their gain from the sale of QSBS should be careful to avoid the following common pitfalls which may result in adjustments on exam: 

1. Failure to Proactively Monitor QSBS Requirements: Stockholders are expected to routinely monitor their holdings throughout their holding period to ensure that all QSBS requirements are met. Stockholders should maintain documentation throughout their holding period (even if they acquired the stock beyond their typical document retention policy period). This could include audited financial statements, Sec. 10-K filings, opinion letters, stock purchase agreements, etc.
2. Ownership Errors: Stockholders seeking QSBS gain exclusion occasionally make fatal errors with regard to their ownership, including:
   1. Failing to reinvest proceeds from the sale of QSBS in an IRC Sec. 1045 rollover into new QSBS within the required 60-day window;
   2. A partner contributing QSBS to a partnership; and
   3. An S corporation converting to a C corporation with expectation that the C corporation stock will be QSBS.
3. Miscalculating the Gain Exclusion: Stockholders may exclude the gain equal to the greater of $10,000,000 or ten times their aggregate adjusted bases of the stock per tax year for QSBS issued by a particular corporation. Stockholders must apply the proper exclusion percentage based on the date the stock was acquired, as follows: 

There are many moving parts to the exclusion of QSBS, and a misstep could result in a significantly larger tax bill. Taxpayers who wish to take advantage of this favorable provision should engage a trusted tax advisor to make sure they meet all the requirements.  

In This Issue:

• Full Court Press: IRS Targets Compliance in the Sports Industry
• Method Madness: Transfer Pricing Controversy
• IRS Provides Updates on Efforts to Combat ERC Fraud Via Various Programs