Navigating Key Changes to IRC Section 1202 and QSBS Planning

Benjamin Aspir:

Sure, thanks Kayla. Before we take a deep dive into section 1202, we'd like to set the table on what 1202 was about why it was it enacted 1202 was enacted in 1993 to spur investment in small business corporations. It allows eligible shareholders, depending on when the stock was acquired to exclude capital gains up to the greater of 10 times their basis or 10 to $15 million lifetime exclusion. The one big beautiful bill act, which I'll just refer to as OB three, which passed in July of 25, greatly expanded and enhanced the benefits of section 1202, 1202 and we'll go into delve into a little bit deeper later on the presentation. But 1202 has five core requirements that can get pretty complex. It must be issued by domestic corporation with less than 50 or 75 million depending on when the stock was issued of assets. It must be issued by a corporation that used at least 80% of the assets in active trader business.

The stock must be held by a non-corporate taxpayer. It could be held by a partnership, it could be held by a S corporation, it could be held by a trust. It cannot be held by another C corporation must be acquired by original issuance and there's a minimum three to five year hold. So the investment timeline you see in front of you before we talk about the OB3 enhancements, we'll talk about the original version of section 1202, which is still in effect. The OB3 enhancements applied to stock acquired after July 4th. Originally stock acquired from August of 93 through February ‘09. Those a 50% solution and an effective tax rate of 15.9% because there's a cork in section 1202 that taxes the nonexcluded part at 28%, that quirk is still in effect, stock acquired from 2009 to September of 2010, the exclusion was 75% and then from September 28th, 2010 through 2025, July 4th, 2025 is a hundred percent exclusion.

The OBA, the OB3 greatly enhanced the benefits of 1202. It shortened the minimum hold period for stock issued after the enactment date. So stock can be held for less than five years. If it's held for three or more years, the exclusion is 50% instead of five years. If it's held for four years, the exclusion is 75% and for five years the exclusion is a hundred percent as well. There is as well for pre OB3 shares, there's an A MT adjustment for a 7% A MT adjustment post OB3 shares. There is no a MT adjustment to summarize the highlights for section 1202. So what changed? Increased the exclusion rate from 10 million to 15 million, the greater of a 10 times basis or 10, so 15 million instead of 10 million. So increased the exclusion and the minimum exclusion up to 50% higher than the previous version of section 1202.

Another major change, which we will talk about, we'll talk about planning around that, around the gross asset limit. It increased the gross asset limit of the corporation. This is at the time of issuance of the stock from 50 to 75 million. That's going to qualify a lot more corporations for section 1202 and shareholders. And like I mentioned, there's a three to five year hold instead of a minimum of more than five years. Also mentioned the question we receive a lot is couples married finally jointly do they get a double exclusion of the 15 or $10 million lifetime limit. Our firm's position is it is one exclusion. It's not doubled because the tax code specifically says taxpayers filing separately. The exclusion is split at seven and a half or 5 million depending on when the stock was issued. What did not change the original issue was requirement. I mentioned the excluded fields, qualified trader businesses, any service type fields, accounting firms, law firms, engineering, health services, hospitality, restaurants, the active asset tens I mentioned redemptions, which we'll talk about later. Legacy stocks or stock issued prior to OB three. They're still under the old rules of the 10 million of solution and the minimum of more than five year hold. I'll turn it over to Kayla to talk about equity leak instruments.

Kayla Konovitch:

Thanks Ben. So this is an area that we receive a lot of questions on. How are options warrants convertible debt or safes? How are they treated for QSBS purposes, which is a great question. So in order to, before we actually tackle the specific instruments, let's first talk about what is original issuance. This is actually really the first item to address in QSBS eligibility right after you know that it's a US C corporation, the focus is really on original issuance. So stock that has to be acquired at original issuance. We know in exchange for money property other than stock or services, and by the way for services, many times that's when employees are offered incentive stock options, stock-based compensation. So that's where it would fall under. So you have original issuance again when there's an exchange of money, property or services for this original issued stock.

Now I want to point out that this doesn't mean it's just the original does not mean first original issuance. There could be multiple rounds of financing and you could be eligible in each issuance for QSBS. So it's not limited to just the first round. Again, you have to go through all the testing and eligibility, but it could apply to multiple rounds of financing. So it's not just the first round, but what does not qualify is a secondary purchase. So if you're buying stock from another shareholder, that would not qualify, right? Because that original stock was not issued to you, you purchased it from a third party so that itself would not qualify. And we do see this, I can tell you in the private equity or even venture space, if you have continuation transactions, they're really tricky because you have to ensure that you still have original issuance and it's not, the new buyer certainly would not qualify because that would be secondary.

Or if you have secondary funds right where they're buying, you would have to look specifically through the partnership at original issuance. So that's important too. Keep in mind as well. And just to point out as well, if you have one of these instruments that's issued to you, let's say a stock option or even convertible debt, those instruments are not equity itself, so it's not original issuance. When you get that specific instrument offering to you, it's only once a converts or it's exercise, that's when you're holding original issued stock. So I just wanted to point out that that itself, the instrument like the option or the convertible debt or warrant, that itself is not eligible for QSBS. And the other item regarding original issuance is that it does carry over the original issuance and the holding period by transfer of gift through death or even a partnership distribution.

And we'll talk about partnership distributions a little bit more shortly. The second item we need to look into really is the holding period. When does the clock start ticking for the three or five year holding period? So the general rule is that qualified small business stock has to be held for three to five years plus in order to qualify for qualified small business stock. And again, that only starts once you're holding the actual stock and you have an unrestricted right to those shares and it would start from the day after purchase. So that's when the holding period would stock holding period would start. So now the question becomes, okay, if we're looking at these specific equity linked instruments, how does QSBS apply? How does it work? So first, like I mentioned, again, it has to be original issuance. When you're holding that equity linked instrument itself that does not qualify.

It's only once the stock option or warrant or convertible debt is exercised or converted into equity, that itself, then you're holding original issuance. And then the second is that the holding period would then begin on the date of exercise or conversion. So immediately that date of exercise or conversion, the holding period begins, and that's also when you test for eligibility for  a QSBS. Now if you have stock based compensation, so when does the holding period, they're varying dates for the holding period depending on the stock. So typically the incentive stock option, it's the date of exercise that the holding period would begin. Now if you're holding restricted stock and you did not make an 83 B election, which the 83 B election is typically what it does is essentially treat it as if you own the stock for tax purposes, even though legally you don't yet you can make an election to start the holding period.

So if you have restricted stock and you did not make an 83 B election, then again, once the stock is fully vested, that's the date that the holding period will begin. If you have restricted stock and you made an 83 B election, then it's the date of the election that the holding period would begin. And that actually is true for the long-term short-term capital gains holding rates and for qualified small business stock purposes. So that's an important planning item as well. Just to add here, if you have preferred stock that converts to common, that's okay as well and the holding period will tack. Okay, so now the safes safes are simplified agreements for future equity. We're not on this webinar going deep into safes, but what we need to understand is that it's a little bit tricky for tax purposes in order for it to qualify.

It's really fact dependent depending on the terms of that specific agreement. Are the terms equity or is it more like debt or is it more of something like a prepaid forward contract? And depending on how it's treated for tax, what the characterization of the agreement is will depend on what the tax treatment is. So if you go through the terms, you believe that it's equity, like you're looking at certain things like there's no interest accrual, there's no maturity date, it might be eligible for dividends, maybe not voting rights, but maybe it could be eligible for dividends. Typically you would see very often it's junior to any debt holders, any of the creditors. So you're treated more like an equity owner. So those are some of the facts that we look through to determine is this safe treated as equity again on issuance of the safe.

So if it is treated as equity, then you would say that on the date of issuance is when you would actually have good, the holding period would begin. But really the testing for QSBS would start on that date. So again, it's just important to look at the terms every now and then. Y Combinator has the standard templates for this. People often change some of the terms, so you need to look out for that because that could change the treatment as well. So if you have good equity holding, that's typically when the testing and the holding period would begin for safes and more so in the past two years, many of the agreements we're reviewing are actually equity and they may even put in the intent of the treatment into the agreement. Although that's not the overriding factor to say just because they wrote that they intend to treat as equity, that doesn't mean that it is.

You do need to look at the agreement for the treatment. So just some best practices, generally it's a good idea to exercise or convert the options into equity early. However, the fact pattern needs to support that, right? So if it makes sense, you should convert early this way you can start the holding period, the clock ticking sooner. Also consider making the 83 B election to also start the holding period for QSBS and long-term treatment. So that might be another opportunity and just remember at each stock issuance is when you really need to be documenting the gross asset test and active trader business and all the other eligibility requirements. So that's at the time when you have the original issuance is when the testing will need to start. Okay, next polling question, do you currently own or intend to invest in qualified small business? Stock A is yes, B is no or C is undecided. Okay, and in the meantime I will pass it over to Stan.

Stanley Barsky:

Thank you Kayla. So we're going to talk now about installment sales of qualified small business stock and specifically focusing on the prorata versus first in first out treatment. So first, let's take a half a minute to reacquaint ourselves with the installment sales background and the general about installment sales. So income from an installment sale should be reported using an installment method unless the taxpayer elects out of that method. So again, very sort of important to keep in mind. The taxpayer can elect out of the installment method and report all the income in the year of sale, but otherwise it has to be reported as the payments are received as we'll discuss the installment sale. What is an installment sale that's a sale or a disposition of property in which at least one payment would be received after the close of the year of the disposition.

So the classic example is I sell stock for a hundred dollars of closing and another a hundred dollars, let's say two years after closing. And that could be just a time-based sort of deferral. Come hell or high water, they have to pay me that a hundred dollars in the second year or a third year, whatever the case may be. Or it could be contingent on performance of the business. So normally, again, setting aside 1202, the seller would recover tax basis based on the ratio of gross profit to total sales price and the way that ratio is decided is addressed in the regulations. Broadly speaking, if there is a maximum selling price, the seller recovers tax basis in proportion to the ratio of the payment to the maximum price. So if I sell for a hundred dollars upfront and the maximum selling price is a hundred is contingent or not, I recover 50% of my basis upfront. If there is not a maximum selling price, but there is a maximum number of years over which the price is to be paid, then the taxpayer recovers basis relatably over those years. Finally, if the price and the payout period are potentially unlimited, the taxpayer generally recovers tax basis rateably over a 15 year period and here are the results of the polling. Question number two.

Okay, so now let's talk about the application of the installment sale rules to 1202. There are essentially two potential approaches. First, you apply section 1202 first to the gain reported under the installment method. Second, you apply 1202 prorata to the gain reported under the installment method. So this presentation discussing sort of the detailed nuances of installment sales is way beyond the scope of this presentation. I actually wrote an article on that going through numerous examples that's published in tax notes. But basically the takeaway here is that a lot of times setting aside section 1202, people would say, okay, we're going to typically use the installment method because that differs the gain. But when 1202 is overlaid on that when you're selling 1202 stock in the installment sale, that calculation could change. Potentially there is support for either approach, although the IRS instructions to form 10 40 Schedule D appear to favor the prorata approach.

But you can see how applying to Volvo two first might be beneficial because you might say, Hey, I want to for as much as possible by excluding as much as possible upfront front, but again, what approach is beneficial depends on the facts and there's really no shortcuts here. Both approaches should be modeled out to determine what's the best and in some cases it may actually be beneficial simply to act out of the installment method, report everything in the year of sale because that might maximize your 1202 exclusion. With that said, I'm going to pass it on for the sale choice of entity to I believe, Jeff.

Jeffrey Kelson:

Yes, thank you Stan. So we get this question all the time. Should I convert my LLC or S corporation to a C corporation so I can take advantage of qualified small business stock status? It's a loaded question and it's not one right or wrong answer. So let's go through. So for an LLC to go to a C corp to qualify for QSBS status, you can incorporate it or check the box in a form 88 32 that is deemed an issuance of shares. So both ways are acceptable, but here's really the rub. Any built-in appreciation in the LLC that you have enjoyed prior to the conversion will never ever be excludable under 1202. And the reason is simple, you didn't earn it while you were QSBS. And so why would we allow you to exclude that? It would be unfair. So what we recommend is when LLCs check the box to be a C corp to qualify QSBS, if they get valuation and that valuation becomes the benchmark where you know, any appreciation above that will be excludable and anything and the built-in appreciation will always be taxed no matter when it's sold, assuming that it's sold for at least what it was worth at the time of conversion.

Also, I want to bring up that gross assets. You'll see that now under the new law you can have 75 million or less of gross assets that you need to qualify. Typically, gross assets is the tax basis, but not when you contribute property and conversion from an LLC to a C corporation is treated as property. So therefore in that instant, you don't look at the tax basis, you look at the fair market value of the assets are that you have. So that's an exception to using the tax base. Be very mindful because if your LLC has gross assets over $75 million, it's not a qualified business. So that's something that gets missed a lot. Let's talk about traps and structuring and why I'm saying proceed with caution. First of all, you should look at the aggregation rules. You have over 50% ownership in a corporation you might have to combine.

It's also a little like catches like gotchas, like the redemption. If there's redemptions prior to or shortly thereafter someone invests in the QSBS, it might taint that investment because the IRS is trying to police that instead of one shareholder selling to the other, one person puts in the money into the corporation and then the corporation redeems the shareholders that want to sell. So it's sort of policing it by having a couple years on either side that could disqualify. We're not going to go into it here, but just something to consider. Also consider if an F reorganization. You see that a lot in S-corp. Also an LLCs to a holding company for outside capital to preserve attacking and also something that also gets overlooked. When you convert an LLC to a C corporation, it's effectively subject to section 3 57 C because it's an incorporation and if you have liabilities in excess of the tax basis in the LLC, it could be income on the conversion.

So you got to watch if you have a lot of liabilities, we you do that. So there's a lot to consider. Obviously an S corporation is more difficult. I am sorry. So an LLC, you just check the box, right? Easy S corporation requires restructuring, so you cannot just terminate your S status and be a C corp. I mean you can, but you would not qualify for QSBS because you didn't get an issuance of shares. All you did was terminate the S status. And there's a case on this letter case where an S-corp merged into a new C corp and the judge and they lost. That said, that wasn't new issuance, it was just the S-corp sort of terminating its election. However, new issuances after the conversion can be QSBS if the issuer qualifies. So when you want to convert an S corp to C corp status to enjoy the benefits, it requires at least something like an F reorg where you set up a corporation above the old S and it's a C corp and that causes the old S to be also a C corp.

There's a few ways of doing it, but you have to be setting up a new corporation and at the end of the day there must be two corporations around, not one. So that's important. You got to also address earnings and profits post-term. We're not going to go into all the stuff that happens when an S corporation loses its status or changes its status, but there are things that need to be looked at there about taking the money out, perhaps tax-free out of previously tax aaa, you have a certain time period and there are other ways, as I mentioned besides the F reorg, but that avoids the retitling of assets and that's really a complication that a lot of taxpayers don't want to go through and the FEO release that problem.

So as I mentioned the S corporation, I'm repeating here, but it's not treated as a stock insurance. A lot of people get that wrong merging into a C corp. Also not good the letter case. So just one thing to look out for, sometimes it's not beneficial to do this at all. Eventually you're going to have an asset sale, you're going to be paying a tax inside C corp branch, whereas if you kept it as an LLC, you can sell the assets, you can sell the interest, you'll just be tax that if you're active at 20%. So sometimes it's better believe it or not, to convert, but every fact pattern is different. You have to know what your exit strategy is. If you're going to be making distributions, that would be tax dividends. You got to be careful that that can make the C corp less beneficial even though might qualify for qs. Ps okay, stand.

Stanley Barsky:

Thank you Jeff. So now we're going to talk about something that comes up quite frequently. It used to come up before, and it still comes up after the O-B-B-B-A, which is right sizing, which obviously after the new law, the magic number is 75 million. And the general idea is you want to buy a company or you want to invest in a company and it's just above the limit. So let's say it's say $2 million and you are so close, but you're clearly over the limit. And the question is, is there something you can do? Obviously if the company is way over the limit, it's probably not worth thinking about very much. But if it is fairly close and just over the limit, you might think about what can we do to still salvage the 1202 benefits.

So here we are. Typically it comes up when a buyer forms a new C corporation to acquire the assets of an operating business because then let's say you are buying a business for $80 million, you have to fund the buyer with $80 million. And if you fund the buyer with $80 million, well now it's above 75, it doesn't qualify anymore. And for this purpose, both equity contributions as well as debt proceeds are taken into account. So you wouldn't necessarily write a check for $80 million to fund everything as a capital contribution. A lot of times what a fund might do is they might raise some equity from investors, let's say 30 or 40 million, and then they would borrow the rest, but the borrowing would still be funded into the buyer company. So that cash would still be counted against you. Don't forget the transaction costs. You may be buying a company for 74 million, but you might have three or 4 million of transaction costs that tip you over the limit. In all of these cases, you have to think about right sizing. Also keep in mind that if sellers contribute assets in tax free section 3 51 rollover, the fair market value of those assets rather than the carryover basis counts towards the $75 million test. Which again is something that might tip you over.

Going to the next slide, let's think about some possible solutions. Again, this is just meant to be a kicking off point and to give you a flavor for what potentially could be done. Well the first fix that we would analyze is can we distribute, also known as spinning off or spinning out to sellers any unwanted assets prior to acquiring the business. Potential candidates include accounts receivable real estate, whether that is or isn't used in the business and ancillary business operations that maybe there is a primary business that's being operated and a smaller tangential business that the buyer doesn't really want to buy. Another thing you could think about is to reconsider working capital and you might sharpen your pencil and think what is the absolute minimum amount reasonably necessary to fund the company in the early periods post close? And instead of funding the company or pre-funding the company with working capital to carry through for the next two years, maybe you can limit that to the next two quarters and still be okay. Finally, you could think about setting up different acquisition companies for different business lines. That is obviously the most complicated potential approach would require the most thought and analysis. And frankly, all of these require thought and analysis, but in the end, the payout is well worth it. I will now turn it over to Kayla to discuss partnerships.

Kayla Konovitch:

Thanks Dan. So very often we might be purchasing qualified small business stock indirectly, right? You didn't directly. Can you hear me?

Benjamin Aspir:

Yes, we can hear you.

Kayla Konovitch:

Okay, perfect. Yeah, so we're often one may purchase qualified small business stock indirectly through a partnership or through an S corporation. So the question is how can one qualify through a partnership or an S corp? There are a few rules for eligibility. So the first is that the entity, the partnership or scorp needs to have acquired the stock at original issuance and hold it for the three to five plus year holds period, what we discussed earlier. So we essentially still have to have original issuance at the partnership level. Then when you're looking at the partner or shareholder level, that partner had to have been a partner in the partnership at the time the partnership acquired the stock, right? So you were a partner when the partnership made the original issuance acquisition and throughout the holding period of that stock until exit. So that's really important because again, if you came in later into the partnership and you weren't there at the time the acquisition was made by the partnership, you would not be eligible because you wouldn't have that original issuance on a look through basis to you as the partner.

In addition, on a look through basis, the partner or shareholder, their exclusion amount would be limited to their share of their percentage of the QSBS gain through that entity. So they get their proa share of the exclusion through the partnership. And also really important, the partnership could distribute out the QSBS eligible stack to the partner and that partner can still retain eligibility, the eligibility and the holding period would fully track to the individual partner. However, a partner cannot contribute QSBS stock into the partnership. So pay attention to that because you can get a distribution from a partnership, a distribution out of QSBS property and still retain Q SB S eligibility. However, an individual or a partner can contribute the stock in exchange for interest in the partnership that would actually taint and kill the eligibility. So that's really important, especially when there's any sort of restructuring that's going on.

Occasionally it comes up and it would take the eligibility. So keep that in mind. So that's in a flow through partnership structure. Now another area of interest in the financial services with the PE VC in that space is carried interest. If a manager is entitled to carried interest from the fund, can they receive when they're receiving the capital gains from carried interest? Is it eligible for qualified small business stock? Could they receive the exclusion? So this is a gray area and there are differing opinions here under section 1202 itself. In the code it just says partnership interest and it doesn't actually define what a partnership interest means. So it is quite ambiguous and it's great. Is that just a capital interest? Does it include a profits interest? Now if you look to section 10 45, which is kind of like a sister provision where you held good qualified small business stock, but you didn't hold it for the full term of the five year or three to five year holding period and you identify another qualified small business stock opportunity within 60 days of sale, you can roll over the proceeds into this new QSBS and still one defer gain and two retain the holding period so you potentially can get the two SBS exclusion on the backend.

So that's the section 10 45 provision, which is related to the section 1202 provision. Now under section 10 45, the regulations are very clear that for 10 45 rollover only a capital interest is eligible for this exclusion. So the question is do you have to apply the 10 45 roll to level two? There's definitely some questions here. So again, it is a gray area and you have to figure out what level do you feel you have a basis to take a position? Is there a substantial authority? Is it reasonable basis that you believe or feel that there is support to actually make a case to say that there is a position here for exclusion of QSBS exclusion for carried interest? So this is something I always tell my clients that whoever's preparing the individual return, because it's really at the personal tax return that the exclusion is taking is taken.

You should have a discussion with your advisor, the taxpayer and the advisor to really see what their comfort level is for taking the position for exclusion on carried interest. Also important is that if you do have a profits interest, that's granted sometimes we have a GP entity where a new GP comes in, but they weren't there during the first or second acquisition that the fund made in those situations, then that partner would not be eligible for sure, not be eligible for QSBS because again, we said there has to be original issuance through the partnership where you are a partner at the time the partnership made that acquisition. So that's important to look at as well. And whenever you're admitting new key service partners into let's say a GP entity, you have to add, they really need to be added before the acquisition is made. Also important if there's new partners coming in or redeeming partner, there may be a shift in ownership within that partnership. So it's very important also to understand that the smallest ownership percentage during that holding period is what would potentially be eligible for the exclusion. So it's the smallest percentage during the Holt period. And again, just to reiterate with section 10 45 rollover, it's very clear a carried interest is not eligible, only a capital address is eligible for the 10 45 rollover.

Okay, polling question number three, a shareholder may benefit from investing in multiple qualified small business 1202 eligible corporations. A is true and B is false. Okay, Jeff, do you want to kick off the bits?

Jeffrey Kelson:

Sure, thank you. Thank you. Kayla. Here at EisnerAmper, we come across so many different taxpayers that are looking to go QSBS or set up their business as A-Q-S-B-S and we just experience, and it's not just with the tax base sometimes with other professionals, attorneys and whatnot that there's a lot of myths that go around that really I think we're going to try to dispel here. We just picked 10, probably could have gone more, but so let's take 'em one by one and common myth number one, I'm going to take this slowly, okay, because some thinking and debunking, right? In some cases one can converting from a pass throughs that can be an LSC or an S-corp to a C corp 12 two can offset a hundred percent of the appreciation prior to the conversion when they exit, when they sell. So what that's saying is what people are getting wrong is they think if they were an S corp or an LLC and they had say already 10 million of appreciation and when they sell it, they have a $15 million gain, 10 million is still taxable even though you get a $15 million exclusion because that was incurred while you were not A-Q-S-B-S prior to.

So that's an important point to make that that can change maybe whether you're going to convert or not. So the pre-app appreciation game will always be taxed upon the sale of QSBS up to the recognized game even if you meet the QSBS holding period. So I think that's the biggest myth. We hear it so many times, everybody's telling me that, yeah, my advisor told me to go QSBS because then I can flu all again. I said not the gain that you already have built in, and that's what valuation comes in the benchmark.

Kayla Konovitch:

I'll take myth two. So this is actually what I was speaking about earlier in the presentation, right? If you receive options restricted stock or convertible debt when you're holding that instrument, that is not when the holding period would begin. You don't yet own qualified small business stock. So people just think, oh, okay, I was issued an option. My holding period begins in the date of the date of issuance. It doesn't, it's on the date of conversion, it's when the option converts to equity or the warrant converts to equity or convertible debt, right? Once you're actually holding the equity, I think that one's a little more obvious, but that's when the holding period would start. It does not tack. So that's very important. And if you did make an 83 B election, then yes, that's also when the holding period would begin. So again, holding an option or warrant that instrument itself is not eligible, it's only on conversion or when you exercise that you would actually have QSBS elig potential. That's when the holding period would start.

Jeffrey Kelson:

Thank you Kayla. We got the answers are 91.5, the may benefit. Yes, you can have multiple and sometimes you can do a lot by having multiple with packing and other things, but we're not going to get into that right now. Okay, let's go to the next myth I have the next myth I would say of the 10 myths we're going to cover, this is the most under the radar myth. This is the one that you only discover when you do the return in the year of the sale and the exclusion. So not in section 1202 itself. So let me read the myth first. Section 1202 gain will not reduce an NOL Caro, meaning that if have an NOL coming into your individual return for this year and you have a 1202 gain, that's excludable, it won't eat off the NOL. That's the myth. And a lot of people do have NOLs now because of section 4 61 L, which limits your business losses to 500 and thousand dollars pegged to inflation.

So very easily you can have a big NOL coming in the following year. That's how it works. Any excess business loss next year is and not operating loss, well guess what? Not in 1202, but in section 1 72 there is a provision that says that to the extent you have the excludable gain and an NOL and to the extent of the NOL, it will offset absorb the NOL. So that's a terrible result because you thought you had everything done, you just didn't realize that the area salt, you had an NOL and to the extent you had that NOL coming into the air, it would absorb it. So yeah, that can really bite you. So that's myth number three. Number four,

Benjamin Aspir:

Myth number four. Whenever I do my elevator pitch on 1202 to potential clients, they hear the $15 million exclusion or the 10 times basis occlusion and their eyes light up. I don't blame them, but I always end with this caveat and I say it's a slam dunk if it's a stock sale, if it's an asset sale, it is a corporation. So that first level of taxation is that gain on the assets was still going to be taxed at 21%. However, when they liquidate the C corporation and distribute the proceeds as a capital gain, if the shareholder and the corporation qualify for section 1202, they could apply the section 1202 solution to the post tax proceeds upon liquidation.

Jeffrey Kelson:

Thank you Ben. And that speaks to the fact that it only protects sell of stock, so it would prevent the second tax. But if the corporation, the C corp selling assets, which a lot of buyers want to buy for the tax advantage, it would still will incur the inside tax at 21. A word to the why is there caution? So myth number five, and Ben mentioned this at the top, but it bears repeating any gain taxable on the section 1202, meaning that you might have 50% because he held it three years or 75% because of four years or something going way back, you invested before 2008 that you would think that that would be taxed at the capital gains rate at 20%, right? Okay, so I get 50% exclusion. So the other 50% is not excludable is taxed at 20%

And the reality is it's tax at 28%. So that is because when this code section came in to in 1993, that was the capital gain rate and it's under section one H and it's been there and it hasn't changed the entire time. And it references 1202, just like 1 72 and myth three references 1202 in that code section. So it references 1202 and section one, which is the tax rate section. And one H says any non-excludable 1202 gain like 50% or the 25% will be taxed at 28%. So when you have a 50% exclusion, it's not really a 50% exclusion, it's really more like a 33% exclusion. And if it's a 75% exclusion, it's more like a 65% exclusion. And plus you have to add the net income investment tax to it because C corp stock is always deemed to be subject to net investment tax six. Oops,

Stanley Barsky:

Right six is me. So the question that we sometimes get asked is, can an S corporation simply convert back to a C corporation and qualify for 1202 because now it's a C corporation? And the answer is that's not considered an issuance of stock for section 1202 purposes. There is actually there earlier case law on this point and albeit in the more complicated fact pattern. And so the short answer is no, you cannot simply uncheck the box. In fact, if you want to convert, as Jeff mentioned earlier, S corp and qualified for C corp at 1202 status, there's a lot of thinking and analysis to be done. And frankly modeling as to whether that's worth it. Kayla.

Kayla Konovitch:

So we actually, every now and then, section 10 45 executing on the 10 45 rollover is actually not easy to execute on. You have to write, you have to identify another QSBS within 60 days. So we do sometimes have this in the venture capital space where the fund had an early exit, they'll sell one of their QSBS positions and again, it's only maybe two years in and they're ready, have many new investments that they're already looking at and they could close within 60 days on another QSBS. So in that context, what ends up happening is the rollover, you can make the election at the partnership level or at the individual level. So here we might have the partnership make the election, however they think, okay, well everybody in the partnership should be eligible for this rollover. However, as I mentioned earlier, under carried interest that for 10 45 purposes, one is not eligible profits interest or carried interest. So that's really important because it's only the capital interest that would be eligible. And that is something that comes up when we're in this context and they just think, well, I was a partner, why wouldn't I be eligible? But specifically the profits interest is not eligible for the 10 45 rollover. That's an item to keep an eye on, especially in the financial services context.

Stanley Barsky:

So the next one has to do with the active trader business requirement. And a lot of times people think, well, I have a good trader business when I invest in the company and I'm done. I don't have to think about it anymore. But in fact, that requirement has to be satisfied for substantially all of the taxpayers holding period of the stock. And there's a number of things that come into play in making sure that happens. One, you sometimes have businesses that when you invest in them, they have a, largely the main business is a good qualified trader business. And let's say they have as a small side business, a tainted type of business, well that tainted business can start growing and increasing proportionately compared to the size of the good trader business. That might be a problem for a 1202 eligibility or you have to watch out what portion of your assets are good business assets and what are impermissible liquid working capital type assets because there is a restriction on how much working capital you can have. So everything has to be analyzed and you have to continue monitoring it frankly, even after you invest in the company. Kayla.

Kayla Konovitch:

Okay, so this one, there's a myth that you only need to test the gross assets once upon issuance and that's the only point in time you're testing. So what I want to clarify is yes, that's the point in time you're testing. However, you still have to go back historically through that period. So it's all historical and at close and immediately after issuance that you're looking at the gross asset test. So that's really important because even at the time that the stock is issued, maybe it was under the 50 or 75 million threshold, however historically maybe it wasn't. And that can be a problem. So again, really important that you're looking at gross asset test, which by the way is based on the tax basis of the assets unless it's property conversion like Jeff had mentioned earlier. So you're looking historically at the time and immediately after the issuance of the stock to measure the gross asset test.

And then the final myth that we're addressing today is that the amount of a section 10 45 rollover, that the full amount would be excluded for 10 45, section 10 45. However, there are limitations and just because you're doing a 10 45 rollover, if you're not fully rolling over the full proceeds, you wouldn't get a full exclusion. And at a minimum you need to actually roll over the initial basis, otherwise you wouldn't even get anything excluded, anything deferred, I should say under 10 45. So basically it doesn't mean just because you did a 10 45 rollover that the full amount would actually be deferred. There are limitations and there's a specific calculation to calculating what would be excludable or deferred under section 10 45. And that brings us to a case study.

Benjamin Aspir:

So we're going to briefly walk through a case study. We spoke about converting from an S corp to a C corp, NLC, a partnership to a C corporation for section 1202. So here are the facts. Bruce and Alfred have 50 50 partnership in their LLCA form in the beginning of 2018. Seven years later in 2025, they convert to a C corporation. The fair market value at the time of the conversion of the partnership of the assets being contributed to the corporation was $15 million. For this example, we'll assume that their tax basis was zero. And as we mentioned earlier, Jeff talked about in his myths only post-conversion appreciation may be eligible for the QSBS exclusion.

We are also going to assume that the company, the newly formed corporation, the stock at the time of sale on July 10th, 2028, which is three years later. Remember we spoke about the three year hold and the 50% exclusion. Bruce sells his shares for a hundred million dollars. Bruce met all the requirements and so did Wayne Enterprises Corporation. So what was the result he sold? He had zero tax basis, the sales price was a hundred million dollars. So that absent going 1202 for a second, Bruce would have a hundred million dollars long-term capital gain tax at percent plus 23.8%. So Bruce would have a 23.8 million capital gain tax bill. So Bruce's gain eligible for exclusion because we mentioned with the OB3 enhancements with the three year hold, you get a 50% exclusion. So his exclusion is based on the fair market value of the assets contributed at the time of conversion.

So the assets contributed were 15 million. At the time of conversion, it's a 50%. He was a 50% owner. So Bruce gets to exclude 10 times. It's the greater of. So the benefit is times half greater of seven and a half million or 10 times his seven and a half million dollars basis. So clearly is much better to use. A 75 million exclusion, 10 times seven and a half million. Bruce's exclusion rate, like I mentioned for the three year hold is 50%. So the first 3 37 and a half million of capital gain is sheltered with section 1202.

The remaining amount, as we mentioned earlier, there's a 28% tax rate on the amount not excluded. So the other 37 and a half million is going to be taxed at 28%. As you see on C, it's going to be 28 plus to 3.8 net invest income tax. And the remaining 25 million that's left is going to be taxed at your typical, your normal long-term capital gains rates of 23.8%. So Bruce's tax bill ends up being 17.8 million instead of 21.3 million. So this results in substantial savings of up to close to $6 million. It really shows you the potential planning benefit of converting or contributing assets as quirk in the tax law that allows instead of tax carry over tax basis for the section 1202 solution, the fair market's value. We're going to skip over this. This is just a slide because we're running short on time just showing the benefits of section 1202 if a C corporation versus a partnership. We're going to move on to the next polling question. The minimum holding period to benefit from a section ative gaming solution is always five years true or false. And while the polling is up, we're going to move on to the next slide Documentation.

Jeffrey Kelson:

The reason why documentation is so important is because this is historical. You're holding it for five years, so you have to keep all the documents to show that you were an active trader business, you're a qualified trader business and that you never had exceeded the limit of either 50 million or gross assets is 75. And as Caleb pointed out before, you have to go back almost to the beginning of time, not before 1993, but if the company was around in 1993, you got to look back what, 33 years sometimes to make sure it never ever violated. And that was the issue at hand with the Dr. Drew versus the US case that he could not produce all of the documents prior to 2009 to show that it was under 50 million. But he said, look, but it's like 20 million now, so how could it have been over 50 million before? And the judge said, well, that was a big economic crisis in 2008. How do I know it wasn't a hundred million in 2008? You can't produce the documents. So audit readiness is very important to get a study that shows you qualify to have all the documents and yeah, and just don't delete them. Yeah. So do we have this?

Yeah, so build and maintain a dedicated QSBS file cap table, stock issuances, board minutes, financial statements, quarterlies, please keep it. The IRS looks at it. They order this stuff quite a bit. That's right. False is right. You can hold to three years, get 50% exclusion or four years 75. So the action checklist, Kayla,

Benjamin Aspir:

A lot of questions we received regarding sexual toll. What does the IRS require in terms of documentation? Shareholder communications? How do we maintain QSBS status? Surprisingly, the IRS has little to almost no requirements of documentation. However, upon audit shareholders is going to need to prove that the company met the requirements and that they may all the requirements. So we recommend there's a best practice system to maintain a Qs BS file, historical balance sheets, stock certificates, like Kayla mentioned, one of her myths, it's a continuous monitoring of the balance sheets. It's not you qualify one and you monitoring your business operations business evolve over time. They revenue streams evolve over time. Are they drifting towards consulting that could tainted, like I mentioned, the gross asset active business test check for redemptions, consider 83 B elections to start the clock on the holding period for the three to five years. If selling early before three years, consider a rolling over under 10 45 like Stan discussed. Maybe potentially rightsizing the balance sheet before any new money comes in to get in under the gross asset test. And lastly, consider admitting key service partners before QSBS acquisitions.

Kayla Konovitch:

Okay, thanks Ben. So over here what we just did is we're just showcasing some of the ways that we can help qualified small business stock. Like I mentioned in the beginning of the presentation, I mean this is the number one topic that's been hitting our national tax office. They're inundated daily with consulting and questions around qualified small business doc as it really represents a tremendous opportunity. So we thought it might be helpful just to present some of the ways that we can help, whether it's the eligibility analysis, going through specific testing, structuring, right, you need to do modeling for should you operate as an LLA, should you operate as a C corp? What's the benefit? So we can do an analysis around that as well. And overall, to ensure qualification eligibility to all partners, investors, founders, individuals. Obviously our recommendation is really to do analysis and fully document and support the position because of course the burden of proof is on the taxpayer and we want to ensure that our clients and the taxpayers are audit ready if this is questioned.

And we have actually seen in the past two years where the IRS did challenge or did question QSBS eligibility. So that is an area that we can help with. We can do a two phased approach where first we start out, we obtain the documents, we go through it and then analyze to determine do we have an eligibility here? And if we believe it's a go, we go to phase two that does a deeper dive thorough analysis, full memo with all the supporting documentation. And we've actually seen these go through in IRS audits. So that's another way we can help. And then overall, really trying to help maximize the exclusion with planning. So some of them items that we mentioned in this session and many other ways that we can help you ensure they're getting maximizing on the basis or even thinking about the way you're structuring or even gifting or setting up trust for eligibility for multiple exclusions. So there's many ways that we can help and just wanted to really thank everyone for joining and feel free to reach out with any questions. We're here to help. So thank you everyone.

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