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On-Demand: Maximizing The Qualified Small Business Stock Exclusion - Section 1202

Nov 9, 2022

In this webinar, join EisnerAmper for an update on Section 1202, a discussion on the Qualified Small Business Stock exclusion (QSBS).


Jeffrey Kelson:Thank you. Hello, everyone. We're going to be covering Qualified Small Business Stock, which seems to be a hot area in the tax world, and we're going to do it from, we titled it Section 1202 Qualified Small Business Stock-Leveling Up because we'll hopefully get to a little more advanced topics in this presentation.

Jeffrey Kelson: We're not going to overlook the requirement, but we're going to try to talk about what we're seeing out in the real world and some of the issues that are coming up. I'm very pleased to announce today's speakers. First we have Ben Aspir. He is a senior manager in our tax group in our private client services group. He will be speaking along with Kayla Konovitch. She's a tax partner in the financial services group and head of our VC tax practice, and she works a lot with PE funds and VC funds; and also, Jocelyn Borowsky who is a partner in Duane Morris. She deals with estate planning, and as she says all day and night, in the tax area.

She's based in Wilmington, Delaware, and we are pleased to have everyone aboard, so thank you. The agenda today for the hour will be 1202, The Best Game in Town. We're going to be talking about the overview and benefits just to kick it off and the qualifications. We're going to talk about planning and something called stacking, which you'll see in more on the estate side. We're going to have a couple of case studies and then we can't leave you without traps for the unwary, and things we're seeing some war stories. Now we're coming across and some unintended consequences of some recent tax legislation and how it impacts qualified small business stuff. So hopefully, you'll enjoy the presentation and get something very valuable out of it. We have an esteemed group here, so it'd be hard not to. We're going to kick it off with you, Ben.

Ben Aspir:Thank you, Jeff. Before we take a deep dive into 1202, as Jeff mentioned, we thought it was important to go through an overview of all the requirements, all the hurdles that one has to jump through to benefit from the 1202 exclusion. What is Section 1202? Section 1202 was passed in 1993 as a way to encourage investment in small business corporations. The benefits of 1202 is that if a shareholder qualifies under Section 1202, they could potentially exclude from federal tax the greater of $10 million or 10 X their basis in the company. It sounds almost good to be true, but we've had many clients qualify for it and have significant savings, sometimes equaling millions of dollars in tax savings.

As you'll see today, there are several rabbit holes that one could fall into with 1202 and have to make sure to either avoid them. This potential planning that we'll talk about a little bit later, that can be done surrounding 1202 to maximize the exclusion. The limit is per company, the $10 million limit, so one can invest in 10 different qualified small businesses and potentially exclude $10 million or 10 X the basis in each business. For a couple married filing jointly, there's some questions as to whether they get double the limit. The prevailing opinion is that they do not. It's 10 million for a couple married filing jointly.

It's important to note that not only is the gain excluded from federal capital gains tax, which is currently 20%, it's also excluded from the 3.8 net investment income tax, so essentially, almost a 24% tax savings if someone benefits from 1202. With 1202, and we'll talk about holding periods and which types of businesses qualify, generally with 1202, you have to hold it for five years, but there's a second prize, a consolation prize section 1045. We're just going to touch on it briefly today because of our limited time. But essentially, what 1045 allows is someone holds good qualified 12 business stock, if they hold the shares for six months and they identify within 60 days of the sale and they invest in another qualified small business, it's a deferral provision they could defer the gain and the holding period continues on. Moving on-

Jeffrey Kelson:This is crucial or beneficial where you didn't meet the five-year hold test, right, Ben?

Ben Aspir:Exactly. We've got clients come to us and they've sold their stock after three years and they think there's no other option. So 1045 is a great out potentially if they don't hit the five-year rule. Depending on when the stock is acquired dictates the exclusion ratio on qualified small business stock. If it was acquired from August 11/93 through February 17/09, it's a 50% exclusion rate. Then from February 18/09 through September 27th of '10, it's a 75% exclusion rate. Then here's where it's really a home run. If someone acquires qualified small business stock after September 27th of '10 and they hold it for five years, they could potentially exclude up to 100% of the gain subject to the 10 million limit or 10 X basis. This chart really illustrates why 1202 has become so popular recently and why it didn't really get much of the limelight for the first 10 or 15 years that 1202 was available.

One of the main reasons being was that for about a decade, capital gains rates were 15%. For the way 1202 works is, if you were in the 50% exclusion ratio, the amount that's not excluded is core 1202 is taxed at 28%. Essentially, you have an effective tax rate of 14% with Section 1202 back when rates were 15%. So if capital gains rates for 15% and your effective rate is 14%, it wasn't necessarily worth the headache to go through all the hoops for 1202. At a high level, there's two types of requirements of Section 1202. There's the corporate level requirements that the corporation has to meet and then there's shareholder level requirements, and we'll go into greater detail. But just in our overview for 1202, the stock must be issued by domestic C corporation with less than @50 million in assets, it's tax basis. At the time of and immediately after issuance, the stock must be issued by a corporation that uses at least 80% of its assets in an active trader business. This is one of those rabbit holes that traps for the unwary.

A lot of people are unaware of it, and we'll also get into greater detail when you have capital raises, significant cash inflows, that could be problematic. It must be held by a non-corporate taxpayer, so it can be held by a partnership or an S corp, it's just that S corp stock or partnership interests itself cannot be 1202, but QSBS can be held by partnerships in an S corp. We'll go into that in greater detail. Another big one, and this is a shareholder level requirement, they have to acquire the stock on original issuance. Lastly, like I mentioned previously, it has to be held for more than five years. Like I mentioned earlier, the active business requirement, and this is when we do our 1202 studies and we start kicking the tires, we like to look at the historical balance sheets. We've seen some companies get tripped up is they've had significant cash and that can get them tripped up if 80% of the assets are not used the active trader business.

There are special carve outs for new companies within the first two years. If they held it for R&D expenses or reasonable working capital needs or startup expenses, the company cannot hold more than 10% by value of portfolio securities, and the same thing for real estate holdings. Another corporate level requirement for 1202 is 1202 lists out businesses lines or trades or business that are ineligible for 1202, so you'll see of a theme here. Any service types of businesses, so accounting, engineering, law firms, those are not eligible for 1202. Here's a rather vague catch-all. Any trader business where the principal asset or such trader business is a reputation or skill of one or more employees, so there's no guidance on that. But there's 199 A, the qualified business deduction, unrelated to 1202, but they essentially copied and pasted language in 1202. That guidance, which is not binded to 1202 mentions that the principle asset of trader business is more when you're dealing with celebrity endorsements. You see the celebrity chef and their name is on the bottle of sauce and they're making money off of that, so it's very specific.

Banking and assurance is ineligible into a lot of the financing industry. Farming, hospitality and oil and gas would be ineligible for 1202. So 1202, like I mentioned, does not have a lot of helpful guidance, so we have to sometimes look to other co-sections. When there is any IRS ruling released, any insight we can we get very excited, so in the last year there's a couple of letter rulings. The first one, the taxpayer requested a letter ruling from the IRS related to, they were in the industry of selling prescription drugs, basically a pharmacy. Like I mentioned earlier, the health industry is ineligible, but the question is, so they're not performing in a diagnosis, this taxpayer. They were simply dispensing prescribed drugs. The IRS concluded that the taxpayer is not a business involved in the health field, and so that did not disqualify from the 1202s. This, of course, was a favorable ruling.

But another ruling that was issued this past year is so favorable, was the taxpayer was a website and basically, they facilitated renters and landlords. It was a website database, lessors and lessees to rent out space. You can look at it two ways when you're that type of business. They're really just the technology platform facilitating two different types of ... the landlords and tenants. The IRS took a pretty harsh approach to them and said, "You're in the business of brokering, which is an ineligible business," and so that was a little bit surprising in the tax industry that the IRS took such approach. Now, it's important to note, before I turn it over to Kayla, is that letter rulings are only binding directly to the taxpayer, but it does help us to see what the IRS's inside is into asserted in issue.

Kayla Konovitch:Thanks, Ben.

Ben Aspir:I'll turn it over to you, Kayla, now. Sure.

Kayla Konovitch:Yeah. Another requirement is that the stock has to be acquired at original issuance, which essentially means that you have to purchase a stock directly from the corporation. It has to be issued by the corporation in exchange for either for money, for property or for services as compensation for services that you provided to that corporation. Now Ben mentioned earlier in order to be eligible you have to hold the stock for more than five years. The question is, "Well when does the holding period begin?" Typically, it's going to begin at the date of the issuance when the stock is actually issued. Now, if you are going through a tax-free reorganization or a tax free rollover where it would fall into Section 351 or 368. Then in those cases the holding period would actually tack from the original acquisition of the stock, so there was a benefit there.

You can get attacked on holding period with a reorganization; however, it's important to note that there is a limitation. If you had good qualified small business stock and then with this reorganization you no longer are holding qualified small business stock, you have a limitation of the unrealized gain at the time of the reorganization of the cap of the amount that you're eligible for the exclusion on. Then any post appreciation after this exchange, this reorganization, you would not be eligible for the exclusion. So you would need evaluation at the time of this reorganization and that amount of unrealized gain would be eligible, but not any further appreciation.

Now, of course, if you had good qualifying small business stock and you had a reorganization that qualified and you're still holding good qualified small business stock, there wouldn't be any limitation. Ultimately, if you met all the requirements, you would still be eligible for the full exclusion. Now, again, Ben mentioned earlier Section 1045, which is the deferral provision where you have a rollover, you didn't fully hold the stock for five years but you sold it early and reinvested in another qualifying small business, in that case, the holding period would also tack on. So there's a benefit or per care, they would also get the tacked on holding period and potential exclusion on the back end. Okay, our first polling question.

Astrid Garcia:Polling Question #1

Kayla Konovitch:While we're waiting for the timer to run out, I just want to focus on healthcare for a moment. Healthcare itself is actually a very broad term, and under Section 199A it actually gives us a little bit more of a definition when we're talking about the service of health of what it means. If you're in the service of health, like you're an individual who's a practitioner, a physician, a pharmacist, a veterinarian, a therapist, the individual offering that service would actually ... you would not qualify even if you structured through a corporation; however, if you were doing research or testing or manufacturing for healthcare equipment or pharmaceuticals or something like that, you could be eligible. It's very specific to the service of health versus if you're doing something that's in the health tech sector or something like that, so just a good idea to be mindful of that. Everything in health is not out, it's very specific to the service of health as a provider, as a practitioner.

Okay, so this is good. Really, the answer really is it depends, it really depends what we're talking about when we're saying healthcare, so that's good. Okay, so back to holding period. If you were issued stock options, warrants or convertible debt, those instruments itself are not eligible, they're not qualifying. But as soon as you exercise the warrant or option or you convert the debt to equity, that's when your holding period would begin. That's very important in tracking your holding period because you don't want to mess up with the dates and then potentially sell to early because you didn't have the tracking down correctly. Now if you received any stock based compensation, then generally if it's incentive stock option, it's a date that you exercise that the holding period would begin; however, if you have restricted stock where you made an 83(b) election, the holding period would begin on the date of the election. Of course, if you didn't make the election, then ultimately, it's as soon as you vest, that's considered when the holding period would begin. Now, I just want to take a moment to really talk about SAFE notes.

This has been a very hot topic, we're getting a lot of questions here on SAFE notes, especially in the venture practice where essentially the SAFE note, it's issued by a startup, an early stage company. It's a very simple, the SAFE actually stands for a simplified agreement for future equity, and it has very standard terms and there's not much negotiation that goes through it. So it's simple and easy for the company and it actually is very simple from a legal and a business perspective; however, I want to point out from a tax perspective, it is not simple. There are a lot of questions on what the tax treatment of the note would be. Is the SAFE note a prepaid forward contract? Could it be debt or is it equity? So it really depends ultimately on what the terms of the agreement are. You have to look through it and say, "Are these terms equity-like?" There is a trend that a lot of the SAFE notes that we're seeing lately, they're actually post money SAFEs which have much more equity-like terms.

So you have to look out for things of if there's interest payments required on what the maturity may be. Typically, there won't be, but you'd have to also look for the voting rights or is there an option to get a dividend payout? In the hierarchy of payout, Is the SAFE note junior to the debt holders? So there's significant factors that you'd have to actually look at to determine if this really would be equity or not. It's really important because that will dictate them what the tax treatment is, and that will tell us, "Well, when does the holding period begin?" If this is to really equity on day one, that's when your holding period would begin, so it's just been a very hot topic. It's easy for startup companies to use, and we're seeing it a lot, especially in the venture space. Okay. We mentioned before in order to have original issuance you have to have newly-issued stock. In exchange, it could be for money but you can also have it in exchange for property.

If that is the case, then if you're exchanging property for this newly-issued corporate stock, the holding period will begin on the date of the exchange. It doesn't take over a tacked on holding period of the property you're exchanging. So the holding period begins on the date of exchange and the basis for only for Section 1202 purposes in computing that exclusion amount, that basis cannot be less than the fair market value of the property exchange. Now, this is really important because when you have a property contribution you need to get valuation, and that valuation is going to set the hurdle. It's going to set the basis limitation for computing the exclusion, it's really important. Whatever that number is, if you did a valuation and it came out you had zero tax basis but a $10 million valuation, you would only be entitled to exclusion potentially on any of the appreciation that is above the $10 million because that first $10 million was really the value of those assets. So it's only the future appreciation that would be eligible for this exclusion.

What I want to really focus on and point out here, because I'm seeing 15 different questions coming in right now, all on the same exact question, which is about, "What if you have an LLC and you're converting it to a C corporation, can LLC units be eligible for exclusion?" The answer is is it falls into this provision of property contributions. What happens is that you have an LLC, that's taxes and partnership, and you can do an entity classification election on the Form 8832 and you can elect to be treated in taxed as a corporation. Now, it's very important, again, to get this valuation because that valuation will set that threshold and that hurdle for what amount would be eligible for future appreciation. There's a couple of dynamics here that you have to consider and take into account. So one is the fact that you need a valuation. That valuation can't be too high. If it's valued at more than 50 million, you'll never meet the gross asset test and automatically, you re out, so you need a valuation.

It can't be too high, but also, getting a valuation that is a higher amount can actually set the 10 X basis factor for determining the 1202 at a higher amount. Again, that number's also your cap where anything built in up to that number, you can never get the exclusion. It's only that subsequent appreciation on the staff that you're eligible for the exclusion. There's a number of things to consider here, and we will actually go through an example with everybody. When an LLC converts to a C corporation, this is something, every week we're getting questions, especially we're seeing a lot of startup companies. They're going out there, they're raising capital, and they may be looking at some venture funds. One of the requirements is that these funds, they don't want to invest directly in an operating partnership. For certain reasons, they want to be in a corporation, they have tax-exempt investors or foreign investors, there's certain reasons. This is a pretty common requirement for the venture funds, and so the startups will often, we see that they go through this conversion. Jeff, you might want to jump in here about an S corporation. I know that's your favorite topic.

Jeffrey Kelson:Thanks, Kayla. The difference between converting an LLC to a C corp to qualify for 1202, and an S corp going to a C corp is vastly different. The LLC, as Kayla pointed out, all you need to do is check the box and you're deemed to have issued stock, it makes it a lot easier for an LLC. In an S corp, you actually have to enter into some sort of reorganization, because for the S corp to issue stock, you would almost have to do something akin to an F reorganization where there's a NewCo that's issuing stock. That's a distinction between going from the two pass two entities to a C corp. Okay.

Kayla Konovitch:Then we'll do an example shortly of this conversion and understanding the mechanics and what amount can be excludable, so we'll get to that in a moment. Do you want to take this?

Ben Aspir:Yeah. As Kayla mentioned, there's the original issuance requirement and some of the most common questions we get related to transfers of qualified small business stock. So just to briefly go through this, contributions to partnerships or S corporations will terminate S corporation status because it's no longer originally-issued stock. QSBS distributed from a partnership generally retains a status as long as the partner was in the partnership. When the partnership acquired the QSBS contributions to a single member llc, like a disregarded entity generally retains a status.

If that disregarded entity converts you to let's say, a partnership that could be problematic in 1202 stock. Inherited stock or requests of QSBS, the status is generally retained. Distributions from S corps to a shareholder is a very interesting question that I've gotten in the past because when you distribute appreciated property from a corporation and an S corp is a corporation, it triggers gain. There is a position that can be taken potentially that the entry level gain that's triggered upon the distribution of the QSBS may be eligible for Section 1202, but it's not clear. Moving on to our next polling question.

Astrid Garcia:Polling Question #2

Jeffrey Kelson:While we're waiting for this, one thing I like to bring up that gets overlooked is this exclusion is when you sell the stock, right? That's how you would get this exclusion. If the corporation itself sells assets, it gets taxed internally, but if it distributes the proceeds out in liquidation to the investors, then that's excluded. It excludes the outside gain, not the inside gain. Just a lot of people overlook that.

Ben Aspir:Yeah, whenever we discuss 1202 we say it's a home run if it's a stock sale, but if it's an asset sale, it's nice but it's not nearly as lucrative.

The correct answer is false. I guess Kayla mentioned, any pre-contribution appreciation would not be eligible for 1202. Kayla highlighted the importance of having a valuation done if a business is thinking of converting to a C corporation for 1202.

Jeffrey Kelson:Ben, I always like to explain the reason for the rule. The reason for this rule is they don't want the appreciation while you were not a qualified business to get magically excluded once you convert to a qualified small business stock. So they're policing it so that the appreciation and the pass-through doesn't qualify before you convert it.

Ben Aspir:Exactly. I'm going to turn over to Jocelyn to discuss estate planning surrounding QSBS.

Jocelyn Borowsky:Okay, well let's shift gears and talk about a little bit of estate planning with QSBS. I'm going to start with a simple example. Suppose your client owns $20 million, Theresa that's her name, she owns 20 million worth of QSBS which she plans to sell shortly. Now, let's just stipulate for this example that the QSBS has low basis. We're not looking at doing the 10 X basis exclusion, we're just dealing with the $10 million exclusion and we're under the 100% exclusion rule. Okay, so there gives $10 million of QSBS to her husband, Patrick. Can Patrick and Theresa both use the $10 million gain exclusion? As Ben mentioned earlier, there's a specific rule that says if they're married filing separately, each spouse can only claim a $5 million exclusion. Then the rule for spouses who are married filing jointly is a bit ambiguous. So I've seen a difference on opinion on this, and for that reason, perhaps this planning idea of giving QSBS outright to a spouse isn't such a great idea.

Also, oftentimes the clients who come to me with QSBS planning tend to be younger than typical estate planning clients, and so they don't necessarily want to make a gift of $10 million worth of QSBS to a spouse outright. Let's go to our next example, which involves planning with a trust. Theresa can consider making a gift of $10 million worth of QSBS to a trust for the benefit of Patrick. So the good news is, trusts are eligible shareholders for QSBS purposes, and transfers by gift or death into a trust or outright for that matter can tack the donor's holding period for purposes of that five year rule. But this example is a bit of a trick question because generally a trust for a benefit of a spouse is a grantor trust. Whenever planning for QSBS purposes a trust should be a non-grantor trust. The way to make a trust a non-grantor trust is in how it is drafted, applying or avoiding the grantor trust rules, so it has to be drafted carefully.

Another issue with a trust is again, even if it's a trust for the benefit of spouse, there's always a consideration of potential marital discord, but when you have a trust you can draft around that sometimes. Oftentimes, because the clients tend to be younger, sometimes they don't have a spouse, they don't have children, so you can do planning. You can create a trust for the benefit of other family members and have a kick out clause. The purpose is not to kick out the children but to provide that if a child is born, then that child becomes the beneficiary, and the other family members may cease to be beneficiaries. That's the benefit of using a trust, you can draft around those issues. But oftentimes, clients who are younger don't want to create an irrevocable trust for other family members because they do not get the benefit of that trust and not beneficiaries and maybe they're too young to use up their gift tax exemption.

Let me pause here for a moment and just mention that while we're talking about planning to multiply the use of this $10 million QSBS exemption, whenever a gift is made into a trust, you also have to have in mind the donors gift tax exclusion, that's a separate number. In 2022, the gift tax exclusion amount is $12,060,000. Conceivably, a person could fund a trust with $12,060,000 of stock and thereby, have it be exempt from gift tax, it will be eventually exempt from a state tax when that person dies. If a stock is sold, if it's QSBS stock and it's sold for a $10 million worth of gain can be also excluded, so it's a triple play win, win, win. The trust must be a non-grantor trust. I cannot stress that enough. Let's shift our example. Supposing Patrick and Teresa have two kids, a son and a daughter.

So the idea of stacking is instead of creating a single trust that's a non-grantor trust to hold $10 million worth of stock, that instead of that Theresa creates one trust for her daughter and one trust for her so. If the value of that stock is to appreciate over time each trust, if it's drafted correctly and it is a non-grantor trust, each trust can get its own $10 million exclusion for QSBS purposes. You also have to be mindful of the gift tax exclusion, so ideally, there would create one trust with under $12,060,000 worth of stock for each child. Now, you don't want to get too carried away with this because of Code Section 643(f), as in Frank, it's an anti-abuse rule. I'm not exactly sure where you'd draw the line, but it's a rule that says if you have multiple trusts created by the same donor with the same beneficiaries and it has a tax avoidance purpose, the IRS will then treat all of those trust as a single trust so it would defeat the QSBS planning.

But I don't think doing this for one or two beneficiaries is abuse. I just came back from a conference where people were talking about a client who did 40 of these, and in my view that seems like it's a bit over the top. If you were involved in that planning, please let me know if and when you get audited because I'd be curious to hear. Okay. One of the problems with making a completed gift is that the donor uses the donor's gift exclusion amount on that gift. If the donor is young or has already used up the donor's gift exclusion amount, this type of planning won't work. Also, a lot of times the clients will say, "But wait a second, if I'm settling a trust, I want to have access to this trust. I want to be a beneficiary of that trust."

Normally, the rule of thumb is, if your settler or your donor to the trust is also a beneficiary, normally, that trust is a grantor trust and you don't want it to be a grantor trust, you want it to be a non-grantor trust. We're going to go next example is, that's not this example. One more. Yes DINGs, you might have heard of DING. That is a solution to this situation. The NG in the word DING stands for non-grantor, and this is a very special type of trust that affords the donor the ability to be a beneficiary of the trust and also, it weaves its way around the grantor trust rules so that it is a non-grantor trust. Now, there are many, many letter rulings that describe exactly how to set up a DING trust. The key point here is that it needs to be set up in a jurisdiction that has special legislation. New York and New Jersey do not. California does not.

Delaware does and so do a hand ... well, maybe 19 other states have this special legislation in place. If you're going to set up one of these DING trusts, you need to have it qualify in one of those states. You might wonder, "Well, if I don't live in one of those states, can I do this?" The answer is absolutely, yes, you can. You don't have to live in a state that has these laws to settle a trust in those states. I also should mention that while there are many, many letter rulings approving the form of a DING trust and telling you exactly how to set up a DING trust, the DING trusts are on the IRS's no ruling list now, which just simply means they're not going to issue any more letter rulings, blessing the DING trusts.

But it also is suggested that perhaps the IRS might not be quite as generous with its DING trust rulings in the future. So just you should know that there might be some risk associated with this type of trust and that perhaps it might not be considered a non- grantor trust in the future if you imagine a world where a different ruling were to come out in the future. But the benefit is that the donor can have access to the trust property, and because the I in ING stands for incomplete gift, the donor does not use up the donor's ... any gift exclusion amount. So that can be helpful in the situation where the donor has already used it up or just doesn't want to use it up at that point in time. Well, anyway, I have lots more to say about this subject but I am close to the end of my time slot, so if you want to contact me offline, my email is available in these materials. I'm going to pass it on.

Jeffrey Kelson:Thank you. We got a polling question.

Astrid Garcia:Polling Question #3:

Kayla Konovitch:While we're waiting just to answer some questions coming through, there's one here about, "Well, what if you have a partnership that's distributing property that's qualifying small business stock to a partner, would that be eligible? Would that work?" The answer is yes, it would retain the qualification to the individual. You can have a partnership making a distribution of qualified small business stock to the individual; however, note that the individual cannot contribute a qualified small business stock into a partnership in exchange for interest. That would actually kill it. So you can do it from a partnership to the partner but not back as a contribution into a partnership.

Some other questions I saw regarding, "If you have a corporation, that it's a U.S. corporation but it has some non-U.S. activities or foreign branches or corporations, would that qualify?" The answer is it should be able to because as long as you're meeting ... it says a U.S. corp, and if you're directly invested in U.S. corp, as long as the qualifying activity of the business still meets that test, I don't think it makes a difference if it's abroad or not, so that still could work potentially. Some other question about convertible debt. I think we mentioned this before, that if you have convertible debt that instrument itself is not going to be eligible, but once you convert it to equity, and it could be preferred shares or something like that, that would be eligible. That's when the holding would begin, once you have that equity.

Kayla Konovitch:Okay, so this is true. The stock warrant in a qualified small business is not eligible for the exclusion. The warrant is not eligible. Once you exercise the warrant at that point you would have to do the testing to determine if it's eligible and the holding period would begin. Okay, so back to what we were discussing earlier where you had property where at the LLC interest you wanted it to take the assets essentially and exchange it for interest in a corporation. Well, really to convert the LLC to a corporation. We're going to go through an example now of how this works and what the exclusion will be. Ben, maybe you'll take this with me, I'll go through the facts, and then we'll discuss what the result would be. So in 2010, Jane and John, they form a 50/50 partnership. They form ABC LLC. The LLC is taxed as a partnership, and a few years later in 2014, they want to convert the LLC to a C corporation.

Like we said before, you need to get a valuation of the assets to determine what is the value of the assets. Here we did a valuation, it was $7 million in value. Now the basis of these assets are zero, and it's very key to keep your eye on these things. So the inside tax basis is zero, but the value of the assets that you're exchanging, contributing to the corporation is $7 million. Now, that's when you do the testing, it's at the time of this conversion and you have to go through the testing assuming that we meet all of the qualified small business stock criteria, we're a good qualified small business. Okay. Now, a few years later in 2022, Jane wants to sell her 50% interest in ABC Corp for $50 million. How do we approach this? There's really two levels that we need to look at. First, we need to look atm what is our gain? Not even thinking about 1202, what is the gain here? So in first step-

Ben Aspir:If the notice that Jane held her shares for more than five years from the time of conversion from LLC to the ultimate exit.

Kayla Konovitch:Sell date, right? As the first step we're looking at what's the gain, not even thinking about 1202. She got $50 million in proceeds and again her basis of that stock was zero because it was that rollover basis. It was a tax-free reorganization and ultimately, she had zero inside basis. She has a $50 million long-term capital gain hair, so that's the first step. The second step is that you're going to have to focus on, "Okay. Well, what amount of that 50 million gain is eligible for exclusion under 1202?" So what do we do in the next step?

Ben Aspir:Generally, when you contribute property into a corporation, the basis carries over. So 1202 has an interesting quirk to it that if you contribute property the basis for the $50 million asset test that we mentioned previously is the fair market value. If you contribute $60 million of fair value of assets into a corporation, it's a non-starter for 1202 because you have to be under $50 million. But where it also could benefit a shareholder is for the 10 X basis, so their basis for calculating the exclusion is the fair market value of the property contributed for 1202. This is an interesting quirk in 1202 that you generally don't see in other parts of the-

Jeffrey Kelson:In some cases, it can be beneficial to roll in a pass-through entity so you can multiply the basis more than if you were just ... it all has to be calibrated. You'd have to crunch the numbers, but it is kind of an odd quirk, yes.

Ben Aspir:As Kayla mentioned, the pre-contribution appreciation with $7 million, so Jane's share of 50% of $7 million is three-and-a-half million dollars. So Jane can exclude the greater of to $10 million or 10 X Jane's basis of three-and-a half million, so its $35 million. Jane can potentially exclude from federal capital gains tax 35 million dollars. Jane must pay tax on the first three-and-a-half million, like Kayla mentioned, because that three-and-a-half million was a pre-contribution gain. If that was the appreciation in the assets prior to the conversion in 2014, Jane could then exclude the 35 million on their Section 1202, the 10 X the three-and-a-half million.

If you think about that, even ignoring state taxes for a second, 24%, almost on $35 million, that's a significant tax savings. Then Jane pays tax on the remaining gain outside of the 10 X benefit. So Jane's total taxable gain is $15 million, that initial three-and-a-half million we mentioned, then the 11-and-a-half million of gain outside the 10 X basis. The federal tax savings potentially at $35 million at 23.8%, even ignoring state taxation for a second is over $8 million. So there could be significant benefit from 1202 here.

Kayla Konovitch:It's interesting because if they didn't even undergo the conversion, if it was always a C corporation from day one, the amount of her exclusion would've been capped at 10 million. Here, she actually got an added increased benefit actually in converting getting this valuation and getting 10 X basis, she was able to exclude 35 million of the gain. It's an interesting fact pattern the way it worked out here.

Ben Aspir:This fair market value contribution rule, like I mentioned, can hurt a shareholder if they're contributing assets that are too high, and it can benefit when they ultimately sell the company under the 10 X basis rule. Next polling question.

Astrid Garcia:Polling Question #4

Ben Aspir:The correct answer is false. QSBS must be held by non-corporate shareholders. So a QSBS held by another C corporation would be ineligible for 1202. I'll turn it over to you, to Kayla now.

Kayla Konovitch:thanks, Ben. I just want to spend a little bit of time on this structure here. We've been getting some questions in the past year on this. If you have really late stage venture or maybe even early growth equity funds, we're getting this question where the fund wants to make an investment in an operating partnership, but in order to do so, they want to set up a corporate blocker for different business reasons, for tax reasons, they have foreign investors or tax-exempt partners and they don't want to be directly invested in operating partnerships. So they're setting up a corporation, a blocker corp. So what happens is, is they form this new corp, the fund puts the cash in and in exchange, they're getting newly-issued shares of the corporate stock. Now this corporation then immediately goes and purchases the interest in this partnership. So the question here is, in order to qualify, we know you have to have a good qualifying trader business at the corporate level. Now the corporation itself is just a holding company. It really doesn't have its own activity. All the activity's at the partnership level.

So the question is, would this structure qualify for the exclusion if we sold the stock or the corp? So the rules under the Code of Section 1202, it actually does a look-through provision where you have a corporate subsidiary relationship. There's a parent and there's a corporate subsidiary. If the parent owns more than 50% of the corporation, you would attribute the activity of the sub to the parent. You would also have to use that, the same method for us of the gross asset test. You would have to look at it combined. So in a corporate sub context you would actually attribute the activity up to the corporation. The question here is, does this work if the corp owns a partnership interest. The code is actually silent as to this if it does or doesn't qualify. But our thought is, and I think general consensus is that if you own more than 50%, same as a parent corporate relationship, you should be able to attribute the activity of the partnership to the corporation if you owned it more than 50%.

The big question comes into play is, "Well, what if the corporation owns a minority interest, they own less than 50%. Would that qualify?" It's a good question, would it qualify? We were doing quite a bit of research as an aggregate versus entity theory if as you directly have the activity of the partnership. But we did some research and we're looking at the corporate tax-free reorganization rules under 368. Under the code and the regulations there, there is actually some parameters or rules where you would attribute the activity of the partnership to the corporation if you owned the interest; however, you have to meet one of two tests. One is that the corporate partner has to have a significant interest in the partnership. Of course, what does significant mean?

It has to be at least a one-third interest in the partnership in order to attribute out the activity, or the corporate partner can own just a meaningful interest, which is at least 20% and it conducts active and substantial management functions for the partnership. So that corporation is actually actively involved in the partnership making really significant business decisions involved with the operations and the employees so they're really quite active in the partnership. You need to meet one of these two tests in order to tribute up the activity to the corporation. I'm just bringing this up. This is some proactive structuring we've been getting from some clients, and it's good food and for thought if this could work or not, and it's specific to your facts and circumstances. So just something to think about if this is an opportunity here, obviously if it's done right and, again, very specific but something to think about. All right, Jeff.

Jeffrey Kelson:Ah, traps for the unwary. Thank you, Kayla. There are traps for the unwary in QSBS besides just mere qualifying. One of them that gets overlooked is stock redemptions. There's two possible ways to get knocked out. If there was 2% of the stock that was redeemed during a four-year testing period, which begins two years before your purchase and two years after. A second one that's 5% of the stock is redeemed by value as of one year before you ... it's a two-year period, but beginning one year before you made your investment and ending one year after you've made it. Why is this rule here? Because it's to police a sale between two shareholders instead of just selling one to the other, which does not qualify for QSBS by having the corporation be a middle person and redeem it and then issue it, they're trying to stop that because they want more investment into the company, not just to benefit departing shareholders.

So that's why those two tests are there, be mindful of that. They can really trip you up. There's some exemptions for death and divorce and disability, that wouldn't be considered a redemption and some other de minimi tests, but basically don't overlook the redemption. Sometimes they can be sneaky, and you look back and it's there and you have to deal with it and could ruin it. The biggest change in the tax code that's detrimental to many taxpayers that incur software development costs on R&D expenses is this 11-22 elimination of the immediate expensing on the Section 174 for R&D expenses. This a gigantic. I can't overstate it enough. We thought it would be legislated the way it isn't, so why am I bringing this up here? Besides, it's just a good nugget of information for you to have is that it impacts the $50 million basis rule, because before, when qualified small business stock potentials would incur R&D expenses, it would never fill through the tax basis balance sheet.

It would just be expensed. It never sat up there. It didn't have to amortize it now, which you have to do over five or 15 years depending. Now, with this new rule beginning 11/22, you could see companies lose their QSBS status much sooner because if they're incurring these kind of expenses and they're sitting in the tax-based balance sheet; unintended consequence, but big impact here and impact in other areas of the tax code, too. This R&D thing is just gigantic, and it doesn't seem to be retroactively legislated away if you're hoping for that. It's failed on several occasions. Bonus depreciation, beginning as many of you work it's 100% deductible. You can make a bonus depreciation and it never enters the balance sheet. Beginning in 2023, there's a 20% reduction.

So in 2023, you can only take bonus depreciation on 80%. That goes to 60, 40, 20 over the next four years until it's completely gone and will not be anymore bonus depreciation unless they change the legislation. That can also impact that $50 million tax basis. Gross asset test. Be very aware these two provisions are going to ... especially the R&D, especially. State treatment of the qualified small business stock, many states, well states are all over the map. New York allows the complete elimination, it follows the federal, but New Jersey and Pennsylvania, for instance, do not and neither does California. Those states tax the qualified small business gain that's excluded for federal, so you have to never forget about the states. Always remember the states. Kayla, you'll take us through the capital infusions?

Kayla Konovitch:Yeah. Very often, you make an investment in a corporation and now they want additional capital infusion, they're making another platform investment or whatever it is, they need more capital. You just need to be careful if you're putting more cash into the company. One is, are they issuing additional shares, new shares for that capital? If that is the case then, just a reminder, you need to actually go through the testing again at that point in time to determine if those new shares are eligible as a qualified small business stock. At that point, are your gross assets more than 50 million? You have to look at these tests again with any new issuance. In addition, even in the case maybe there's not additional shares issued and maybe you're going to say it's just an additional commitment into the corporation. You have to be mindful of the active trader business requirement because you can't have too much cash on your books, and that test is actually not looked at just at issuance. It's actually looked at throughout the life of the corporation, and it has to be substantially through the holding period.

So substantial, it's at least 80% of the time you can't have more too much cash. So you just have to be careful adding when you're more cash. Will it change anything? Will it disqualify you from eligibility? Especially if this new share is to do the testing again if those new shares are eligible. Then one final thought, we're seeing a lot of secondary funds out there. A lot of limited partners are coming in and buying out another partner, so you have one LP buying out another LP. We just need to be very mindful of the fact if you're getting a K1 and you came into the partnership at a later date and it says on it, "The X amount of line nine or line 11 of your gains may be eligible for exclusion," that's great that you have good qualified and small business stock, but you individually need to determine if it's original issuance to you.

The footnote will usually will give you an acquisition date when the partnership purchased that stock. You have to know the date that you became a partner, were you there at the time the partnership made the acquisition? Just because you're getting a footnote that you may be eligible does not mean that you are. And it is your responsibilities and comment on you to determine if you are eligible for the exclusion, so just be careful of that. You don't want to take something that you can't substantiate, so just be careful looking at the date that you were a partner at the time the partnership made the acquisition. I think that hits us right at 1:00.

Jeffrey Kelson:Wow.

Kayla Konovitch:Yeah, there's a lot of questions coming through. We'll try to get back to people with our questions. Feel free to reach out to us. Our contact information is on the slides. Astrid, I don't know if there's some of the closing.

Jeffrey Kelson:Yeah, very engaged group here with lots of questions, so we appreciate it. Thank you, guys. Thanks, everyone.

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