On-Demand: Section 1202 Capital Gains Exclusion | Part II

After we present, and the presentation is going to include examples, we will then have a roundtable with Ben and Kayla discussing their real-life stories that they're dealing with in an everyday basis in planning for Section 1202, which I think will give you great insight and to want to benefit, but also the complexity. There's not a straightforward code section by any stretch of the imagination that worked in it.

So, let's start off with Ben Aspir. At the end, we'll have time for questions from all the attendees, and we might be answering them during the polling questions as well. Go ahead, Ben, take it off. Take it off.

Benjamin Aspir:Thank you, Jeff. Welcome, everyone. Thank you for joining us for today's sequel on Section 1202, part two. So, for those of you that joined us on the first part, part one, this may be somewhat of a repeat, but it's important to have a refresher on it to truly appreciate the second half of today's presentation on the case studies, and like Jeff said, when we have our discussions on some situations we've encountered.

So, Section 1202 was enacted in '93 as a way to spur investment in small corporate businesses. And what is it? It allows the greater of a $10 million or 10 times the basis exclusion on the sale of qualified small business stock. And we'll walk through what qualified small business stock is. That qualified small business stock has to be held for at least five years.

And the exclusion can either be 50%, all the way up to 100%, which we'll walk through on the next slide. What the dates on the exclusion ratios, because depending on when the stock is acquired, that dictates what your exclusion ratio is, not when its sold. But has to be held for five years. But your exclusion ratio is based on when the stock is acquired.

The $10 million exclusion limit is per company. So, you can invest in several different qualified small businesses and benefit. It's not a limit on all the investments you ever made. Just be aware that if you're filing your personal tax return as married filing separately, that cap is at $5 million, instead of $10 million each spouse.

And the exclusion from gain is exclusion from federal capital gains tax, which is currently 20%, and could possibly be going up higher depending on how the legislation falls out later in the year. And it is also an exclusion from this net investment income tax of 3.8%. So, if you're eligible for 1202, it can be fairly lucrative. Your savings at least at the federal level at 23.8%. And potentially at the state level, if your home state recognizes section 1202.

At the bottom here, I've mentioned 1045. We're not going to go through it in depth today. We just would like our participants to be aware that it's defer provision that if you hold qualified small business stock, and you sell before the five-year period, and if you've held it for more than six months, if you identify another qualified small business to invest in within 60 days, you can defer the gain, and continue on the 1202 status, and the holding period that comes along with it.

So, if you look at the chart on your screen, you'll see that August 11, '93 was when 1202 was enacted. So, August 11, '93 through February, '09 is 50% exclusion. And so, if you're in that bucket, the maximum tax rate you're going to pay is 15.9%. And how do we get there?

Jeffrey Kelson:That's acquiring the stock during that period, right, Ben?

Benjamin Aspir:Right. If the stock is acquired during that period, and you've held it for five years, you're going to pay an effective tax rate of 15.9%. And there is an AMT effect there. Because the amount that's excluded is a percentage of that, 7% of that is an add vat for AMT. February 8, '09 through September 27, 2010, the exclusion ratio is 75%. Your effective tax rate is 7.95% on that.

And then, if the stock is acquired after September 27, 2010, best case scenario, you get to exclude the entire gain up to 100% depending on how big the gain is. There is a cap on it, and we'll go into greater depth on the caps. So, what are the requirements for 1202 to have eligible qualified small business stock? So, at a high level, the stock must be issued by a domestic corporation with less than $50 million in assets at the time of immediately and after issuance.

And must be issued by a corporation that uses at least 80% of his assets, and the active trader business must be held by a non-corporate taxpayer. So, it could be held by an individual, it could be held by a partnership, an LLC tax as a partnership, an S Corporation. It just can't be held by another C Corporation. The stock must be acquired by taxpayer an original issuance, and like I mentioned earlier, must be held for more than five years.

And we'll go into greater depth on the slides what these qualifications really mean. So, a lot of times this is lost. A lot of people don't realize you have to have this act of business requirement. And so, companies have to be aware if they have a capital infusion that they're aware of this active business requirement. At least 80% by value of the assets must be used by the corporation in the active conduct of one or more qualified trades or businesses.

So, there are exceptions for reasonable working capital needs, if the cache is set aside for R&D expenses, or if it's for startup expenses. There are further limits if more than 10% of the assets by value are portfolio securities that can trigger, and that disqualify 1202 status. And the same thing for real estate holdings. So, just be aware of this when tracking the assets for Section 1202. You must have this active business requirement because I have seen it triggered and unfortunately, companies lose their 1202 status.

Jeffrey Kelson:And also, can't be personal service companies, as you pointed out, which some people overlook.

Benjamin Aspir:Correct. So, the 1202 doesn't tell us know which companies are eligible. They tell us which companies are not eligible. So, as you see on your slides here, it's your personal service type businesses, doctor's practices, county firms like EisnerAmper, law firms, engineering, you see a theme here, architecture. We've got the second one, just catch all any trade or business with a principal asset of such trade is the reputation or skill of one or more of its employees.

It's obviously a very vague, very confusing wording. But if you look at section 199A, which is not related 1202, but the way they define it is very narrow. They talk about it, one of the examples they gave there is if you have a chef who's licensing out their name, or their likeness for certain food product. So, there was some confusion of whether a plumber because it's the reputation of skill that people come into that. Would they get caught in that?

So, it's a very narrow definition. It's not binding on 1202, but just to our participants are aware what the IRS is thinking maybe, banking, farming, many oil and gas type business that's eligible for depletion is not eligible for 1202. And any hospitality business is not eligible for 1202, like hotels, motels, and restaurant.

And before I turn it over to Kayla to talk about the original issuance requirements, there's been some questions with 1202 as far as let's say you're an adjacent field that let's say you're in a field adjacent to accounting. So, you're an accounting software business, would that disqualify you from Section 1202?

No, it generally would not, because you're not actually practicing accounting. You're truly a software business that's providing service to accounting firms. So, accounting firms are ineligible, but just because you're in a field that's adjacent to an ineligible business does not necessarily disqualify you. So, I will turn it over to Kayla to go over the original issuance requirements.

Kayla Konovitch:Okay. So, what does it mean to be original issuance? That means that the qualified small business stock needs to be acquired at original issue directly from the corporation. And it has to also be in exchange for money, property other than stock, or compensation for services performed for the company. So, like an employee working for the corporation, that can be eligible.

Now, the holding period begins on the date of issuance. That's when you would measure did you meet the five-year test? So, that's the general rule. Now, if you do have a tax-free incorporation, or a reorganization, under Section 351, or 368, the holding period would actually tack. So, that's actually a nice benefit there.

However, I do want to point out, there is a limitation, where if you originally had good qualified small business stock, and then you did this restructuring, and it's no longer if you tested it then and looked at it, it would not be actually qualified small business stock, then you have this tab where you'd be limited to that unrealized gain at that time that would be eligible for this exclusion.

Now, if of course, you had qualified small business stock, and it was before the reorg, and after, it's still qualified small business stock that you're holding, then there would be no limitation. Another provision, Ben mentioned before, it is the Section 1045 rollover, where you have a deferral, you can roll it over into another qualified small business stock.

In that case, the holding period would also tack. So, if you held it for one year, you could then roll it into another qualified small business, and you would just need to hold it for another four years or so to meet the five-year holding period.

Jeffrey Kelson:I can talk about one question here. If the corporation does a subsequent issuance after the initial issuance of stock with the second issuance qualified? The answer is yes, of course, the purchases five-year holding period was started that date. And they would be measured differently than people that had it from the original issuance.

Kayla Konovitch:Okay. So, that's the right answer. It is false. The stock must be purchased. It must be originally issued, purchased directly from the corporation. In order to qualify, you can't sell it to your friend. That would be on the secondary market. That would not qualify. Okay. So, continuing with the holding period, we get a lot of questions with this in venture capital.

If you have stock options, warrants, or convertible debt, is that eligible for this exclusion? So, the actual instrument itself, the actual option or warrant itself is not eligible. But once you exercised, or converted the debt to equity, at that point, you may be eligible. So, once you exercise a converted, that's when you would look at the eligibility. Does it qualify as a qualified small business?

And that's when the holding period would begin. If you have stock-based compensation, like incentive stock, it's the date that you exercise the stock that the holding period would begin. If you have restricted stock where there's no 83(b) election, it's the date of vesting. But if you did make an 83(b) election, then it's the date of election that your holding period would begin so you can begin your holding period sooner.

Of course, there're other things that you need to consider when you want to make an 83(b) election. So, certainly, you have to think about multiple items there. In addition, if you have convertible preferred stock, and you convert it to common stock, that would also, the holding period would tack. Okay. So, before we mentioned for original issuance, well, in exchange, that either has to be money, property, other than stock or compensation.

So, if you did contribute property in exchange for stock in a qualified small business, then the acquisition date is looked at as the date of the exchange when that happened, not the original date when you purchased that property. In addition, when you're doing your calculation of gain, you're actually looking at the fair market value at the date of contribution as opposed to the tax basis.

That's only for computing to gain under the 1202 for looking at the amount that's excluded. And if there was any previous unrealized appreciation at the time of conversion, that amount itself would not be eligible for the exclusion. It's only the post appreciation that would actually have potential to be eligible. One of the examples is if you have an LLC that converts to a C Corporation, because that's viewed as a contribution of property.

There may be eligibility, but again, it's only measured from once it converts to a C Corporation, you have the corporate stock, that's when you look at it. And we're going to go through an example with the property contribution.

Jeffrey Kelson:Somebody asked if after two years, a company liquidates and proceeds are received, how long does taxpayer have to reinvest? Remember, you haven't held it five years, so you can't take advantage right then of 1202. But you can reinvest it under Section 1045 into another small business stock. You don't need to actually segregate those funds. You just need to reinvest those funds. And then, you trapeze into another. You can tack it on for purposes of 1202. So, you get to defer it in the short term.

Benjamin Aspir:We have another question on married filing joint couple, does each spouse get $10 million? The prevailing thought is, is that they do not. It's a combined $10 million. It's obviously not 100% clear, but the majority opinion on those that are involved in 1202 is that a married filing joint couple gets a total of $10 million. And the reasoning behind this is, is that because the tax code specifically says it goes out of its way to say that couples that are filing separately, each got a $5 million limit instead of $10 million in it.

Jeffrey Kelson:And let me just grab this one quick. Does the clock start upon exercise data to warrant or upon granting? It's upon the exercise of the warrant when you actually get the stock, or if you get restricted stock, as Kayla pointed out, when you make the 83(b) election if you do. So, it has to vest or be turned into stock.

Benjamin Aspir:Yeah. So, some of the most common questions that Kayla, Jeff and I received regarding 1202 has to do with transfers of shares of qualified small business stock. So, if you look at the chart here, does a contribution to a partnership, if you contribute 1202 stock into a partnership, is the 1202 status retained? Generally, the answer is no. It is not retained because you're violating the original issuance requirement.

If you distribute from a partnership to a partner, is the status retained? So, the partnership is the original acquire, they purchased the 1202 stock directly, and they distribute out the stock to its partners, is the 1202 status retained? Yes. But just keep in mind that the partner has to have been in the partnership when the stock is purchased and the entire time until it's distributed.

Otherwise, if the partner leaves and comes back, they lose the 1202 status. The person receiving the stock, it doesn't ruin it for the entire partnership, but that individual partner. How about if you contribute 1202 stock into a single member LLC, or any other type of disregarded entity, would that trigger a disqualification 1202? The general opinion is it would not because for federal tax purposes, it's ignored, a single member LLC.

So, that wouldn't be a problem, generally. If you gift to an interest in a partnership to an individual, so the partnership holds 1202 stock, and they gift that interest to an individual or non-grantor trust. It's unknown whether the 1202 status would be retained. If you gift a partnership interest to a grant or a grantor retained annuity trust, state planning technique, or if you gift it to an intentionally defective grantor trust.

Generally, the status is retained, the 1202 status, another state planning technique. What about on the sale of family limited partner interest to a defective grantor trust? And that involves an exchange for a promissory note generally, that would retain 1202 status. If you contribute 1202 stock into an S Corporation, would the status be retained? It would not.

Same reasoning as the first one contributing to partnership, you would violate the original issuance requirement. This is actually a question I've gotten a couple months ago, it's a good question. You contributed to a single member LLC. It doesn't disqualify 1202. But then, you add a partner to that disregarded LLC. So, then it becomes a partnership. Is the 1202 status retained?

It is not because it's converted to a partnership. And you would disqualify the 1202 status. We're not going to spend a lot of time on this, but I think it's important for our participants to be aware, because we are talking about a lot of people ask, can we convert to a C Corporation if we're a partnership? So, one of the methods of it, so obviously, or if you form a C Corporation, so generally, if you form a C Corporation, you issue cash, you receive stock back.

It's considered under Section 351. It's not a taxable transaction. But there are other ways, if you convert a partnership to C Corporation, you have the assets over method with a partnership transfers is assets to the newly formed corporation. And then, the partnership liquidates, and then you have the assets up method, where the partnership distributes his assets in liquidation to the partners, and then they contribute the assets into the corp.

And then, you do have the interest off method. And there's a little bit of a question on whether that would be eligible for 1202. Generally, the opinion is, is that it would still be eligible. So, basically, they transfer their shares into the newly formed corporation.

Kayla Konovitch:So, there's a polling question that came up here. Does California allow for this qualified small business stock exclusion? Unfortunately, California does not allow that. But I will point out that New York, you could get the exclusion. New Jersey, there's pending legislation, so we don't know necessarily where that will go. And I know Pennsylvania also does not allow. So, I really will caution you to really check the states, wherever your residency is to determine in that state if they do allow it or not, because it is state by state.

Benjamin Aspir:So, the correct answer is false. Gain on the sale of options is not eligible for 1202 solution. You only are eligible once those options are exercised when it's actual stock, and that's when the clock starts ticking. Also, for the holding period. Kayla?

Kayla Konovitch:Okay. So, let's look at this example. Well, this example what we're doing here is we're looking at a corporation that has an asset sale. And you get a lot of questions around this, does an asset sale of a corporation qualify for this exclusion? The answer itself, the asset sale does not qualify. But if you do sell the stock, it can. So, let's see how this works over here.

So, here, we have Mary is the sole shareholder of ABC Co. Her basis in ABC stock is $100,000. And she acquired on January 1, 2012. And all the requirements are met, she met the $50 million limitation, a good qualified business activity. Now, on February 1, 2019, the tax basis of the assets are a million dollars. And she wants to sell the assets on February 1, 2019.

She's going to sell it to a third party for $5 million. So, what happens here? First of all, we have assets that they obviously want to sell. The basis is a million, and the proceeds are $5 million. So, there would be a $4 million gain to the corporation. That game would be taxed by the corporation, and is not eligible for this exclusion. So, you would be paying a 21% tax rate on the $4 million gain, plus about 9% state income tax as well.

So, you'd be paying $1.2 million on the sell. Now, you have $5 million of proceeds, less the $1.2 million of taxes you need to pay. That means that you have $3.8 million left in the company. You have cash of $3.8 million sitting in the company. Now, ABC Co wants to distribute this out, the $3.8 million of cash to Mary in complete liquidation of the company.

In this case, what happens is now, essentially, Mary is redeeming her stock. She's selling, redeeming it, she no longer will own it. So, here, because this is good qualified small business stock, she can exclude the gain. So, it's $3.8 million proceeds, less the $100,000 stock basis that she has in the corporation, that's a $3.7 million dollar gain, that could be excluded.

Again, you look at 10 times your basis, or the $10 million exclusion, here, she'd be able to take the $10 million exclusion because it's greater and she would exclude the full $3.7 million.

Kayla Konovitch:Then should you take $880,000 of additional tax. So, there's certainly a benefit that is qualified small business stock. However, there is that corporate tax that they did have to pay on the asset sell. So, that's something to consider, and it might not be the best result, but you can still get something. Jeff, do you want to add something?

Jeffrey Kelson:No, I was just going to say this, it speaks to the fact that it doesn't eliminate both taxes if you sell the assets. It only eliminates on the stock exchange. So, it's not impervious to sales of assets. It really just eliminates sales or gains on the stock. I think this bears that out. That's still price to pay. So, you're not worse off, but you haven't enjoyed the benefits if you had sold the stock.

Kayla Konovitch:Correct. Okay. Ben, do you want to take example two?

Benjamin Aspir:Sure. So, on January 1, 2021, David and Mia formed a 50/50 partnership, DM LLC. On July 1, 2012, they decide to convert into a C Corporation. The FMV of the assets at the time of conversion, and I'll talk about why that's important, why we need to know the fair market value. Fair market value of the assets at the time of conversion was $7 million.

The tax basis of the assets for sake of simplicity, we're just going to assume it was zero at the time of conversion. That the stock in DM does qualify for 1202. And then, on October 1st, eight years later, Mia and David sell their shares in DM for $100 million. Nice return on investment. So, the reason why we mentioned the fair market value is when a partnership converts to a C Corp just for purposes of 1202, you have to measure the fair market value of the assets.

Because whatever appreciated gain is at the time of conversion is not eligible for 1202. The IRS doesn't want companies just avoiding all the gain that they would have recognized if they sold a partnership, or any other, or an LLC. So, it's very important to have evaluation if you're considering converting your partnership into a court for purposes of 1202 evaluation of the assets.

It will help you though, because if you remember, at the beginning of the presentation, we mentioned that you get the greater of $10 million or 10 times the basis. So, this could be used for your basis for calculating the 1202 exclusion. It'll make more sense on the next slide. Right. So, there's $100 million sales price, they had no basis. So, no basis in their shares. So, Mia is a 50% shareholder.

Absent 1202, she would have $50 million long-term capital gain. So, like I mentioned, the gain eligible for exclusion, since it was acquired in 2012 is 100% gain exclusion. So, $10 million, the greater of or 10 times the basis. So, the assets at the time of contribution were $7 million. So, she's 50% shareholder, so half that $3.5 million, so 10 times that is $35 million.

So, like I mentioned, the first $7 million of gain is not eligible for 1202. That's half of the fair market value of the assets contributed at the time of conversion. So, Mia being a 50% owner, half of that is $3.5 million. The first $3.5 million of the gain is taxed. Then, a capital gain rates, then look at this, Mia can include up to $35 million, because 10 times the basis for 1202, she can exclude.

And then, the remaining gain, which is your $50 million allocated sale price minus the $3.5 million gain is not eligible for 1202, minus the $35 million exclusion gain is $11.5 million. So, on a $50 million gain, me is only paying tax on $15 million. So, she's escaping federal tax. She's excluding federal tax on $35 million worth of game.

So, by taking the benefits of the 1202 solution, she's saving $8.3 million, which is obviously a significant amount of money. Actually, I've seen a lot of questions in the Q&A, and there's a lot of questions that we received as far as gifting of shares. So, there's definitely planning techniques around section 1202 that can be done. There're obviously gift tax consequences, you'll have to file gift tax returns.

But let's walks you through the example, and you'll see, I'll illustrate this. So, a Mary Beatle owns 100% of ABC Corp's stock. Mary owns 1,000 shares. So, the stock was purchased in 2014. So, remember, exclusion ratio is based on acquisition date. So, since she purchased in 2014, if she holds it for five years, she can exclude 100% of the gain up to the caps we mentioned.

The shares are qualified small business stock eligible. Her basis in the share is zero. So, four years later, Mary decides to gift each of her four children 20% interest. So, 200 shares to John, Ringo, George and Paul, the names might sound a little bit familiar. And then, two years later, the entire Beatle family sells all their shares in ABC for a total of $50 million.

So, what are the tax consequences? What are the benefits of Mary gifting the shares to her four children, gifting 80% of the shares to her four children? So, absent 1202 each, it's a $50 million sales price, they each own 20%. So, they would have a $10 million capital gain. But with 1202, if you gift the share, the holding period tax.

So, when Mary gifted her shares in 2018, she first purchased them '14, she held it for four years. So, the children, they step into the shoes, and it's if they held it for four years too. So, essentially, Mary and each of her four kids get to exclude $10 million. If Mary hadn't done this gifting scenario, she would have been able to exclude $10 million, and the remainder would be taxed.

So, she's saving close to probably $10 million in tax by utilizing this gifting technique. But again, like I mentioned, obviously, there's gift tax implications. But there's definitely planning that could be done around this.

Kayla Konovitch:I see some questions here on the holding period. When you have property that you contributed in exchange for stock, the holding period starts on the date of exchange. So, in this scenario, we had the LLC that converted to a C Corp. It's when you convert to a C Corp that the holding period begins. So, you'd have to have five years from that time.

Jeffrey Kelson:Who was asking about carried interest? We're going to get into that in a little.

Kayla Konovitch:Yeah.

Jeffrey Kelson:That's Kayla's area.

Benjamin Aspir:So, the correct answer is true. Only C Corp stock is eligible for the exclusion. Not S Corp stock, not an LLC interest. An LLC or an S Corp can hold 1202 stock can own it, assuming they purchased it directly, but only C Corp stock is eligible for the 1202 solution.

Kayla Konovitch:Okay. So, we're just going to walk through an example now. Just something that comes up from private equity. This is actually, what I would say is a cautionary tale. It is something that happened with a client, and because of some restructuring that was done, they actually were no longer eligible for the exclusion. So, what I want to point out here is that we had, it's not on the chart, but above the ABC retail holdings, above the blue box, there was a fund.

They formed this new corporation. They had original issuance here in this corporation, and they purchased ABC Retail Publishers Inc., and the subsidiaries there. So, originally, when the structure was just like this, we believed that they had good, qualified small business stock. They met all the tests, and we think that they may have had good issuance.

But what happened next is that a few years later, they wanted in ABC retail holdings, there were employees that had incentive stock options. And for certain reasons, they wanted to restructure this, and give profits interest, and employee incentive units of an LLC interest instead of doing this incentive stock options. So, what they did is, the lawyers, they drew up what the transactions, and what the steps of the transaction were.

And we'll go through these all, in detail. But we can see here, this was the final structure that resulted. So, essentially, the investors at the top, in that dark blue circle, they originally directly owned ABC Retail Holdings Inc., the holdings company, which was good original issuance. And what happened is that in exchange, what they did, they exchanged the stock of ABC Retail for interest in ABC Retail Holdings LLC in a partnership.

All they did was a contribution, and exchange of the stock for interest in the partnership. And all the partnership does is really hold the stock. So, ultimately, the investors, really is they're the same as before. They're still on the stock, it's just through another partnership now. It all seemed in their mind, like it was okay. They were talking about selling the stock, and then we brought up, wait a second, because of this transaction, they're no longer holding good qualified small business stock.

It actually was, if they jeopardize the position, because when you have a partner, a partnership itself really could be viewed really as looked for, for this provision where it's the individual owner that owns the stock, individual partner. But a partner cannot contribute stock to a partnership in exchange for interest. That is specifically this example in Section 1045. But also, the house report in Section 1202 seems to indicate that that would not be allowed.

So, in such a transaction of exchanging the corporate stock and exchange for this partnership interest, would actually be disqualified. So, the client was not happy to learn that. And just putting that out there is something to think about, really to make sure when you're first going into the acquisition to understand, and know, and identify that you have good qualified small business stock, and that's attracted over the holding period to make sure it continuously qualifies.

In this case, they could have probably would have continued with their stock options instead of restructuring. Okay. So, here, in this example, what I want to illustrate is what if you have a corporation that operates through a partnership? So, what you would have, let's say, as a fund at the top, they form a new original issuance corporation, which purchases an operating partnership.

So, the corporation's activity would really have to be what the operating partnership that business activity in order to qualify. In order to meet the business requirement test, we have to have 80% of your business an active trader business. So, the question is, can a corporation operate through an LLC structure? So, this is something that a lot of us have given thought, and other professionals, and commentators.

First off, the intent of this provision of the section 1202 exclusion, is actually to incentivize and motivate people to encourage cash flow to small businesses. So, really, when you view that that can actually be seen as you know what, it is accomplishing that. You have the small partnership, you're going to be funding it for cash, and that's really helping out small businesses.

So, people think the intent of the law is that maybe it should qualify. In addition, the actual provision of Section 1202 is not very elaborative, and it does not speak to be operating in a partnership form, it is silent. And there is this question, is the partnership, there's two theories, you can either approach it as an entity approach, or an aggregate approach, where you look through the partnership, and ultimately at the partner, and attribute that activity to that.

So, if you take the look-through approach, then you would say that that parent corporation, if they hold, let's say, 51% interest in that partnership, then essentially, directly, they can pass that activity test because they have this activity from the partnership that's attributable directly to them on a look-through approach. So, the survey question here also, if the corporation is an active corporation, or it's really passive, and it's not doing anything.

We've seen some companies that they're going to make sure that corporation has active management activity to make sure that it is active just to help solidify the case. So, there's certainly this question of how this would be viewed. In addition, not just the 80% business active test, but also the $50 million gross asset test. That would be something, are you looking at the corporation's pro rata share of the joint venture?

What if that would be if the joint venture, that partnership is under $50 million of gross assets, you might say definitely, that would qualify, and they would be okay? What if the partnership has $90 million in gross assets, and the corporation only owns 51%? So, essentially, their pro rata share would only be 45 million. In that case, do we say that that's okay, and that would work?

So, it's definitely a little bit more questionable if the partnership itself has over that $50 million amount. But if you take the look at the partnership, it's a look-through, you don't treat it as a separate entity, maybe you can get there. So, it's certainly something to consider in the structure, if this would work.

Benjamin Aspir:So, to echo what Kayla was saying, what was the original intention of 1202? It was to encourage investments in small business corporations. It's actually a very good question, do founder shares qualify for Section 1202? Because they wouldn't have necessarily contributed cash into the corporation in exchange for the shares.

We believe they would, because they've contributed, they could have contributed services to the company, and it's in line with what the purposes of Section 1202 was intended for. And then, as far as 1045, we mentioned previously, holding period, tax on in the Section 1045 election, it's enough in election, unlike section 1202, which is an exclusion.

You don't attach a form or anything other than filling out the gain and marking that as 1202. You don't make an unofficial election on your 1040 that is 1202. But whereas, 1045 is an affirmative election to rollover the gain, and defer the gain if you sell it within less than five years. If you purchase convertible debt and convert it to equity within 60 days of the sale, just keep that in mind with Section 1045. And then, lastly, we're going to have Kayla cover carried interest, which is a very hot topic for 1202.

Kayla Konovitch:Okay. So, in our last presentation, I actually covered the carried interest topic a little bit more. We did get a lot of follow up questions post the webinar. And what I will say here is well, generally, it is a great question. Is the carried interest eligible for this exclusion? The question becomes, well, were you considered to have had an interest in the partnership at the time, the partnership acquired the qualified small business stock.

And the question was carried interest or profits interest is did the GP, the general partner actually have this interest at the time, because their carried interest may have kicked in the future, but they did have the right to it? So, it certainly is a question. And Section 1202 itself does not address it. But it does refer to your interest in the partnership at the time, which is a little bit ambiguous.

What does that mean? What is the interest? Could you construe that to be the interest, what you had to write in or entitled to, or is it your smallest interest? That's certainly a question. Whereas, under Section 1045, where there are that's the rollover provision, where there are treasury regulations, it says there that the interest is your capital interest. So, there's certainly a question here. Do you need to say, well, the 1045 rules have to apply to the 1202? So, it's a question. And I think ultimately, you're going to have some people that say qualify, some people to say that it does not qualify.

So, really, what I would encourage and advise is every taxpayer, general partner for getting this carried interest, really, to speak to your tax advisor and have a discussion. See if you're comfortable with the position. If there's a return signing position, if you feel like there's substantial authority, or just a reasonable basis, and you may need to disclose the position.

But it's really worth having a conversation with your advisor, and discussing what sort of exposure, and what your comfort level in taking the position that it would be eligible. So, definitely, feel free to reach out on this, and have a discussion. I would happy to help.

Jeffrey Kelson:Okay. Thank you, Kayla and Ben. That was outstanding. And we're not done with both of you. We're going to ask you some real-life situations. By the way on the 1045, I like to say trapeze into a 1202. So, you can own something for two years. And then, if you reinvest that into another qualified small business stock, you sell it, and reinvest it, and hold that qualified small business stock for three plus years, do you get 1202 treatment on that?

And the answer would be, yes, you can trapeze from 1045, keep the ball in the air into a 1202. And count the ownership during the 1045 period. So, let's turn it over to Kayla first and ask you a question, Kayla. So, you deal a lot in the private equity land, what are some of the situations that you see coming up that you get?

Kayla Konovitch:Okay. So, actually, we've been really hearing about constantly, everybody's coming in with questions in the private equity side. What I would really say I'm seeing a trend, the private equity funds are really, really, really being proactive about their structuring, when they're going into a deal, and acquire a portfolio company. They really think about it, and how we can orchestrate this, and engineer it that we would be eligible for this exclusion.

Just as an example, if they're forming a holding companies to purchase target company, they'll be looking at that. We've been getting a lot of questions where the corporation is operating for a partnership that's coming up a lot right now. Previously, they had a lot of alternative investment vehicles where the fund had an interest directly in an operating partnership.

Now, some of them are going through this investment through a corporation that's operating as a partnership to get this eligibility. So, there's really, really been a lot of discussion in this area, and proactive planning to really get the benefit. At the same time, I do want to point out that there is a provision in Section 1202.

Section 1202(k) puts in some language about that the IRS has authority to come in, and put in some regulations to prevent any abuse if you're using split off shell corporations or partnerships. So, there is that potential. Although, it's been over 27 years, and there hasn't been any regulations that came out, and no legislative history. So, it's really just a question there. So, you definitely need to be mindful in your structuring that you're not bordering abuse.

Jeffrey Kelson:And what would strike you as abusive? Give me an example of what, to you, would strike as an abusive versus something that would be good tax planning.

Kayla Konovitch:Yeah. So, I would look at something as abusive, if you had it company that was way over $50 million, so orchestrate it, let's set up multiple corporations with each one under $50 million, and try to circumvent it, and get around it like that. That might be seen as abuse, as opposed to a position where you have a corporation that's operating as a partnership, where it goes according to the intent.

And certainly, if the partnership had less than $50 million, which would be attributable to the corporation, why wouldn't that work? It seems to be much stronger case based on the code of what we have, that that would be something that has promise.

Benjamin Aspir: Maybe timing around those cap rates, where you might trigger the $50 million limit. If you're at $40 million in assets, and you're planning a $20 million raise, maybe timing that cap raise, to get under the 50, at least for those shares. And then, at a later time, having a different raise, obviously, there's this cash needs, but it's something to keep in mind.

Jeffrey Kelson:Ben, let's ask you a question. You come more from the commercial space. So, what would you say is one of the biggest misconceptions about 1202 that many people hold?

Benjamin Aspir:I think one of the most common misconceptions in 1202 is that the biggest benefit is if you have a stock sale. Most deals these days are asset sales. They're generally much more beneficial to the buyer. So, people seem to disregard 1202. "Oh, it's an asset sale. We're not going to benefit from it."

I think our slides earlier, when we walked through the example on the asset sale, it really drives home. You're not going to get the full home run, a Grand Slam, but you can still have a home run on it. You can still save a significant amount of cash on the second level of taxation when the corporation liquidates, and apply 1202 there.

Jeffrey Kelson:Right. So, I guess you're saying that if you sell the assets, which is an attractive purchase for the acquirer. They want to get the step up and basis. If they do acquire the assets, you do pay the tax, but you're no worse off because you don't pay the second tax on the liquidation because that's protected under 1202. I guess you could get an example though, where you set up a C Corporation that you would not normally have to set up. And you don't hold it five years. What's the downside there versus never having planned for the QSBS? The double tax, right?

Benjamin Aspir:Right, you'd be double taxed. At least now, the corporations are taxed at 21%. Obviously, with C Corporations, also, if you have losses, they're stuck at the entry level, they don't flow through to the owners.

Jeffrey Kelson:Right. It's a good planning technique, I guess, we could say, if you're going to hold the five years. And if you don't hold it five years, it could be worse off in a sense, if you sell the assets, right?

Benjamin Aspir:Right.

Jeffrey Kelson:What else have you seen, Ben, that people have misconceptions?

Benjamin Aspir:With the S Corps, a lot of people tend to see S Corps. If anyone is taking tax classes, they're described as C Corporations pretending to be partnerships. But they really C Corporations, with an election may on the subchapter S. So, either the S Corp stock may be eligible for 1202. It would not be, even if you terminate the election and become a C Corporation, you have to be aware that you need to be issuing new stock. Because if you do not, you won't have met that original issuance requirement that we just described earlier.

Jeffrey Kelson:All right. That's interesting that you can't just convert from an S to a C. You actually might have a structure where there's a company above this issuing new shares. Because the conversion itself doesn't take into account the issuance of new shares. It's just a conversion. And how about the built-in appreciation of an S Corp or an LLC that converts to a C Corp to take advantage? Do you get the 1202 for the built-in appreciation or only for the go forward?

Benjamin Aspir:Only the go forward. The intent, and the reason behind that is that the IRS didn't want to prevent abuse from people converting, and then sheltering all that gain, the pre-C Corp gain, pre-1202 gain. So, that's all taxed.

Jeffrey Kelson:So, what would you recommend? Would you recommend a valuation at the time you convert the LLC or the S Corp to a C Corp so have a benchmark?

Benjamin Aspir:Absolutely. And like Kayla said, I think planning is very important to have to go back six years, or however long to figure out what the value of the company was when the partnership converted to a corporation is going to be very hard. Planning upfront and having evaluation at the time of conversion is very important.

Jeffrey Kelson:Okay.

Kayla Konovitch:Just another interesting item that actually came up yesterday is in the venture capital private equity space, they often have the raising of funds, and then they have in the limited partnership agreement that they can have a subsequent close, where they have no new partners come in at a later date, maybe in year two. And they actually are treated as if they were there from day one.

Legally, economically, you do this rebalancing of your book, and tax accounts, and you treat it as if there were there since day one. So, I've gotten the question on a venture capital fund where they had this situation with a subsequent close, but in year one, the fund actually had purchased some good qualified small business stock.

And then, a couple months later some new partners came in, but they rebalanced everything to consider that they were there on day one. The question is, is that partner considered the new coming partner consider to actually have acquired bid in the partnership at the time they acquired that stock? And certainly, very questionable, we were looking into it.

We don't think it qualifies, but I think that's something really important to look into. And that's why when we're doing the analysis, and giving the footnotes on the K-1, we'll actually put the date of acquisition when the partnership purchased the stock. And that's going to help the individual determine if they're eligible for the exclusion to that are eligible.

Jeffrey Kelson:Okay. One question I want to point out that's been asked by some of the attendees is, is there a tax filing position for C Corp owning a partnership interest when they qualified as an operating business activity? I guess, they're asking, do you get attribution up? And you would.

Benjamin Aspir: Kayla, see that a lot in the PE space, correct?

Kayla Konovitch:Yeah. We definitely do, and that's something that you would be eligible for the exclusion.

Benjamin Aspir:Someone asked, if your legal entity is an LLC, but you've elected to be taxed as a C Corporation. Is that eligible? Yes. As long as for tax purposes, you're a C Corporation, that would be fine for 1202.

Kayla Konovitch:Just have a lot of trust questions here. If you do have multiple trusts, and that they're not grantor trusts, where it's not ultimately one beneficiary, each trust could get $10 million exclusion. That's not abuse. That's strategic structuring, planning, taking full advantage of the provision.

Jeffrey Kelson: I have a great one. It hasn't really been asked, but it's been asked around. So, you have the $10 million, that that's the limit or 10 times. Is that for the lifetime of the ownership of the stock or is it annual?

Benjamin Aspir:$10 million cap is a lifetime for a company, but the 10 times basis cap is a yearly limit. So, there may be opportunities, if you have multiple tranches of stock being sold high basis shares, low basis shares to optimize the annual limit, and yearly limits. But the $10 million limit is lifetime limit per company.

Jeffrey Kelson:So, I guess you can sell part of your stock in December of one year, and part of your stock in January of the next year, and then get to annual period. So, you can increase the amount of QSBS exclusion.

Benjamin Aspir:Correct.

Kayla Konovitch:Also, a lot of questions here. The qualified small business stock itself, it's not an election, it's not anything that you need to elect, or send to IRS, or anything. It's an exclusion that you just take on your tax return if you're eligible. And the documentation, which is really key is that, well, what I would advise is really, you need to speak to the corporation to make sure that they're an eligible C Corporation, to make sure that they were under $50 million of tax assets at the time of issuance.

So, it's really, you need to speak with the corporation, and get that certification from the officer saying that they did meet the eligibility. And obviously, you have to have had original issuance, but it's important to speak to the corp, get the documentation from them to solidify, and ensure that you are eligible. And it's not something that you send to the IRS. It's something you keep in your records to back up your position of eligibility.

Jeffrey Kelson:And one of the things you might need to know is they have to have more than $50 million of assets because it's not only at the time you invest, but any time prior. So, that's something you might have to inquire of the company to find out that information. I think one thing is once you go over $50 million in the future, that stops any future insurance from qualifying. But the people that were in before went over 50, it can go over 50. And whatever they sell, they still can enjoy the exclusion, or depending on the date they purchased.

Benjamin Aspir:Yeah. Your grandfather in.

Jeffrey Kelson:Right.

Kayla Konovitch:Yeah. So, there's a question here. What if I bought stock and I was a small business, and later they went on to an IPO, which is obviously great. As long as when they had it was qualified small business stock, they should be eligible.

Jeffrey Kelson:Right. I guess the answer is anything that happens after is fine, you're protected. It's what happened at the time you purchased or prior, and the $50 million asset. That's why this is such a great benefit, because it can go up really high. You're limited to the amount of exclusion, the $10 million or 10 times. But you can also stagger the sale to take advantage of it, and have a plan around it.

Kayla Konovitch:Another great point somebody was asking about depreciation. It is your tax basis of the assets that is net of depreciation, which is actually a really great point because we have bonus depreciation now, where you can get 100% bonus depreciation deduction. That would reduce your assets for the $50 million gross asset test. So, that's certainly a great planning benefit and opportunity to meet that $50 million limit.

Jeffrey Kelson:Okay. Any other questions anyone wants to tackle, because I think we've got a couple more minutes?

Benjamin Aspir:Yeah. Just this is a question I've gotten and recently, just on state taxation. Is it where the company is located or where the stockholder is located? So, assuming it's a stock sale, and just speaking in general terms, not in absolute terms, when you sell the stock, the gain is sourced to your home state. So, it depends on where the shareholder is located as far as state taxation on the sale of your gain.

Kayla Konovitch:Yeah. And one last question here. The way this is reported, if you're a partner in a partnership, it's reported to you through your K-1. If the K-1 itself has gone to reflect the full gain, the partnership does not take the exclusion. It's ultimately the individual that takes the position on their tax return, and excludes all or a portion of the gain. So, it's important to the footnote, and you take the exclusion on your individual return. It's not the partnership that takes the exclusion. They'll just pass the information to you.

Jeffrey Kelson:All right. Thank you, everybody. Kayla and Ben, that was outstanding. I can learn so much from just listening to you guys, and dealing with this. As you see, it's a very multifaceted code section, not straightforward, requires a lot of diligence before you qualify for it. So, please, if we brought out anything, it's just how important it is to really plan for this properly, and to understand the ramifications, and get the proper information from the company.

Transcribed by Rev.com