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Oct 1994

Fifty-percent exclusion of gain from small business stock - incentive or mine field?

by Martucci, Steven R.

    Abstract- The Revenue Reconciliation Act of 1993 has introduced a new tax incentive for people who hold investments in small business enterprises. Known as Section 1202, the tax incentive scheme allows individual taxpayers to claim a 50% exclusion on any capital gains that arise from the sale of small company stock that has been held for at least five years. Four criteria must be met before the exclusion claimed can be approved. These are that the company must have been a small business when company stock was issued, that the company prove it had been active during the five years the stock investment was held, that the stock must be a qualified small buiness stock as defined by the IRS, and that the stock has to be disposed off by the investor after it has been held for five years.

IRC Sec. 1202 was added by the Revenue Reconciliation Act of 1993 to provide an economic stimulus. It is one of the most complex provisions added by the Act and could prove to be a nightmare for the unwary investor. The authors explain the rules and show where the explosives are hidden.

While passage of the Revenue Reconciliation Act of 1993 (RRA 93) was the culmination of an eight-month deficit reduction effort by the Clinton administration, it also included many investment incentives. One of the incentives added is the new IRC Sec. 1202, which, subject to limitations, for noncorporate taxpayers excludes 50% of any capital gain from the sale or exchange of qualified small business stock held for more than five years.

In general, the following criteria must be met in order to qualify for the gain exclusion under IRC Sec. 1202: 1) the corporation must be a qualified small business at the date the stock is issued; 2) the corporation must meet certain active business requirements during substantially all the period of time the taxpayer holds such stock; 3) the stock must be qualified small business stock; and 4) the taxpayer must dispose of the stock in a sale or exchange after holding the stock for more than five years.

While this 50% exclusion will not affect tax returns for five years, taxpayers must give serious attention to this provision now. When read literally, IRC Sec. 1202 appears to be every investor's dream; however, it doesn't take much exploring below the surface to see many inherent complexities and pitfalls waiting for the unsuspecting investor. IRC Sec. 1202, appearing to be just another economic stimulus provision, is actually one of the most complex tax provisions codified by the RRA 93, and is certain to be a nightmare for taxpayers and tax preparers in years to come. For taxpayers able to avoid the tax traps, however, IRC Sec. 1202 will result in the gains being taxed at a 50% lower capital gains tax rate. Proper planning and record keeping from the onset is critical given the complexities of the law.

Qualified Small Business

To be considered qualified small business stock, stock must be issued by a qualified small business. IRC Sec. 1202(d) defines a qualified small business as any domestic C corporation if:

* such corporation's aggregate gross assets at all times on or after August 10, 1993, and before the issuance, did not exceed $50 million; and

* such corporation's aggregate gross assets immediately after the issuance, including amounts received in the issuance, do not exceed $50 million.

For purposes of this test, the term "adjusted gross assets" means the amount of cash plus the aggregate adjusted bases of other property held by the corporation. In determining the aggregate gross asset amount, a corporation must use the fair market value of contributed assets at the time of such contribution and not the carryover basis permitted by other sections (e.g., transactions described under IRC Sec. 351, or any transaction pursuant to a plan of reorganization under IRC Sec. 368). Further, if the corporation is a member of a parent-subsidiary controlled group, the group will be treated as one corporation. The implications of this section can be devastating for the unwary. For purposes of this aggregate gross asset test, a parent-subsidiary controlled group is determined using the parent-subsidiary controlled group test in IRC Sec. 1563(a)(1), except that the "at least 80%" thresholds are reduced to simply "more than 50%." Unsuspecting shareholders may be disqualified from using the IRC Sec. 1202 exclusion by the assets of other corporations without even being classified as a controlled group for regular income tax purposes.

It should be noted that only parent-subsidiary controlled groups are treated as one corporation under the gross assets test. Since brother- sister controlled groups are not included in this restriction, an individual may create multiple corporations and each corporation may be a qualified small business. The $10 million limitation on the gain eligible for IRC Sec. 1202 treatment (discussed later) is a per-issuer limitation, and thus will not limit the use of brother-sister corporations.

A corporation that satisfies the gross asset test as of the date of issuance of qualified small business stock, but later fails the test, will never again be able to issue qualified small business stock. However, any previously issued stock will not lose its qualified character solely because of this occurrence. This assurance is very important for new corporations desiring to go public.

As a final requirement, the corporation must also agree to submit written reports to the Secretary and to the shareholders that the Secretary may require to carry out the purposes of IRC Sec. 1202. Congress also added IRC Sec. 6652(k) which imposes a $50 penalty, $100 in the case of negligence or intentional disregard, for the failure to file each required report. Since these penalties are assessed for each report not filed, corporations with many shareholders could be subject to substantial penalties.

Active Business Requirement

A corporation must also meet an active business requirement for substantially all of the taxpayer's holding period for such stock. A corporation meets the active business requirement during a period if--

* it is an eligible corporation; and

* it uses at least 80% (measured by value) of its assets in the active conduct of one or more qualified trades or businesses.

Eligible Corporation. To be able to issue qualified small business stock, a corporation must be an eligible corporation, defined in IRC Sec. 1202(e)(4) as any domestic corporation except a domestic international sales corporation (DISC) or former DISC (Secs. 991-996), a corporation that has an IRC Sec. 936 election in effect, or which has a subsidiary with an IRC Sec. 936 election in effect, a regulated investment company, real estate investment trust, or real estate mortgage investment conduit (Secs. 851-860), and a cooperative (Secs. 1381-1388).

The 80% of Assets Test. Assets held to meet the reasonable working capital needs of a qualified trade or business are treated as used in the active conduct of a trade or business. Furthermore, assets held for investment that are expected to be used within two years to finance research and experimentation or increases in working capital needs are included for purposes of the 80% active business test. After a corporation has been in existence for two years, however, no more than 50% of the assets of the corporation may qualify as used in the active conduct of a qualified trade or business by reason of these working capital rules (current and future needs combined). Assuming that increases in property, plant, and equipment are not considered part of the working capital needs, many growth firms in capital intensive industries may face difficulty meeting the active business requirement.

Congress included rules clarifying that assets used in certain activities are considered to be used in an active conduct of a qualified trade or business for purposes of the active business requirement. If, in connection with any future trade or business activity, a corporation uses assets in start-up activities, in research and experimental activities, or for in-house research activities, such assets are treated as being used in the active conduct of a qualified trade or business, regardless of whether the corporation has any gross income from such activities at the time. Congress also clarified that rights to computer software that produce active business computer software royalties shall be treated as an asset used in the active conduct of a qualified trade or business.

For purposes of the active business test, any stock or debt the parent owns in a subsidiary is ignored and the parent is deemed to own its ratable share of the subsidiary's assets. The term "subsidiary," as used in tests related to the active business requirement, includes any corporation that the parent has more than a 50% interest with respect to either total value or total voting power.

Qualified Trade or Business. For purposes of the active business requirement, the term "qualified trade or business" means any trade or business other than one involved in--

* the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset is the reputation or skill of one or more of its employees;

* banking, insurance, financing, leasing, investing, or similar business;

* farming (including raising or harvesting trees);

* a business under which a deduction is allowed for depletion under IRC Secs. 613 or 613A (e.g., an oil and gas extraction business); and

* operating a hotel, motel, restaurant, or similar business.

EXHIBIT1

IRCSEC.1202(B)DOLLARAMOUNTLIMITATIONS

Assumptions:

*Aninvestorpurchased1,000sharesofqualifiedsmallbusinessstock

1-1-19x1for$800pershare.

*Marketvalueon12-31-19x6is$20,000pershare.

*Alternative(1):sellall1,000shareson12-31-19x6.

*Alternative(2):sell500shareson12-31-19x6and500shareson1-2-19x7.

(1)(2)

Date12-31-19x612-31-19x61-2-19x7

Sharessold1,000500500

RealizedGain:

Amountrealized$20.0$10.0$10.0

Adjustedbasis(0.8)(0.4)(0.4)

Realizedgain19.29.69.6

IRCSec.1202(h)gainlimit:

(1)$10,000,000lessprior

IRCSec.1202gain,or10.010.00.4

(2)10timesadjustedbasis8.04.04.0

Gainclassification:

IRCSec.1202gain10.09.64.0

RegularLTCG9.2-0-5.6

Nettaxableincome14.24.87.6

Taxliability(28%)3.9761.3442.128

Cumulativetaxliability3.9763.472

Taxsavings.504

Dollaramountinmillions

Congress has placed significant limitations on the type of business activity it wishes to stimulate. As it has done in the past, Congress again appears to be using tax incentives to stimulate investment in capital intensive industries (e.g., manufacturing, high-tech, bio-tech) but not in service oriented businesses as evidenced above. While RRA 93 did not reduce long-term capital gain tax rates in general, IRC Sec. 1202 does provide an indirect long term capital gain preference for investors in certain industries.

Prohibited Holdings Under Active Business Test. A qualified small business corporation does not meet the active business requirement if more than 10% of its total assets in excess of its liabilities consists of stock or securities in other corporations that are not its subsidiaries. For purposes of this test, a corporation is again treated as a subsidiary if the parent owns more than 50% of either the total value or the total voting power.

A qualified small business corporation also fails the active business requirement if more than 10% of its total assets consists of real property that is not used in the active conduct of a qualified trade or business. In considering this 10% real property test, the ownership of, dealing in, or renting of real property is not considered to be active conduct of a qualified trade or business.

Purpose of "Substantially All" Wording. With the exception of a specialized small business investment company, (an eligible corporation licensed to operate under IRC Sec. 301(d) of the Small Business Investment Act of 1958), all corporations must meet the active business requirements during substantially all of the period for which the taxpayer holds such stock. The "substantially all" requirement seems to imply that temporary violations of the active business requirement will not disqualify gain on stock from exclusion under IRC Sec. 1202. Thus, once the five year holding requirement is met, taxpayers must weigh the benefits of selling the stock and locking-in the 50% exclusion (albeit at the cost of accelerating the tax on the remaining gain) against the risk of losing the exclusion totally by unknowingly violating the active business requirement under regulations that are yet to be written by Treasury. At this point, however, it is not clear how Treasury will interpret the substantially all requirement.

The need for detailed record keeping would seem to be imperative--if for nothing else, based on the uncertainty of what the regulations, when written, may contain. The substantially all terminology will at least allow taxpayers the opportunity to preserve IRC Sec. 1202 treatment by selling qualified small business stock within a short period of time after the corporation fails to meet the active business requirement.

Qualified Small Business Stock

The 50% exclusion generally applies to the sale or exchange by a noncorporate taxpayer of qualified small business stock, deemed by IRC Sec. 1202(c) as any stock in a domestic C corporation that meets the following requirements:

* As of the date of issuance, such corporation is a qualified small business as previously defined;

* The stock is acquired by the taxpayer at its original issue after August 10, 1993, either directly or through an underwriter; and

* The stock is received in exchange for money, property other than stock, or as compensation for services rendered to the corporation in a capacity other than that of an underwriter.

Even if the above requirements are met, stock will not be treated as qualified small business stock unless, during substantially all of the taxpayer's holding period for such stock, the corporation meets the active business requirements (waived for specialized small business corporations) and is a C corporation.

Limitations Related to Redemptions. Congress passed two special rules to prevent evasion of the requirement that the stock be newly issued. Even if the aforementioned criteria are met, stock will not be considered qualified small business stock in either of the following two situations:

* If, within two years before or after such issuance of stock, the corporation pup chased any of its stock from the taxpayer or from a person related to the taxpayer under IRC Sec. 267(b) or IRC Sec. 707(b); or

* If, within one year before or after such issuance of stock, the corporation made one or more purchases of its own stock from any shareholders totaling more than 5% of the value of all the stock of such corporation.

For purposes of these two redemption rules, a corporation is treated as purchasing an amount of its stock equal to the amount treated as redeemed under IRC Sec. 304(a). For purposes of the 5% redemption test, the value of the stock acquired is measured as of the date acquired. In contrast, the total value of the stock of the corporation is measured as of one year prior to the acquisition in question. For privately held corporations, compliance with subsequent valuation reporting requirements imposed by the Treasury may be difficult and expensive (e.g., how often will these valuations be required?).

Tax-Free Transfers of Qualified Small Business Stock. When qualified small business stock is acquired by gift or at death, the transferee steps into the shoes of the donor or decedent. The transferee is treated as having acquired such stock in the same manner as the transferor; in addition, the IRC Sec. 1202 holding period of the transferor is tacked on to the IRC Sec. 1202 holding period of the transferee. Likewise, when a partnership transfers qualified small business stock to a partner that held its interest in the partnership during the complete period of time the partnership owned such stock, the partner steps into the shoes of the partnership with respect to the qualified small business stock.

Conversion of Qualified Small Business Stock. Any stock acquired solely through conversion of other qualified small business stock in the same corporation is also qualified small business stock. Furthermore, the IRC Sec. 1202 holding period of the original stock is tacked on to the IRC Sec. 1202 holding period of the acquired stock.

Stock Received Through IRC Sec. 351 or 368 Transfer. If Congress did not provide a special rule, any taxpayer transferring qualified small business stock in an IRC Sec. 351 organization (transfer to controlled corporation) or IRC Sec. 368 reorganization would have lost all exclusion benefits of IRC Sec. 1202. Under IRC Sec. 1202 (h) (4), however, Congress has created such an exception and a taxpayer in this situation is able to treat the stock received in an IRC Sec. 351 or 368 transaction as qualified small business stock. The amount of gain eligible for IRC Sec. 1202 treatment is limited to the realized gain at the date of the incorporation or reorganization. (If however, the stock received in the IRC Sec. 351 or 368 transaction is also qualified small business stock, the limitation does not apply). This special treatment applies to an IRC Sec. 351 organization only if the corporation issuing the stock owns, directly or indirectly, at least 80% of the stock of the qualified small business whose stock was exchanged.

Limitation of Exclusion Amount

The exclusion of gain on the sale or exchange of qualified small business stock held more than 5 years is limited to the greater of--

* $10 million, $5 million for a married individual filing separately, less the amount of IRC Sec. 1202 gain from prior years; or

* 10 times the basis of the stock that was disposed of in the current year.

EXHIBIT2

EFFECTOFIRCSEC.1202(I)BASISRULES

Assumptions:

*TPrealized$10milliongainfromthesaleofXCorporationqualified

smallbusinessstockin19x7.

*TPsellsXCorporationqualifiedsmallbusinessstockin19x8for$1,000.

*Thestocksoldin19x8wasreceivedbyTPin19x1inexchangefor

appreciatedpropertyaspartofaSec.351organization.

*Adjustedbasiswas$80.

*Fairmarketvaluewas$100.

Ondateofcontribution:

Fairmarketvalue$100.0

Adjustedbasis(80.0)

Built-ingain$20.0

IRCSec.1001RealizedGain:

Amountrealized1,000.0

Adjustedbasis(80.0)

Realizedgain$920.0

IRCSec.1202EligibleGain:WithoutWith

Sec.1202(i)Sec.1202(i)

Amountrealized$1,000.0$1,000.0

Adjustedbasis(80.0)(100.0)

Realizedgain$920.0$900.0

10timesbasislimit$800.0$1,000.0

IRCSec.1202eligiblegain800.0900.0

RegularLTCG120.020.0

Nettaxableincome520.0470.0

Taxliability(28%)145.6131.6

TaxSavings14.0

Dollaramountinmillions

EXHIBIT3

MARRIAGEPENALTY

Assumptions:

*On1-1-19x1,John&MarySmithpaid$100,000for100,000sharesof

qualifiedsmallbusinessstock.

*Fairmarketvaluein19x6is$201pershare.

*Alternative(1):Sellall100,000shares;filejointly.

*Alternative(2):Divorceandeachsell50,000shares.

(1)(2)

TaxpayerJohn&MaryJohnMary

Sharessold100,00050,00050,000

RealizedGain:

Amountrealized$20.1$10.05$10.05

Adjustedbasis(0.1)(0.05)(0.05)

Realizedgain$20.0$10.0$10.0

IRCSec.1202(b)GainLimit:

(1)$10,000,000lessprior

IRCSec.1202gain,or10.010.010.0

(2)10timesadjustedbasis1.00.50.5

Gainclassification:

IRCSec.1202gain10.010.010.0

RegularLTCG10.000

Nettaxableincome15.05.05.0

Taxliability(28%)4.21.41.4

Combinedtaxliability4.22.8

Taxsavings1.4

Dollaramountsinmillions

Both limitation rules are applied on a per-issuer basis (i.e., each taxpayer applies these limits separately for the qualified small business stock of each corporation). While the $10 million amount is a cumulative limit with respect to sales or exchanges of stock of that corporation in any year, the 10 times basis rule is an annual limit. The following example demonstrates the above rules and a potential tax planning strategy:

Example: Assume an investor purchased 1,000 shares of qualified small business stock on 1-1-19x1 for $800 per share. Further, assume the market value of the stock is $20,000 per share on 12-31-19x6. If the investor sells all 1,000 shares on this date, he will realize a $19.2 million gain, of which only $10 million qualifies for the 50% exclusion. If, however, the investor sells 500 shares on 12-31-19x6 and 500 shares on 1-2-19x7, $9.6 million gain is realized in each year. The full $9.6 realized in 19x6 qualifies for IRC Sec. 1202 treatment using the $10 million limit and $4 million of the $9.6 million realized gain in 19x7 qualifies for IRC Sec. 1202 treatment using the 10 times basis limit. Splitting the sale between the two years will save $504,000 in federal income taxes.

Allocation of Gain Between Married Individuals. In the case of a married couple filing a joint return, the gain qualifying for IRC Sec. 1202 treatment is allocated equally between the spouses. This will be relevant for purposes of determining the unused portion of the $5 million limitation amount in subsequent years in which a joint return is not filed. The effect of this rule may be significant, especially if the couple later divorces.

Example: Assume H and W are married and always file jointly. In 19x1, H and W each purchased some qualified small business stock in their individual names. Also assume that the basis of the stock is low (i.e., the 10-times-basis rule does not control). If H sells his stock in 19x6 and realizes a $10 million gain, $5 million will be excluded under IRC Sec. 1202. If H and W divorce in 19x7 and W then sells her stock at a $10 million gain, only $2.5 million of W's gain is excluded under IRC Sec. 1202. The portion of W's gain eligible for IRC Sec. 1202 treatment is limited to $5 million; i.e., $10 million, less half of the $10 million excluded by H in 19x6 on their joint return.

It would seem prudent for a lawyer to consider this possibility when designing property settlements involving qualified small business stock.

Special Basis Rules for Property with Built-in Gains. Without any further restrictions, taxpayers would likely transfer appreciated property into a corporation and later exclude 50% of the built-in gain under IRC Sec. 1202. Section 1202(i) provides special basis rules to prevent such abuse. For purposes of IRC Sec. 1202, if property is transferred to a corporation in exchange for its stock, the basis of the stock received is treated as not less than the fair market value of the property exchanged and the holding period begins on the date of the exchange. Furthermore, any basis adjustment for additional contributions to capital is also treated as not less than the fair market value of the property on the date contributed.

Congress intended the contributed property rule discussed above to prevent taxpayers from using IRC Sec. 1202 to exclude 50% of built-in gains (i.e., gains that occurred prior the property being contributed to the corporation). Increasing the adjusted basis, however, also increases the 10 times basis limitation. Thus, the rule Congress created to limit the IRC Sec. 1202 gain will in some cases increase the amount of gain that qualifies for IRC Sec. 1202 treatment.

Example: Assume TP realized a $10 million gain from the sale of qualified small business stock in 19x7 and excluded $5 million of the gain under IRC Sec. 1202. TP will therefore be subject to the 10-times- basis limit on future sales of stock in this corporation. In 19x8, TP sells qualified small business stock in the same corporation for $1,000. This stock had been received in 19x1 in exchange for appreciated property as part of an IRC Sec. 351 organization. The basis of such property was $80 and the value on the date of the transfer was $100. Under IRC Sec. 1001, TP realizes a $920 gain on the sale of the stock. Without the special basis rules, only $800 of the gain (10 x $80 basis) would be eligible for IRC Sec. 1202 treatment. To prevent the $20 built- in gain from receiving IRC Sec. 1202 treatment, the special basis rules treat the basis, for purposes of IRC Sec. 1202, as being equal to the $100 value of the property on the date of the transfer. While the gain for purposes of IRC Sec. 1202 is only $900, the full $900 gain is eligible for IRC Sec. 1202 treatment (limit now equals $1,000; 10 x $100 basis). The special basis rules designed to prevent taxpayer abuse actually allow TP to pay $14 less taxes.

Disposition of Stock by a Pass-Through Entity

A taxpayer's proportionate share of gain from the disposition of stock by a pass-through entity (i.e., partnership, S corporation, regulated investment company or common trust fund) is eligible for exclusion provided that:

* the stock is qualified small business stock in the hands of the entity;

* the entity has held the stock for more than five years; and

* the owner of the interest in the pass-through entity (i.e., the partner, shareholder, etc.) held the interest at all times during which the entity held the qualified small business stock.

The amount of gain eligible for exclusion is limited to the taxpayer's proportionate share of such gain that would result based on the taxpayer's interest in the entity at the time the entity acquired the stock. If an owner of an interest in the pass-through entity has not held the stock at all times during which the pass through entity held the qualified small business stock, that owner's share of the exclusion is lost forever. When there are ownership changes in a pass-through entity, a portion of the potential IRC Sec. 1202 benefits will be permanently lost. This could be a problem given the complexities of pass-thru entity formations.

Example: A, B, and C (all individuals) form ABC Partnership in 19x1 as equal owners. In 19x1, ABC purchases qualified small business stock for $100,000. In 19x4, A and B buy C's interest in ABC (equal partners). If, in 19x7, ABC sells all the qualified small business stock at a $3 million gain, A and B would each be allocated $1.5 million gain. Of each partner's $1.5 million gain, only $1 million is eligible for IRC Sec. 1202 treatment; the other $500,000 is a regular long-term capital gain.

Treatment of Short Positions

If the taxpayer, or a person related to the taxpayer under IRC Sec. 267(b) or 707(b), has an offsetting short position with respect to any qualified small business stock, the taxpayer is not allowed to exclude any gain from the sale or exchange of such stock. Nevertheless, if the taxpayer has held the stock for more than five years on the date such short position was established, the taxpayer may preserve the 50% exclusion by electing to recognize the gain as if such stock was sold at its fair market value on the first day the short position was established.

An offsetting short position is generally defined as a short sale of substantially identical property or an option to sell substantially identical property at a fixed price. Moreover, the Code makes it clear that, to the extent provided in regulations, a short position is to include any other transaction that substantially reduces the risk of loss from holding such stock.

When a taxpayer elects to recognize gain under IRC Sec. 1202 as a result of a short position, presumably the taxpayer will also be allowed to increase the stock basis by the full amount of the gain, not just the 50% recognized. To limit the increase in basis to anything less than the full amount would eliminate the benefit of IRC Sec. 1202. If the stock subsequently declines in value, the taxpayer should then be able to recognize a loss under IRC Sec. 1001 on a sale or exchange, subject of course, to the limitations in IRC Sec. 1211. Establishing a short position will not only mitigate the economic risk, it will also allow the investor to lock-in the IRC Sec. 1202 exclusion. Thus, an option to sell may be used as a valuable planning tool when a qualified small business stock reaches a plateau in the growth of its market value. Such action will effectively allow an investor to lock-in the IRC Sec. 1202 tax exclusion benefits without divesting of stock ownership. The Treasury may need to cover this in the regulations to limit unintended abuses of such planning strategies. For example, an option may be written so as to have a very low probability of being exercised, with the real value of the option being its IRC Sec. 1202 lock-in effect.

Legislative Regulations Authorized

Congress has granted the Secretary authority to "prescribe such regulations as may be appropriate to carry out the purposes of this section, including regulations to prevent the avoidance of the purposes of this section through split-ups, shell corporations, partnerships, or otherwise." Whether these regulations will be retroactive cannot be foreseen. Since, however, these will be legislative regulations, it is advisable to exercise a certain degree of caution in structuring any transactions to which IRC Sec. 1202 might apply and maintain very detailed records with respect to these investments. Among the many issues that will need to be addressed by these legislative regulations are:

* detailed explanations of the specific trades or businesses prohibited from being a qualified trade or business;

* the meaning of "substantially all" with respect to the active business requirement;

* reporting requirements related to the gross asset test;

* reporting requirements related to the valuations used in the active business requirement (e.g., quarterly?); and

* reporting requirements related to the valuation of stock to determine if the corporation has purchased more than 5% of the total stock value (e.g., retroactive valuations?).

Other Planning Implications

$10,000,000 and 10-Times-Basis Limitations. Since the amount of gain that qualifies for IRC Sec. 1202 treatment is limited to the greater of the $10,000,000 limit or the 10-times-basis limit, it appears each limit is designed for a different type of investor. The $10,000,000 limit will allow small-scale investors to exclude half of all their gains. On the other hand, the 10-times-basis limit will allow large-scale investors (i.e., those investing greater than $1,000,000 in one corporation) to realize gains larger than $10,000,000 and still exclude half of the gain.

If a small investment turns into the next Wal-Mart success story, however, the 10-times-basis rule will be of little use and the $10,000,000 limit will prevent the investor from reaping all tax benefits possible. While IRC Sec. 1202(h)(1) allows taxpayers to transfer qualified small business stock by gift, the resulting gift tax would likely exceed any income tax benefits IRC Sec. 1202 provides. To avoid circumstances such as this, it seems advisable to split corporate ownership among family members.

Marriage Penalty. If a married couple did not have the foresight to split ownership among family members and now face the $10,000,000 limitation, the Code provides a strong economic incentive to effect a divorce (at least in form) to reap the tax benefits of IRC Sec. 1202.

Example: Assume that in 19x1, John and Mary Smith paid $100,000 for 100,000 shares ($1 per share) of qualified small business stock and that all requirements of IRC Sec. 1202 are met. If John and Mary sell their stock for its $20,100,000 value (i.e., $201 per share) in 19x6, they will have a $20,000,000 realized gain, but only $10,000,000 gain will be eligible for the 50% exclusion under IRC Sec. 1202. Assuming their tax rate on long term capital gains is 28%, their tax liability will increase $4.2 million.

Consider the tax consequences, however, if John and Mary divorce, split the stock equally, and sell all the stock in 19x6. Section 1041 provides each taxpayer with a $50,000 basis. Each taxpayer will realize a $10,000,000 gain. Being single, IRC Sec. 1202 will exclude $5,000,000 gain for each taxpayer. Assuming a 28% tax rate, their tax liability will increase only $2.8 million. The divorce has saved $1.4 million in taxes.

It is questionable whether Congress envisioned the magnitude of this marriage penalty when they passed RRA93.

Compensation Planning. Qualified small business stock may be issued in exchange for services rendered to the corporation, other than services performed as an underwriter of such stock. Thus, stock issued in exchange for legal and accounting expenses incurred in a IRC Sec. 351 organization may qualify for IRC Sec. 1202 treatment. To ensure that the control requirement of IRC Sec. 351 is satisfied, the corporation must be sure shareholders who transfer only services receive less than 20% of the total shares outstanding. Likewise, executives may be compensated using qualified small business stock. While the individual providing the services will recognize ordinary income equal to the value of the services rendered, any future appreciation in the stock would be eligible for IRC Sec. 1202 treatment. As explained in the House report, stock issued in connection with the performance of services is treated as issued when income is recognized under IRC Sec. 83. The IRC Sec. 1202 holding period begins when compensation income is recognized.

Under IRC Sec. 83, ordinary income will generally be recognized when the stock received is transferrable or when the stock is not subject to substantial risk of forfeiture, whichever occurs earlier. A taxpayer who does not want to delay the recognition of income until the restrictions lapse may elect to recognize income in the year the stock is received. If this election is made, the ordinary income is the fair market value of the stock when received, determined without regard to any restrictions other than those that will never lapse. As a result of the election, the IRC Sec. 1202 holding period begins immediately and subsequent appreciation may be eligible for exclusion under IRC Sec. 1202. If the stock is expected to appreciate substantially before the restrictions lapse, this election may be very valuable. Note, however, that the IRC Sec. 83(b) election is not made without risk. If the stock is subsequently forfeited, no deduction is allowed for the amount previously included in income. Consequently, if the odds of forfeiture are high, the individual may be better off not making the IRC Sec. 83(b) election, even though this will delay the start of the IRC Sec. 1202 holding period and will likely reduce the amount of gain eligible for IRC Sec. 1202 treatment.

Impact of AMT. One-half of the gain excluded under IRC Sec. 1202 is now an AMT preference. Furthermore, since any increase in AMT caused by this new tax preference is considered an exclusion preference, it will not directly result in an increase in the minimum tax credit. Since the computation of the minimum tax credit implicitly assumes that the AMT exemption amount is used to offset exclusion preferences first, this preference could indirectly increase the minimum tax credit if the amount of other exclusion preferences is less than the AMT exemption amount.

The RRA93 also increased the maximun AMT tax rate for individuals to 28%; thus, for individuals, the maximum AMT tax rate is now the same as the maximum tax rate on long-term capital gains. Therefore, if one is already in an AMT situation and subject to the 28% rate, half the benefits of the IRC Sec. 1202 exclusion would be eliminated. Careful planning by taxpayers will be required to ensure the IRC Sec. 1202 exclusion benefit is not significantly eroded by a corresponding increase in the AMT liability.

Loss of Entity Choice. When a C corporation has less than $75,000 taxable income, its marginal tax rate will likely be lower than the marginal tax rate of its shareholders. Thus, a closely-held C corporation with low income may, if the shareholders are able to defer the sale of the stock far enough into the future, provide taxpayers some reduction in effective tax rates relative to the effective tax rates that would apply if the shareholders made an S election. When a C corporation's taxable income becomes large, however, the high corporate tax rates often make it beneficial for the shareholders to make an S election. If this is qualified small business stock, however, the shareholders will not be able to make an S election without losing the benefits of IRC Sec. 1202. The value of the IRC Sec. 1202 exclusion may be mitigated by an increasing corporate level tax rate. It is possible the cost of this double-tax will sometimes exceed the benefits of IRC Sec. 1202. Consequently, it may be advisable for some entrepreneurs to forgo the IRC Sec. 1202 exclusion benefits in order to maintain the single layer of tax that an S election provides.

Beware

By enacting a 50% exclusion of gain from the sale or exchange of qualified small business stock, Congress has attempted to encourage the flow of capital to small businesses. Whether shareholders will reap the expected tax benefits is much less certain. The five year holding period, combined with the inherent complexity and the numerous limitations, exceptions, and special rules, pose significant obstacles for taxpayers to overcome. For anyone who makes it through the complexities and traps of IRC Sec. 1202 and the ensuing legislative regulations, the 14% effective tax rate may be a valuable reward for their tax planning efforts. Since one-half of the IRC Sec. 1202 exclusion is an alternative minimum tax preference, the benefits of IRC Sec. 1202 will be eroded for many taxpayers.

Kenneth F. Abramowicz, PhD, CPA, is assistant professor at University of Alaska-Fairbanks. Steven R. Martucci is with Ernst & Young, Washington, D.C.



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