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The Qualified Small Business Stock (QSBS) and Section 1202 capital gain exclusion has recently experienced a surge in its popularity as a tax savings strategy. Section 1202 has been around almost 30 years as it was enacted in 1993, however, over the years it has been modified to adjust how much of the total capital gain can be excluded. Stock acquired from August 11, 1993, through February 17, 2009, allows for a 50% exclusion. Stock acquired from February 18, 2009, through September 27, 2010, allows for a 75% capital gain exclusion, and stock acquired from September 28, 2010 to present allows for 100% capital gain exclusion. There is also no longer any Alternative Minimum Tax preference for qualified stock acquired from September 28, 2010.

The gain exclusion is limited to the greater of $10 million OR 10 times the aggregate adjusted basis of the QSBS investment. The gain exclusion limits apply on a shareholder-by-shareholder basis. This allows the potential for planning to maximize the benefit.

Generally, the following criteria must be met in order to qualify for the exclusion:

• The stock must be directly acquired by original issuance from a domestic C corporation
• The C corporation’s aggregate gross assets did not exceed $50 million, before, and immediately after stock issuance
• At least 80 percent of the Qualified Small Business assets are used in the active conduct of at least one “qualified trade or business” as defined
• The stock must have been held for more than five years
• The stock acquired must be at original issuance and acquired in exchange for cash, services, or property (other than stock). The stock must be issued directly by the company and not received from a third party (such as in a secondary offering).

It must be emphasized that the corporation issuing the stock must be a C corporation. There are special and complicated rules regarding potential LLC and S corporation conversions to C corporate status. Your tax advisor must be contacted in such regard. Also, it must be noted that a sale of assets of the C corporation prior to the five-year hold requirement could certainly prove to be tax costly.

The term “qualified trade or business” is generally defined by exclusion. Those not eligible include many professional services, performing arts, consulting, athletics, financial services, brokerage services, banking, insurance, financing, leasing, investing, farming, hotels, restaurants, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. The qualification of the trade or business is one of the most critical aspects of the planning.

There has been limited issued guidance around whether a particular trade, business, or activity is deemed to constitute a qualified trade or business. There is certainly a bias against service industries. Sec. 199A (Qualified Business Income Deduction) cross references Sec. 1202 when discussing a qualified trade or business for its purposes. While certainly not necessarily binding, Sec. 199A Regulations may, at least, provide a certain level of guidance regarding their analysis of what trade or business activities are considered as qualified.

Redemptions, reorganizations, and recapitalizations may hinder the ability to qualify for IRC 1202. Each fact pattern must be analyzed to determine if the corporation and the shareholder meet all of the requirements of IRC 1202. Additionally, the C corporation and shareholder must be able to properly document r that QSBS eligibility has been reasonably attained. Therefore, early planning is strongly recommended.

Further analysis would need to be considered with respect to state and local taxing jurisdictions as they may have decoupled from this gain exclusion.

The following common questions we have encountered regarding 1202 planning:

Q: What if the five-year holding period is not met, but the stock meets all other qualifications for QSBS?

A: IRC Section 1045 generally allows for the rollover of gains from QSBS.

Stock must be held for more than six months and less than five years.

The taxpayer must purchase new QSBS stock within sixty days of the sale of the original QSBS stock and make an election on their tax return.

Q: Is it a $10 million lifetime exclusion for all QSBS transactions?

A: No, it is per stock issuer, therefore investments in multiple companies may qualify for multiple exclusions.

Q: Does a husband and wife each have a $10 million exclusion per issuer?

A: There is ambiguity in the area and should be discussed further with your tax advisor. But we note that there are many tax professionals who believe there is support for the position that each spouse could enjoy their separate $10M exclusion on a married filing joint tax return.

Q: What happens if my partnership distributes QSBS stock to me rather than selling it in the partnership?

A: The stock is deemed to be owned by the partner who received the stock from the partnership, and it is still original issue stock assuming the partner was a partner at the time of original acquisition.

Q: What kind of estate and gift planning is available?

A: If the owner of the QSBS stock passes away, the beneficiary is deemed to own the original issued stock. The value of the stock is included in the owner’s taxable estate.

Stock can be gifted either outright or in an irrevocable trust and still maintains being original issued stock.

When shares are gifted, the new owner now has their own $10 million exclusion. This can be a powerful technique regarding gifting to children and other family members.

It is better to gift the stock when it has a low valuation, closer to purchase and therefore, for better utilization of the lifetime gift exclusion.

Utilizing the power of substitution and then turning off grantor trust status is another technique to transfer QSBS.

Be careful, gifts to trusts that have the same creator and the beneficiary may be treated as the same trust.

A Grantor Retained Annuity Trust (GRAT) is a vehicle that is being used to gift QSBS. The GRAT should be set up years prior to any potential sale of QSBS. This will allow for lower valuations. The key is that after the GRAT term is over, the shares transferring to beneficiaries are no longer includable on the taxpayer’s tax return and now have new $10 million dollar lifetime exclusions.

Income tax proposals must be carefully monitored regarding potential impact on the Sec. 1202 gain exclusion.

Taxpayers should discuss any QSBS investments they made with their advisors when they are made so that the advisors can properly advise. With proper planning, substantial income capital gains can be excluded from income tax. Additionally, advisors can help taxpayers transfer assets to the next generations with little estate or gift tax.

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