A stockholder must hold QSBS for more than five years in order to take advantage of Section 1202's generous gain exclusion.1 Here are some steps to consider if it appears you will be selling your QSBS before satisfying that five-year holding period requirement:
This is one in a series of articles addressing planning issues relating to qualified small business stock (QSBS) and the workings of Sections 1202 and 1045 of the Internal Revenue Code.
1. Postpone the QSBS Sale.
Consider working with the buyer (or your company's management) to postpone the closing of your stock sale until you have satisfied Section 1202's five-year holding period requirement. Depending on how long your sale must be postponed, possible planning suggestions include signing a sale agreement with a deferred (later) closing date, signing a sale agreement coupled with an agreement to have the buyer operate the business under a management arrangement until stockholders are past the required five-year holding period, or entering into a joint venture arrangement with the buyer, followed by the buyer's purchase of the company's QSBS after the five-year holding period requirement is satisfied. Of course, these alternatives do introduce the business risk that a sale delayed may become a sale termination.
2. Exchange QSBS for Buyer Stock.
Section 1202 allows holders of QSBS to exchange their stock for other stock (either QSBS or non-QSBS) in a Section 351 tax-free exchange or Section 368 tax-free reorganization. In these tax-free transactions, the holding period of the original QSBS is tacked onto the holding period for the replacement stock, which can then be held until the combined holding period satisfies Section 1202's five-year requirement. The holder will be positioned to eventually claim Section 1202's gain exclusion when the replacement QSBS is sold if the tax-free transaction involved the exchange of original QSBS for replacement QSBS. If the replacement stock is non-QSBS, then the Section 1202 gain exclusion will apply to the gain deferred when the QSBS was exchanged for the non-QSBS and any additional appreciation will qualify for long-term capital gains treatment. Unfortunately, if QSBS is exchanged for LLC or LP (partnership) interests in a tax-free Section 721 exchange, neither the LLC/LP nor the stockholder of the original QSBS will be able to claim Section 1202's gain exclusion with respect to the former QSBS.
3. Reinvest QSBS Sales Proceeds Into Other QSBS Under Section 1045.
QSBS sales proceeds can be rolled over tax-free into other QSBS under Section 1045 if the rollover occurs during the 60-day period beginning on the date of the sale of the original QSBS. Sellers of QSBS can reinvest their sales proceeds into a common or preferred stock investment in an existing qualified small business. The holding period for the original QSBS is tacked onto the holding period for the replacement QSBS. See point #4 below for a possible solution if no acceptable investment opportunity becomes available during the short 60-day window. A previous article Advanced Section 1045 Planning addresses Section 1045 planning in further detail.
4. Reinvest QSBS Sales Proceeds Into QSBS of a Newly-Organized C Corporation.
We work regularly with sellers of original QSBS who decide to reinvest their QSBS proceeds under Section 1045 in a newly-organized C corporation. This new C corporation issues QSBS and then uses the contributed proceeds to either (1) undertake start-up and/or R&D activities associated with creating a profitable qualified small business from scratch, or (2) undertake a search to identify and purchase the assets or equity of an existing qualified small business. If this route is taken, we assist entrepreneurs and investors with their efforts to comply with the complicated requirements of Sections 1202 and 1045, including developing and implementing business plans and complying with each of Section 1202 eligibility requirements. These holders of replacement QSBS can eventually claim Section 1202's gain exclusion when they sell their replacement QSBS or liquidate the corporation if the venture fails to meet expectations. Like any start-up venture, some issuers of replacement QSBS will be profitable and some will not succeed.
5. If QSBS Is Sold by a Partnership, Either the Partnership or Its Partners Can Elect to Reinvest the QSBS Sales Proceeds in Replacement QSBS Under Section 1045.
Section 1045 provides flexibility when a partnership sells QSBS. Either the partnership or individual partners can reinvest the sales proceeds. But there is a fair amount of complexity that accompanies this flexibility, making it important for the parties involved to work with knowledgeable tax advisors.
6. Section 1045 Permits Sellers of QSBS to Reinvest Their Sales Proceeds Through Partnerships.
Section 1045's regulations open the door for sellers of QSBS to reinvest the sales proceeds through a partnership (i.e., contributing QSBS sales proceeds to a partnership). If a seller of QSBS decides to contribute the sales proceeds to a partnership, those funds must be reinvested by the partnership into replacement QSBS during the investor's 60-day window under Section 1045.
7. Be Sure to Fully Document Satisfaction of Section 1202's (and Section 1045's) Eligibility Requirements.
Stockholders who roll QSBS sales proceeds over under Section 1045 into replacement QSBS should fully document satisfaction of Section 1202's eligibility requirements for both their original and replacement QSBS investments. See the article Dissecting Section 1202's 'Active Business' and 'Qualified Trade or Business' Qualification Requirements for more detailed information. If a seller of original QSBS decides to organize a new C corporation to issue the replacement QSBS, the main challenge will be documenting compliance with all of Section 1202's requirements regarding undertaking start-up and R&D activities (whether the rollover of proceeds involves starting a new qualified small business from scratch or purchasing one.) With respect to satisfying Section 1045's requirements, the election to take advantage of that provision must be properly made on the stockholder's tax return, and reinvestment of the QSBS sales proceeds within the allowed 60-day window should be fully documented.
In spite of the potential for extraordinary tax savings, many experienced tax advisors are not familiar with Section 1202 and Section 1045 planning. Venture capitalists, founders and investors who want to learn more about Section 1202 and Section 1045 planning opportunities are directed to several articles on the Frost Brown Todd website:
If you want an in-depth discussion of Section 1045, see the article Advanced Section 1045 Planning.
Other Section 1202 Articles Include:
- Section 1202 Qualification Checklist and Planning Pointers
- A Roadmap for Obtaining (and not Losing) the Benefits of Section 1202 Stock
- Maximizing the Section 1202 Gain Exclusion Amount
- Dissecting 1202's Active Business and Qualified Trade or Business Qualification Requirements
- Recapitalizations Involving Qualified Small Business Stock
- The 21% Corporate Rate Breathes New Life into IRC § 1202
1 There are exceptions to the general rule when the stockholder receives QSBS as a gift, as a distribution from a partnership, upon the death of the original holder, or in connection with the receipt of replacement QSBS in connection with a tax-free exchange or reorganization.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.