Qualified Small Business Stock After Tax Reform

The Tax Cuts and Jobs Act (TCJA) reduced the corporate tax rate to 21%. This change has led many to speculate that  C corporations are poised for a resurgence.

A  C  corporation is a  legal structure whereby the owners (or shareholders) are taxed separately from their businesses. C corporation stock may constitute qualified small business stock under the tax law (Internal Revenue Code Section 1202), which could allow all or part of  the gain on  the sale of such stock to be excluded from income. To qualify for the gain exclusion, the following requirements must be met:

1. C corporation requirement: On the date of issuance, the issuing corporation must be a domestic C corporation, and the stock must be an original issuance after August 10, 1993.
2. Qualified small business (QSB) requirement: At all times before and immediately after the date of issuance, the aggregate gross assets of the corporation must not exceed $50 million. For purposes of Section 1202, the adjusted basis of any property ontributed to the corporation is equal to its fair market value (FMV) on the date of contribution.
3. Original issuance requirement: The stock must be acquired directly from the issuing corporation in exchange for money or property or as compensation for services provided to the corporation. Stock acquired from an existing shareholder does not qualify. Stock acquired through the exercise of options or warrants or through the conversion of convertible debt may be treated as acquired at original issuance.
4. Active business requirement: The corporation must be an “eligible corporation,” and at least 80% (by value) of the assets of the corporation must be used by the corporation in the active conduct of one or more “qualified trades or businesses.”
   • Eligible corporation: An eligible corporation means any domestic corporation other than a Domestic International Sales Corporation (DISC or former DISC), a regulated investment company, real estate investment trust, real estate mortgage investment
     conduit (REMIC), or a cooperative.
   • Qualified trades or businesses: A qualified business means any trade or business other than:
     1. Any trade or business involving 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 trade or business where the principal asset of such trade or business is the reputation or skill of its employees;
     2. Any banking, insurance, financing, leasing, investing, or similar business;
     3. Any farming business (including the business of raising or harvesting trees);
     4. Any business involving the production or extraction of products of a character for which a deduction is allowable under Sec. 613 (percentage depletion of mines, wells, and other natural deposits) or 613A (percentage depletion of oil and gas wells); and
     5. Any business operating a hotel, motel, restaurant, or similar business.

QSB stock acquired after August 10, 1993, and before February 18, 2009, is eligible for a 50% gain exclusion. The exclusion is increased to 75% for QSB stock acquired after February 18, 2009, through September 27, 2010, and to 100% for QSB stock issued on or after September 28, 2010.

When a shareholder sells QSB stock, the total gain that may be excluded under Section 1202 for each issuing corporation is limited to the greater of:

1. $10 million, reduced by the aggregate amount of eligible gain taken into account under this provision for prior tax years (the “cumulative limitation”), or
2. 10 times the aggregate adjusted basis of QSB stock sold during the tax year (the annual limitation).

Section 1202 applies only upon the “sale or exchange” of QSB stock. Thus, if a C corporation sells its assets, Section 1202 will not be available to exclude corporate-level gain resulting from the sale. However, if the corporation subsequently liquidates by distributing the sales proceeds to its shareholders, the shareholders will be able to use Section 1202 to exclude any gain upon liquidation.

IMPACT OF THE NEW TAX LAW

With the TCJA reducing the corporate tax rate to 21% and Section 1202 offering a 100% exclusion upon the sale of QSB stock, taxpayers must continue to approach the proper entity choice for their business on a case-by-case basis. After all, the owner of a pass-through entity continues to be subject to only a single level of tax. The taxpayer-friendly provisions of the TCJA may narrow the advantages of pass- through status. Section 199A also allows the pass-through business owners to claim a 20% deduction of business income, which reduces the top rate on such income to 29.6%. The imposition of double taxation on C corporation income amounts to an effective tax rate as high as 39.8%. As   a result, doing business as a  pass-through continues to  offer a sizable current tax advantage relative to a C corporation.

Many factors must be taken into consideration in choosing an entity, but opting for C corporation and potential Section 1202 benefits will make sense when:

1. A 5-year holding period is realistic,and shareholders will be able to take advantage of Section 1202.
2. The expected appreciation in the value of thecorporate stock is enough to  overcome the  effect of double taxation on operating income, if income is distributed.
3. Shareholders are willing to retain earnings in the corporation to minimize the effect of double taxation. This is especially true for businesses that need to retain earnings for future growth.
4. Based on the nature of the business, the active business requirement and gross-asset tests will not be problematic.

Example: A  invests $100,000 to form a  new business. The business is expected to earn $200,000 in net income annually for five years, which A will withdraw from the business in full as distributions. After five years, A believes the business will be worth $3 million. Assume that, as the owner of a pass-through business, A would qualify for a full Section 199A deduction, and the stock in the corporation would meet the definition of QSB stock. The federal tax consequences of pass-through versus C corporation status is shown as below:

Based on this example, the Section 1202 exclusion allows A to save $478,000 as a C corporation, despite incurring double taxation on operating income. In addition, the 1202 exclusion may apply for state taxes.

INTERPLAY OF SECTION 1202 WITH SECTION 199A

The 20% deduction offered by Section 199A to owners of passthrough businesses was designed to allow those owners to keep pace with the tax cuts offered to their corporate counterparts. Section 199A, however, with  its limitations, exceptions to limitations, phase-ins and phaseouts, provides benefits that are not always guaranteed. Interestingly, businesses that are not qualified for the benefits of Section 199A will also likely not qualify for a Section 1202 exclusion. Section 199A provides that for business owners with taxable income in excess of a threshold, no deduction is permitted against income earned in a “specified service business.” These specified service businesses are also included among those ineligible businesses under the Section 1202 provision.

CONVERSION OF AN EXISTING BUSINESS

It is anticipated that a 21% corporate rate and the unavailability of the Section 199A deduction to certain pass-through businesses will cause a number of pass-through businesses to convert to C corporations. Businesses that may convert may be service businesses that are ineligible for the benefits of both Section 199A and Section 1202. Care must be given  to the structure of the conversion.

1. S corporation to C corporation
   For stock to meet the definition of QSB stock, the issuing corporation must be a C corporation on the date of issuance. An S  corporation stock can never qualify as  QSB stock, even if the S corporation later converts to a C corporation. Thus, if the S corporation revokes or terminates its election, generally only newly issued shares to new shareholders will meet the QSB stock requirements.
2. Partnership to C corporation
   Converting to a C corporation allows the owners to qualify for the benefits of Section 1202. The holding period of the stock will begin on the date of the transfer, and the partners’ basis in  the stock will be  the basis of the assets transferred to the corporation. As a result, only appreciation occurring after the incorporation will be eligible to be excluded under Section 1202.