Documentation is Key When Claiming QSBS Benefits

TW Langevin

In recent years, the utilization of qualified small business stock (“QSBS”) under Section^[1] 1202 has grown considerably. Many businesses are formed as corporations at conception, private equity investors calculate the tax benefits from Section 1202 into their ROI calculations, and many businesses taxed as partnerships incorporate to utilize Section 1202 for future appreciation. While the utilization of Section 1202 has grown considerably (and this code provision has been in effect since 1993), there is virtually no authority interpreting that Section; there are around a dozen private letter rulings and one case under a companion provision, Section 1045. However, in March of last year, the first Section 1202 case came out from the Court of Federal Claims, JU et al v. USA.^[2] Ju highlights the importance of strong documentation for taxpayers when claiming the exclusion under Section 1202.

QSBS Background

A shareholder (excluding a corporate shareholder) who holds QSBS for at least five years, upon a sale of that stock, can exclude an amount of gain equal to the greater of $10 million or 10 times the shareholder’s original basis in the stock. QSBS is stock that satisfies three requirements: the small business, original issuance, and active trade or business requirements.

"Small Business" Requirement

QSBS must be issued by a corporation that, at the date of issuance, is a domestic C corporation with cash and other assets totaling $50 million or less, based on adjusted basis, at all times from August 10, 1993 to immediately after the stock is issued.

 "Original Issuance" Requirement

The shareholder must acquire the stock directly from the corporation in exchange for money or other property or as compensation.

“Active Trade or Business" Requirement

To qualify as QSBS, stock must be issued by a C corporation that meets an active business requirement—at least 80% of the value of the corporation’s assets must be used in a qualified trade or business during substantially all of the taxpayer’s holding period for such stock.

Background of Ju Case 

Dr. Ju, was an employee of the University of Oklahoma. While employed with the university, he invented two patents. The university’s policy is that all patents on inventions that were made or conceived by university employees are the property of the university and that employees must assign their rights in those patents to the university. Dr. Ju assigned his rights in both patents to the university in 2003. Later that year, the university licensed those two patents to a corporation in return for cash and shares of stock.

The university licensing policy provided that the university will give an inventor 35 percent of the gross revenues, including equity, that it receives under a patent license. While the university will give the inventor cash revenue when the university receives it, stock issued to the university “shall be held by the Controller’s Office” until the employee leaves the university.

In 2015, Dr. Ju had a dispute with the university about the revenue from his patents, and he and the university entered into a settlement agreement. The agreement stated that 18,017 shares were previously issued to Dr. Ju directly, and as part of the settlement agreement, the corporation would reissue 53,441 shares of stock in the name of Dr. Ju, instead of in the name of the university.

In 2016, Dr. Ju sold all of his stock and reported the income on his tax return as a long-term capital gain. In 2019, Dr. Ju filed an amended tax return for 2016. The amended 2016 tax return sought to treat the proceeds from the sale of stock as “qualified small business stock,” instead of long-term capital gains, which would entitle Dr. Ju to exclude part of those proceeds from his taxable income. The IRS disallowed the 2016 amended tax return.

Original Issuance and Five Year Holding Period Requirements – 53,441 Shares

For the 53,441 shares recently issued in his name, Dr. Ju argued he should be able to apply the five-year holding period requirement to these shares since he believed he had ownership rights dating back to 2003. However, the court disagreed. Their decision hinged on when Dr. Ju actually acquired legal ownership of the shares. Since the settlement agreement in 2015 formally transferred ownership from the University of Oklahoma to Dr. Ju, the court determined that Dr. Ju failed the original issuance requirement (the shares were transferred from the university to Dr. Ju instead of directly to him from the corporation) and that the five-year holding period began at the time of the settlement agreement when the shares were transferred into his legal name. Dr. Ju having sold the shares in 2016 meant he also fell short of the five-year minimum ownership requirement.

Small Business Requirement($50MM Gross Asset Test) -18,017 Shares

Here, Dr. Ju faced another hurdle – the $50 million gross asset test. As discussed above, to qualify for the QSBS exclusion, the issuing company’s “aggregate gross assets” must be $50 million or less at all times from its incorporation through immediately after the stock issuance. Dr. Ju presented financial records from 2009 to 2011, demonstrating that the corporation’s gross assets were approximately $2 million during that period, well under the $50 million threshold. 

The court deemed this evidence insufficient. The crux of the issue was the timing. The stock issuance for these shares occurred in 2003, six years before the financial records Dr. Ju presented. The court pointed out that a company’s asset levels can fluctuate considerably over time. Dr. Ju’s documentation, while relevant to the corporation’s financial health in later years,  didn’t address the critical period surrounding the stock issuance in 2003. Specifically, the burden was on Dr. Ju to show that from the time of the corporation’s incorporation through the date he received his shares in 2003, the corporation’s gross assets never exceeded $50 million.

Conclusion

The takeaway here is that if you are receiving corporate shares that are intended to qualify as QSBS, especially if you are not receiving shares at the time of incorporation, then you need to carefully document and maintain records of the corporation’s finances. You need to be able to prove to an agent that here are the corporation’s assets from the moment of formation through the moment immediately after you acquired your stock, and that at all times it was less than $50 million. The IRS is catching on, as taxpayers have, to what it means to have QSBS and the benefits that flow from it. The IRS is going to start making taxpayers earn that benefit.

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[1] Unless otherwise stated, all “Section” references refer to sections within the Internal Revenue Code of 1986, as amended.

[2] No. 1:2022cv01815 – Document 19 (Fed. Cl. 2024).