Potential Section 1202 Pitfalls Upon Partnership Incorporation

Thomas W. Langevin and Mark E. Sims

In recent years, the utilization of Section^[i] 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. This article focuses on a potential pitfall upon converting an active LLC (taxed as a partnership^[ii]) to a corporation. In short, converting an LLC to a corporation often involves complex look-through rules to calculate the proper gain exclusion under Section 1202 upon a future sale of qualified small business stock (“QSBS”), but these complex rules can usually be avoided by contributing the LLC interests to a newly-formed corporation, instead of effecting a conversion.

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. Thus, a shareholder who acquires stock in a corporation via the purchase of an existing shareholder's shares will not be treated as holding QSBS.

“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. A qualified trade or business excludes: (1) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, etc.; (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 subject to percentage depletion; and (5) a hotel, motel, restaurant, or similar business.

LLCs Owning QSBS
It is common, and permissible, for LLCs (often private equity funds) to acquire QSBS on behalf of their investors. Thanks to Section 1202(g), this is generally fine. However, the QSBS benefit is only permissible for partners in the fund at the time the QSBS is acquired and, more importantly, the benefit to those partners is limited to the extent of their interest in the LLC on the date the QSBS was acquired.^[iii]

Example

Hank acquires a 20% interest in an LLC that simultaneously acquires an interest in QSBS. Thereafter, Hank buys out one of his partner’s 30% interest to increase his interest in the LLC to 50%. After five years, the LLC sells the stock for a $1 million gain. Although $500,000 of the gain is allocable to Hank, the amount that Hank may exclude under Section 1202 is limited to $200,000 (20%, not 50%, of the allocable gain).

LLC and Partnership Incorporation Generally
An LLC taxed as a partnership can choose to be taxed as a corporation in one of several methods:

1. Formless Conversion: In many states, the partnership can file a form to convert a corporation under a state-law formless conversion statute.
2. Check-the-box: The partnership can "check the box" to be taxed as a corporation (via Form 8832).
3. Merger: The partnership can merge into a corporation under a state law cross-entity merger statute.
4. Contribution: The partnership or its partners can form a new corporation and contribute the business assets to the newly formed corporation. This can take one of three forms, as described in Rev. Rul. 84-111:
   1. The “assets-over” method: The partnership transfers partnership assets to a newly-formed corporation in exchange for stock of the corporation and the corporation’s assumption of the partnership liabilities. The partnership then liquidates by distributing the corporate stock received to the partners in proportion to their partnership interests.
   2. The “assets-up” method: The partnership distributes all partnership assets and liabilities to the partners in liquidation of the partnership. The partners then transfer the assets to the corporation in exchange for the corporation’s stock and the corporation assumes the liabilities that the partners had assumed from the distributing partnership.
   3. The “interests-over” method: The partners transfer their partnership interests to a newly-formed corporation in exchange for corporate stock. The transfer terminates the partnership (since the partnership will then have a single owner), and the partnership's assets and liabilities become the assets and liabilities of the corporation.

Incorporation and the Original Issuance Requirement
Typically, an LLC incorporates by filing certain documents pursuant to a formless conversion statute. Under that incorporation method, the LLC is deemed to convert via the “assets-over” method.^[iv] While that method briefly results in the LLC, rather than the partners, being the original owner of the corporation’s stock (thus seemingly failing to satisfy the “original issuance” requirement for QSBS), that concern is alleviated by Section 1202(h)(2)(C), which provides that, if a partnership transfers stock to a partner, the partner is treated as having acquired the stock in the same manner as did the partnership.

Potential Pitfall
While Section 1202(h)(2)(C) permits QSBS to retain its status as such upon a conversion, that section cross-references, and makes applicable, Section 1202(g), which limits a partner’s Section 1202 gain to the extent of the partner’s “interest” in the partnership. Nowhere does Section 1202 or its regulations define how to calculate a partner’s interest. However, the regulations under Section 1045, which are often viewed as good guidance on interpreting Section 1202, provide for a similar limitation which is limited to a partner’s capital interest.^[v] If a partner’s 1202 limitation is determined by reference to his capital interest (as opposed to his ownership interest), then the economics can get distorted.

Example

Hank and Dale each invest $10,000 for a 50% interest in an LLC that immediately acquires QSBS.  However, assume that to entice Hank to invest, the distribution waterfall is set up such that first Hank’s capital is returned with a 10% preferred return, then Dale’s capital is returned, and finally the remaining distributions are distributed 50-50. Now, if the LLC hypothetically liquidated immediately after acquiring the QSBS, Hank would receive $11,000 ($10,000 * 1.1) and Dale would receive $9,000. Thus, Dale only has a 45% capital interest ($9,000 / $20,000) and Hank has a 55% capital interest.

Fast forward five years where the LLC has made sufficient distributions to cover Hank’s preference so that all future distributions are 50-50 and the LLC sells its QSBS for a $1 million gain. On Schedules K-1, the LLC is likely to allocate each of Hank and Dale $500,000 of gain. However, for Section 1202 purposes, Hank could have excluded up to $550,000 (55%) of the gain while Dale is only permitted to exclude up to $450,000 (45%). Therefore, Dale will have to recognize $50,000 of gain. Why? Because even though Hank and Dale have a 50% capital interest at the time the QSBS is sold, their exclusion percentages for Section 1202 purposes are determined when the QSBS is acquired.

How does this come into play with LLC conversions? Let’s keep the same example but slightly change the facts.

Instead of acquiring QSBS in their LLC, Dale and Hank, through their LLC, operate a propane and propane accessories company for a number of years when they realize that their business could qualify under Section 1202. So, they decide to effect a formless conversion to convert into a Delaware corporation. At the time of conversion, due to Hank’s accrued preference, if the company liquidated, Hank would receive $600,000 and Dale $400,000. Upon conversion, Dale and Hank each own 50% of the voting stock, but to maintain their liquidity preferences, the newly-converted corporation has two classes of stock.

Five years later, Dale and Hank each sell their shares for a $5 million gain. Do each of them get to exclude all of their gain? Unlikely. Dale will likely recognize $1 million of gain, even though his total gain is under the $10 million threshold.

While it appears Dale and Hank received their stock directly from the corporation, recall that a formless conversion filing utilizes the “assets-over” method for tax purposes. Therefore, for a brief moment in time, the LLC owned the QSBS before immediately liquidating and distributing the QSBS to Dale and Hank.

What were the capital interests at the time of conversion? 60%-40%. So, if the LLC had sold the QSBS stock for $10MM (and realized $10MM of gain), Hank would be permitted to exclude up to $6MM of gain and Dale $4MM. So, Dale and Hank are still locked into those exclusion percentages since they technically acquired their shares from an LLC.

Solution and Conclusion
Instead of using a formless conversion statute, Dale and Hank form a new corporation. Then, they transfer their LLC interests to the corporation in exchange for stock. Under this “interests-over” method, when Dale and Hank each sell their shares for a $5 million gain, each of them can exclude all of the gain because they acquired their shares directly from the corporation.

For an LLC conversion where Section 1202 is involved, it will often be better for the partners if a new corporation is formed, and the partners each contribute their LLC interests to the corporation in exchange for stock. Using this method avoids the impacts of Sections 1202(h)(2)(C) and 1202(g)(3), and the regulations under Section 1045.

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

[ii] Unless stated otherwise, all references to an LLC are references to an LLC with multiple members taxed as a partnership for federal income tax purposes.

[iii] Section 1202(g)(3).

[iv] Rev. Rul. 2004-59.

[v] Treas. Reg. Sec. 1.1045-1(e)(3)(ii)(B).