Sale of QSBS and Installment Sale Reporting
In recent years, the utilization of qualified small business stock (“QSBS”) has grown considerably. Many businesses are formed as corporations at conception, private equity investors calculate the tax benefits from Section[1] 1202 into their ROI calculations, and many businesses that were formed to be taxed as partnerships incorporate to utilize the benefit of Section 1202 for future appreciation. When a taxpayer sells his QSBS, it is not uncommon for the sale proceeds to be paid out over more than one year, often due to a holdback escrow or an earnout. When sale proceeds are paid over the course of more than one taxable year, taxpayers typically report their income on the installment method. While the installment method reporting mechanics under Section 453 are quite clear in most contexts, reporting the gain from the sale of QSBS under the installment method is not so clear.
Section 1202 Background
As discussed in more detail here, QSBS must satisfy the small business, original issuance, and active trade or business requirements. An eligible 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[2]. While that may seem straightforward, Section 1202 is full of nuances.
Background on Installment Sales
Section 453 provides that income from an installment sale should be reported using the installment method unless the taxpayer elects out of that method. An installment sale is generally defined as a disposition of property in which at least one payment would be received after the close of the year of the disposition.[3] Thus, and this is an important point discussed later, Section 453(b)(1) contemplates that the property is disposed of in the year of sale, even if payments are received over multiple years, i.e., the property is not disposed of over multiple years. The installment method provides that a seller’s recovery of tax basis in the disposed property should be determined by reference to the ratio of gross profit to the total contract price.[4]
If there is a maximum price, the taxpayer should recover tax basis in proportion to the ratio of the payment to the maximum price.[5] If there is not a maximum price but there is a maximum number of years over which the price is to be paid, the taxpayer should recover tax basis ratably over that number of years.[6] If both the price and the payout period are potentially unlimited, the taxpayer generally recovers tax basis ratably over a 15-year period.[7]
Approaches for Installment Sale Reporting for Sale of QSBS
The two potential approaches to how a taxpayer could exclude QSBS gain when using the installment method are:
- Reporting the excludable gain first (the exclusion-first approach); and
- Ratably reporting taxable gain and gain that is excludable under Section 1202 (the ratable reporting approach).
Neither approach is guaranteed to be taxpayer friendly in all circumstances, yet both are arguably defensible.
The Exclusion-First Approach
The plain language of Section 1202 arguably supports the exclusion-first approach. Section 1202 says that “gross income shall not include” gain from the sale of QSBS held for more than five years.[8] Because the seller recognizes gain from the disposition of property when the seller sells QSBS, an argument can be made that the first (or earlier) payments should be eligible for exclusion under Section 1202. However, this approach is likely a slightly aggressive position since, as discussed next, the IRS appears to favor the ratable reporting approach.
The Ratable Reporting Approach
The IRS appears to favor the ratable reporting approach, as detailed in the instructions to Form 1040 Schedule D, “Capital Gains and Losses.” The instructions provide, “Figure the allowable section 1202 exclusion for the year by multiplying the total amount of the exclusion by a fraction, the numerator of which is the amount of eligible gain to be recognized for the tax year and the denominator of which is the total amount of eligible gain.”[9] However, guidance published in IRS instructions is typically not binding on taxpayers.[10]
Examples
Example 1 – Sale of QSBS with $0 basis and less than 100% of gain eligible exclusion
Assume Dwight’s tax basis in his QSBS is $0, and Dwight sells all his QSBS for $15 million, with $9 million paid at closing in year 1 and with $6 million to be paid in year 2. Applying the $10 million limitation on the exclusion of gain under Section 1202, Dwight may exclude $10 million of the $15 million gain. Under the exclusion-first approach, Dwight would exclude all the gain ($9 million) in year 1, and he would exclude $1 million of the gain in year 2 (and recognize the remaining $5 million of gain in year 2).
Under the ratable reporting approach, Dwight would exclude $6 million in year 1, and exclude $4 million in year 2. The instructions require the taxpayer to determine the Section 1202 exclusion for year 1 by multiplying the total amount of the exclusion — $10 million — by the ratio of $9 million (the amount of eligible gain to be recognized in year 1) to $15 million (the total amount of eligible gain) — 60 percent. For year 2 the taxpayer would multiply $10 million by the ratio of $6 million to $15 million (40 percent).
A taxpayer that wishes to avoid ambiguity may consider electing out of the installment method, in which case he would recognize all $15 million of gain in year 1 and be able to exclude $10 million in year 1.
Example 2 – Sale of QSBS, $500,000 basis, and less than 100% gain eligible for exclusion
Assume Dwight has a $500,000 tax basis in QSBS and sells the QSBS for $20 million, with $10 million payable in year 1, and $10 million in year 2. Without regard to Section 1202, under the installment method, Dwight should have gain of $9.75 million in each of years 1 and 2.[11] The aggregate Section 1202 exclusion amount should be $10 million. The issue is whether Dwight should exclude the full $9.75 million in year 1, and $250,000 in year 2; or $5 million in year 1, and $5 million in year 2.
Again, there is arguably statutory support for excluding $9.75 million in year 1, because that is the amount of gross income in year 1 that is eligible for exclusion. At the same time, the instructions to Form 1040 Schedule D may require a different result — that is, year 1 exclusion of $5 million ($10 million * $9.75 million / $19.5 million), and an additional $5 million excluded in year 2.
Example 3 – Sale of QSBS and application of 10 times basis exclusion
Assume Dwight’s tax basis in his QSBS is $2 million, and Dwight sells all his QSBS stock for $30 million with $15 million paid in year 1, and $15 million paid in year 2. This scenario highlights a potential trap for the unwary because of the literal language of section 1202(b)(1)(B). Section 1202(b)(1)(B) says the exclusion amount is the greater of $10 million or 10 times the aggregate adjusted bases of QSBS disposed of by the taxpayer during the tax year. As noted above, Section 453(b)(1) contemplates that in the case of an installment sale, disposition occurs in the year of sale.
Without regard to Section 1202, Dwight should report $14 million of gain at closing and $14 million of gain in year 2[12]. The Section 1202 exclusion limit is $20 million ($2 million x 10), and under the exclusion-first approach, Dwight should exclude the $14 million of gain at closing. However, regarding the $14 million of gain reported in year 2, arguably none should be excluded, because while Dwight received the second $14 million installment in year 2, he arguably did not dispose of any QSBS in year 2, and therefore he may not be able to use the remaining $6 million of exclusion (10 times the $2 million tax basis less $14 million excluded at closing). One potential alternative to avoid this result is for the taxpayer to elect out of the installment method.
Aside from electing out of the installment method, in this scenario the instructions to Form 1040 Schedule D arguably achieve a taxpayer-favorable result. The ratable exclusion reporting approach (favored by the instructions) should apply in this scenario as follows: The total amount of the exclusion should be $20 million ($2 million tax basis x 10), the amount of eligible gain reported in each installment should be $14 million, and the total amount of eligible gain should be $28 million[13]. Thus, the ratable exclusion reporting approach arguably results in Dwight excluding $10 million at closing, and $10 million in year 2.
Conclusion
The application of Section 1202 to installment sales contains many nuances and traps for the unwary. Ultimately, it is up to tax practitioners to determine which of the approaches discussed here is more beneficial in a particular situation, and which approach is more defensible. At the same time, much of the ambiguity and uncertainty could be resolved if the IRS issued guidance that was more formal and authoritative than instructions on a tax form.
[1] All references to “Section” or “§” refer to a Section of the Internal Revenue Code of 1986, as amended.
[2] § 1202(b).
[3] § 453(b)(1).
[4] § 453(c).
[5] Treas. Reg. § 15a.453-1(c)(2).
[6] Treas. Reg. § 15a.453-1(c)(3).
[7] Treas. Reg. § 15a.453-1(c)(4).
[8] § 1202(a).
[9] 2023 Instruction for Schedule D, Capital Gains and Losses, at Page D-9, available at https://www.irs.gov/pub/irs-pdf/i1040sd.pdf.
[10] See Zimmerman v. Commissioner, 71 T.C. 367 (1978) (stating “authoritative sources of Federal tax law are in the statutes, regulations, and judicial decisions and not in … informal [IRS guidance].”).
[11] Because the purchase price is paid out 50% in year 1 and 50% in year 2, Dwight would recover 50% of his basis ($250,000) in each year. Therefore, the eligible gain in each year would be $10 million less $250,000, equaling $9.75 million.
[12] Because the purchase price is paid out 50% in year 1 and 50% in year 2, Dwight would recover 50% of his basis ($250,000) in each year.
[13] $30 million purchase price minus $2 million of tax basis.
