Tax Planning - Stacking and Packing the Benefit under Section 1202
Section 1202 provides a significant incentive for taxpayers to invest in small businesses structured as C corporations by allowing them to exclude large amounts of gain on a future sale of stock in those businesses.
Background
A taxpayer (excluding a corporate shareholder) who holds qualified small business stock (“QSBS”) for at least five years, upon a sale of that stock, can exclude, on an annual basis, 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.
Per Taxpayer Limitation and “Stacking” the Benefit
Section 1202 provides that the $10 million or 10 time basis exclusion limitation is a per taxpayer limitation.[1] Under the Code, a “taxpayer” is “any person subject to any internal revenue tax.”[2] Therefore, the gain exclusion from QSBS can be increased if a person’s QSBS is spread over two or more “taxpayers,” so instead of one taxpayer taking a $10 million exclusion, the taxpayer transfers some of his QSBS to another taxpayer and then another $10 million exclusion “stacks” on top of his own $10 million exclusion.
Gifting QSBS to non-grantor trusts is a popular method to stack the exclusion under section 1202, although outright gifts to heirs or other taxpayers would also work. For example, assume Hank formed a corporation for a nominal capital amount and his stock in that corporation is QSBS. Five years into the business, Hank’s business appraises for $15 million. If he sells the stock for $15 million, Hank will exclude $10 million from gain and pay tax on the remaining $5 million.
Alternatively, instead of retaining all of his shares, Hank gifts 1/3 of his shares (with a $5 million value) to a non-grantor trust for the benefit of his son, Bobby. Hank and the trust then sell their shares. Hank receives $10 million for his shares and is able to exclude all of the gain from tax, and the trust receives $5 million of gain for its shares, and it is also able to exclude all of the gain from tax.[3]
If possible, QSBS should be gifted when the value of the gifted shares is as low as possible and ideally well before the QSBS is sold. Completed gifts of QSBS will be subject to the gift tax rules and gift tax return reporting requirements.
Packing the Benefit
This strategy involves a taxpayer trying to pack as much basis into the annual exclusion (i.e., 10 times basis) calculation as he can in order to increase the exclusion limitation beyond $10 million.
The taxpayer could contribute cash or property worth more than $1 million to the issuer in exchange for QSBS. The property can be cash in excess of $1 million, appreciated property (other than stock)[4] whose fair market value exceeds $1 million, or a combination of both. This method works because of a special rule that determines the taxpayer’s basis for purposes of section 1202 by reference to the fair market value of the property contributed. The taxpayer can then use the increased basis in the annual exclusion calculation. For example, if Hank contributes $1 million cash and $3 million of self-created (i.e., zero basis) goodwill to a C corporation, then Hank’s basis for purposes of the annual exclusion calculation is $4 million rather than $1 million, which is his stock basis for tax purposes other than section 1202. This means Hank’s annual exclusion is $40 million (10 times $4 million).
This strategy can be used by any section 1202-eligible taxpayer with appreciated property, but it is most often used in cases where a partnership converts an ongoing business (with appreciated property) to a C corporation.
Stacking and packing are excellent strategies to increase the section 1202 exclusion, but planning for them should not be put off until the last minute.
For questions or assistance with the topics discussed in this brief article, please contact us.
Thomas W. (T.W.) Langevin
513.579.6501
tlangevin@kmklaw.com
Mark E. Sims
513.579.6966
msims@kmklaw.com
[1] See §1202(a)(1), (b).
[2] §7701(a)(14).
[3] See §1202(h) (providing that a transferee meets the original issuance requirement and takes a carryover holding period of the stock if it is received by gift).
[4] §1202(c)(1)(B)(i).
