Availability of qualified small business: some interesting questions Blogs Foley Ignite

Section 12021 is a once vague tax-saving provision that has become known in the last few years. Originally adopted in 1993 as an exclusion of 50% of capital gains, it has since been amended several times. In its current iteration, Section 1202 allows for the exclusion of 100% capital gains for the sale of Qualified Small Business Shares (QSBS) if its requirements are met and subject to restrictions.

An important requirement is that the issuing company be a local C corporation. Following the 2017 tax law, which significantly reduced the US corporate tax rate to 21% (from 35%), the use of Corporation C for new business has become much more popular. In short, the current tax climate can make an investment in a C corporation very tax efficient if the investment is in a QSBS.

We are considering some issues that we need to address in terms of qualifications.

Can Section 1202 be used to buy out another company or even a foreign company?

Section 1202 requires the issuing corporation to be registered in the country,2 and to be actively engaged in a skilled trade or business,3 among other requirements. To this end, the statutes allow the issuing corporation to seek a corporate subsidiary to meet this requirement for active trade or business, as long as the mother owns at least 50% of the subsidiary.4

While Section 1202 was passed to provide a tax incentive to set up small, growing U.S. companies, the bylaws do not appear to preclude raising money in a new C corporation that uses the money to buy out another C corporation.5 The acquired C corporation will perform the test for a subsidiary, as long as the new C corporation acquires at least 50% of the shares of this other “target” C corporation. Furthermore, it appears that such target corporation C may be a foreign corporation.

However, given the intent of Section 1202, it is possible for the IRS to attack using a presumed QSB as a means of acquisition.

Can the active activity of a partnership subsidiary be attributed to QSB?

While Section 1202 specifies when a subsidiary may be “screened” for the mother’s active commercial or business test, the bylaws are unclear when a parent corporation may seek through a partnership (such as a multi-member LLC that has not chosen to be taxed as a corporation). While the IRS provides guidance, the taxpayer may wish to consider one of these alternatives:

  • Apply the “corporate” review rule: the parent corporation must hold at least 50% of the partnership’s capital and profits to review the partnership.
  • Apply the business continuity test to partnerships: the parent corporation must own at least 1/3 of the partnership’s capital and profits if it does not manage the partnership and at least 20% where it does.6
  • Treat each partnership as a “collection” of its partners and allow review, regardless of the percentage held by the parent corporation.

Disqualifying purchases

Section 1202 requires the shares to be initially issued by the corporation.7 If the corporation makes a disqualifying share repurchase, the issue will be prohibited as QSBS status in whole or in part. The redemption is disqualified if it occurs in (a) a 4-year period beginning two years before the issue of shares and the shares of certain related parties (as a founder who holds significant shares in the company) to be repurchased, or (b) in 2 -annual period starting one year before the issue of the shares and more than 5% of the total value of all unpaid shares are redeemed.8

New investors must investigate whether the company made disqualifying purchases before its investment and must seek agreements that it will not do so in the future.

If an existing shareholder wishes to sell his shares and he or she knows that new investors may seek QSBS status, the shareholder must sell his shares to a buyer, not the company. However, the buyer cannot use the QSBS exemption as it requires an original stock issue.

Can ownership of transferred shares qualify for QSBS treatment?

QSBS benefits are only eligible for non-corporate shareholders, including partnerships, LLCs taxed as partnerships, and S corporations.9 Among other requirements, partners include a portion of the QSBS profit proportional to their share of the adjusted QSBS partnership base on their individual tax returns.10

Because many QSBs are funded by venture capital funds set up as partnerships, sponsors often ask if their transferred interests can qualify for QSBS exclusion.

The provisions of Section 1045 (which governs the diversion of QSBS) do not allow the holder of interest transferred to qualify for the purposes of this status. In particular, the provisions concern the capital of the partner,11 and the interest carried forward is a share of the profits of the partnership, not of the capital.

Although these provisions do not explicitly apply to Section 1202, we consider that they make it difficult to argue that a holder of interest carried forward may exclude profits distributed to him or her from a fund holding QSBS.

1 All references to the sections are to the Internal Revenue Code or the Financial Regulations promulgated therein.

5 To qualify as a QSB, a corporation’s total gross assets must not exceed $ 50 million after the purchase of shares by the investor. Section 1202 (d) (1).

6 Section 1.368-1 (d) (4), (d) (5) Examples 8 and 10

8 Section 1202 (c) (3) (A) – (B). The rules provide a de minimis exception to both redemption rules. Section 1.1202-2 (a) (2), (b) (2)

11 Section 1.1045-1 (d) (1) (ii), (d) (2), (e) (2) (A) – (B)

Leave a Comment