Advanced Section 1202 (QSBS) Planning for S Corporations - Frost Brown Todd

Section 1202 provides for a substantial exclusion of gain from federal income taxes when stockholders sell qualified small business stock (QSBS).[1] A number of requirements must be satisfied before a stockholder is eligible to claim Section 1202’s gain exclusion. Those requirements have been addressed in a series of articles on Frost Brown Todd’s website. This article focuses on the planning challenges posed by S corporations for business owners interested in pursuing the benefits of Section 1202’s gain exclusion.

This article is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045. The C corporation has gained favor in recent years as the entity of choice because of the 21% corporate tax rate and the potential for benefiting from Section 1202’s gain exclusion. Additional information regarding the eligibility requirements for Sections 1202 and 1045 can be found in our QSBS library.

The following Section 1202 eligibility requirements show why S corporations and QSBS are incompatible:

Only C corporations can issue QSBS (stock issued by an S corporation can never qualify as QSBS) — Section 1202(d)(1).[2]
A corporation issuing QSBS must remain a C corporation during “substantially all” of a stockholder’s holding period for the QSBS (i.e., after QSBS is issued, conversion by the issuing corporation to an S corporation will usually terminate QSBS status) — Section 1202(c)(2)(A)
A corporation issuing QSBS must remain a C corporation when the QSBS is sold — Section 1202(c)(1).

S corporations are corporations for federal income tax purposes that have made an election to be taxed under the S corporation regime. S corporation stockholders share in the corporation’s income and loss which is passed through on Schedule K-1s. There is nothing inherently wrong with operating a business through an S corporation, but business owners who seek Section 1202’s gain exclusion should avoid S corporations. This article suggests several approaches for addressing the situation where a business has strayed into the grasp of the S corporation.

What approach is available for a business that started life as a C corporation but later elected S corporation status?

Assume that business owners want to be eligible to claim Section 1202’s gain exclusion, but their business has S corporation tax status. Stock issued while the business was an S corporation can never qualify as QSBS. If these owners only want newly-issued stock to qualify as QSBS, they can terminate the corporation’s S corporation election and issue QSBS, subject to satisfying Section 1202’s various eligibility requirements. If existing stockholders also want to position themselves to qualify for Section 1202’s gain exclusion, they should consider the approach of forming a new C corporation discussed below at Restructuring a business to indirectly “exchange” non-QSBS for QSBS.

If the bulk of a company’s stock was issued before an S corporation election was made, simply terminating the S corporation election might be a viable option if the stockholders would later satisfy Section 1202’s requirement that the company was a C corporation for “substantially all” of their QSBS holding period. What constitutes “substantially all” of a stockholder’s holding period has not been defined by tax authorities for purposes of Section 1202. Other tax authorities have “substantially all” to mean as much as 95% or as little as 51% of the applicable measurement period. For planning purposes, one should assume that “substantially all” should fall somewhere between 70% to 95% of a stockholder’s holding period for QSBS. For example, the “substantially all” requirement should be satisfied if a business is a C corporation when QSBS is first issued and later sold, and operates as a C corporation during eight of a stockholder’s 10 year holding period.

What options are available for business owners holding stock issued by an S corporation, assuming the business remains an S corporation?

There are a couple of options available to business owners if they are holding stock issued while operating an S corporation.

Undertaking a restructuring that indirectly converts non-QSBS into an indirect interest in QSBS. Stockholders naturally would like to benefit from Section 1202’s gain exclusion even if their stock was issued while the business operated as an S corporation. This goal cannot be achieved directly because stock issued by an S corporation will never directly qualify as QSBS. If the S corporation election is terminated, any previously issued stock will not qualify as QSBS. One possible workaround would be for the S corporation to contribute assets to a newly-formed C corporation in exchange for QSBS. This restructuring often involves first undertaking a Type F reorganization followed by the contribution of LLC membership interests for QSBS.[3] The restructuring results in a three-tier structure: an S corporation holding company, a C corporation subsidiary and a wholly-owned single-member LLC which is what remains of the historic operating business.

The contribution of the assets of the business to the newco-C corporation in exchange for its stock is accomplished through a Section 351 nonrecognition exchange. One of Section 351’s requirements is that the exchange be undertaken for bona-fide business reasons, outside of the potential tax benefits. If challenged by the IRS, a taxpayer bears the burden of proving that there were bona-fide business reasons for the restructuring. The fact that there are often bona-fide non-tax business reasons for creating a multi-tier holding company structure should work in the taxpayer’s favor.

In the restructuring described above, the S corporation (or in a Type F reorganization, its successor holding company) becomes a mere stockholder of the newco-C corporation. The S corporation’s stockholders should share in Section 1202’s gain exclusion when the newco-C corporation’s QSBS is eventually sold, assuming all eligibility requirements were met. In order to avoid triggering a deemed taxable sale, the S corporation must hold and sell the QSBS. The S corporation’s holding period for the newco-C corporation’s QSBS commences when the restructuring occurs. The newco C corporation often issues additional QSBS to investors and service providers either as part of or after the Section 351 nonrecognition exchange.

For Section 1202 purposes, assets are deemed to be contributed to the newco-C corporation at their fair market value rather than their historic tax basis. This special Section 1202 rule is significant for several reasons. First, the C corporation will fail Section 1202’s $50 million test and no QSBS can be issued if the aggregate fair market value of the contributed assets exceeds $50 million. Second, the spread between the tax basis and fair market value of the assets at the time of the deemed contribution won’t qualify for Section 1202’s gain exclusion; instead, that “built-in gain” is taxed in a sale at capital gains rates. Third, the “Section 1202 tax basis” for assets contributed in a Section 351 nonrecognition exchange is the fair market value (FMV) of the assets, opening the door for taking advantage of Section 1202’s “10X” gain exclusion cap. For example, if assets with a zero tax basis and a $10 million FMV are contributed by the S corporation to the C corporation in exchange for QSBS, and the QSBS is sold for $110 million, the first $10 million of gain would be taxed at long-term capital gains rates, and by virtue of the 10X gain exclusion cap, the next $100 million would potentially qualify for Section 1202’s gain exclusion.

Having an S corporation hold the stock of a C corporation can sometimes result in troublesome tax issues. For example, a problem could arise if there is a desire to distribute earnings out of the newco C corporation. Where the S corporation has accumulated earnings and profits, distributions would be treated as passive income, which could trigger the termination of the S corporation election under Section 1362(d)(3) and the imposition of a 25% tax on the excess net passive income under Section 1375. Planning should focus on structuring non-passive payments.

Converting the S corporation to a C corporation and recapitalizing the C corporation with preferred and common stock. Another approach to create some benefit for existing stockholders involves terminating the S corporation election and recapitalizing the corporation with preferred and common stock. A stockholder can hold both QSBS and non-QSBS in the same corporation. Existing stockholders would be issued preferred stock equal to the company’s value at the time of conversion. The preferred stock overhang should significantly reduce the value of common stock that can be issued for money or services to existing stockholders, employees and new investors. Newly-issued common stock can qualify as QSBS.

Converting the S corporation to a C corporation. An S corporation can be terminated if the sole goal is to position the business to issue additional new QSBS. A former S corporation can issue QSBS, assuming that all of Section 1202’s issuing corporation level eligibility requirements are met. As noted throughout this article, stock previously issued while the business was an S corporation is not eligible for Section 1202’s gain exclusion.

If a goal of the conversion is merely to enable the business to issue QSBS to employees, in order to immediately commence the holding period, the stock will need to either be fully vested when issued or the employee will need to make a Section 83(b) election.[4] If the business has substantial value when stock issued for services, a possible way to avoid substantial compensation income would be to recapitalize the company with preferred and common stock in a Type E reorganization (Section 368(a)(1)(E) recapitalization). The existence of a substantial block of preferred stock usually results in a substantially reduced value for the common stock issued to employees.

A strategy that should fail — liquidating the S corporation and contributing the assets to a newco C corporation. Although a liquidation, re-incorporation strategy seems appealing, there are several potential tax issues that should be carefully considered. The liquidation of an S corporation is generally treated as a deemed sale of the corporation’s assets at their fair market value. A deemed sale could result in substantial up-front tax liability, with no guarantee that Section 1202’s benefits will ultimately be available. If the S corporation holds inventory, receivables or assets that would trigger depreciation recapture, gain on the deemed sale would be taxed at ordinary income rates.[5] If the S corporation has built-in gains at the time of liquidation, the liquidation would trigger a corporate level tax on the built-in gains.[6] Finally, the IRS could attack a two-step liquidation, reincorporation plan by invoking step-transaction doctrine, the liquidation-reincorporation doctrine, or other similar anti-tax avoidance arguments. Business owners should also consider whether there are non-tax issues associated with a liquidation-reincorporation plan.

What are the planning options for business owners interested in Section 1202’s benefits if their corporation issued stock as an S corporation and is now operating as an C corporation?

Good planning options are limited under these circumstances. Causing the C corporation to contribute its assets to a newco-C corporation won’t work because a C corporation cannot benefit from holding QSBS. A possible approach would be to recapitalize the corporation with preferred and common stock, causing the value of the common stock to be depressed by the liquidation preference of the outstanding preferred stock. The C corporation could then issue additional stock for money or services to existing stockholders, employees and/or investors.

Closing Remarks

Despite the potential for extraordinary tax savings, many experienced tax advisors are not familiar with QSBS tax planning. Venture capitalists, founders and investors who want to learn more about Section 1202 and Section 1045 planning opportunities are directed to several articles and blogs on the Frost Brown Todd website:

Contact Scott Dolson if you want to discuss any Section 1202 or Section 1045 issues by video or telephone conference.

[1] References to “Section” are to sections of the Internal Revenue Code of 1986, as amended. Each taxpayer can exclude at least $10 million of gain upon the sale of a particular C corporation’s QSBS, provided all of Section 1202’s eligibility requirements are satisfied. Many but not all states follow the federal income tax treatment of QSBS.

[2] A business entity that has made a “check-the-box” election to be taxed as a corporation can be a C corporation and issue QSBS.

[3] In connection with structuring the formation of the newco C corporation and exchanging assets for stock, complicated issues can arise that are associated with a direct contribution of assets, liabilities and contracts (e.g., loss of EIN, consents triggered, etc.). These problems are often avoided if the transaction includes a first step of undertaking a Type F reorganization, which results in the historic operating business first being converted into a subsidiary of a new S corporation holding company, then followed by the contribution of the LLC’s membership interest in the exchange for newco C corporation stock.

[4] Under Section 83, stock is not treated as being owned for federal Income tax purposes by a service provider if it is subject to substantial risk of forfeiture (generally vesting requirement coupled with the stock being nontransferable).

[5] See Section 1239.

[6] See Section 1374.