During the past several years, there has been a marked increase across the country in the use of C corporations as the vehicle for venture financed start-ups. Much of this interest can be attributed to the reduction in the corporate rate from 35% to 21%, but founders and investors have also increased their focus on structuring investments to qualify for Code Section 1202’s generous gain exclusion. But before claiming Code Section 1202’s gain exclusion, taxpayers must satisfy a number of shareholder and issuing corporation level eligibility requirements. One eligibility requirement that can present significant challenges is the $50 million “aggregate gross assets” limitation.
This is one in a series of articles and blogs addressing planning issues relating to qualified small business stock (QSBS) and the workings of Sections 1202 and 1045 of the Internal Revenue Code.
Section 1202’s $50 Million Aggregate Gross Assets Limitation
Eligibility for Section 1202’s gain exclusion is limited to stock issued by a domestic corporation that was a “qualified small business” on the date of issuance. Two elements of that definition are that the corporation’s “aggregate gross assets”: (1) cannot have exceeded $50 million at any time after December 31, 1992 (so effectively for most corporation, from and after the date of formation); and (2) cannot exceed $50 million, after taking into account any cash or property paid for the stock being tested for QSBS status. Fortunately, the status of previously issued QSBS won’t be affected if the corporation’s “aggregate gross assets” subsequently exceed the $50 million limit. But no more QSBS can be issued by a corporation once it has exceeded (even for a moment) $50 million in “aggregate gross assets.”
Presumably, Congress included the $50 million test as part of the initial enactment of Code Section 1202 in 1993 because its goal was to encourage the flow of capital to small businesses.[i] Unfortunately, the $50 million limitation hasn’t been increased since 1993, in spite of the fact that the aggregate inflation rate from 1993 to 2020 was 83.65%, meaning that to stay even, the $50 million limit would need to be raised to $91,825,000 using 2020 dollars.
How the $50 Million Test Works
The first element of the test. Read literally, a shareholder claiming the Code Section 1202 gain exclusion must prove that the corporation did not fail the $50 million test from the date of its formation (assuming it was organized after December 31, 1992) through the date of the issuance of the stock being tested for QSBS eligibility. It certainly seems unreasonable and unrealistic that the IRS might require the seller of QSBS to establish that the corporation’s “aggregate gross assets” did not exceed $50 million on any day during the testing period, but short of this extreme requirement, it is unclear what level of ongoing documentation should be required by the IRS and anticipated by the taxpayer.
The second element of the test. A shareholder must also establish that a corporation’s “aggregate gross assets” did not exceed $50 million, when the cash or property contributed to the corporation in exchange for the stock issuance in question is added to the corporation’s “aggregate gross assets.”
There is no guidance regarding how the amount of cash and/or value of property being paid for the stock being tested should be aggregated for inclusion in the calculation. Take for example the situation where stock is issued on Tuesday, followed by a separate stock issuance on Thursday. Absent some linkage between the two stock issuances, there appears to be no reason why Thursday’s issuance should be aggregated with Tuesday’s issuance for purposes determining whether Tuesday’s issuance satisfied the $50 million test. But on the other hand, if the two issuances were part of an integrated financing round, and particularly if the corporation had accepted subscriptions for Thursday in hand on Tuesday, it wouldn’t be surprising to find the IRS arguing that Thursday subscription payments should be included in running the $50 million test for Tuesday’s stock issuance. We believe that in the absence of specific Section 1202 tax authorities, the courts would look closely at the applicable facts when applying the “immediately after the issuance” concept to a particular stock issuance, perhaps looking to Section 351 tax authorities considering whether participants have control of a corporation “immediately after the exchange.”
Section 1202 does not provide that the “value” of services contributed in exchange for stock being tested should be included in the $50 million calculation. Excluding services from the calculation is consistent with the fact that amounts paid for services are generally not capitalized and would not show up on a tax-based asset side balance sheet constructed for purposes of running the Section 1202 “aggregate gross assets” test.
The “aggregate gross assets” of subsidiaries are included in the calculation. Section 1202(d)(3) provides that the assets of corporations that are part of the same parent control group are included in the calculation of an issuing corporation’s aggregate gross assets. For this purpose, more than 50% ownership is sufficient for a subsidiary to be included in the computation. The 1993 Conference Report confirmed that a ratable share of a subsidiary’s assets is included in the calculation of a parent corporation’s $50 million test, based on the percentage of stock owned (by value). Where a subsidiary is issuing the stock being tested, the aggregation rules in Section 1202(d)(3) would also appear to pull into the calculation the value of a parent corporation’s assets in a “parent-subsidiary controlled group.” The aggregation of the parent corporation’s assets would appear to apply even if the parent is an S corporation. The value of a noncontrolling interest in a corporation would be the issuing corporation’s tax basis in its stock investment. If the corporation being tested holds a controlling equity interest in an LLC, LP or JV taxed as a partnership or as a disregarded entity, it seems likely that the ratable share rule would apply, with a look-thru to the non-corporate subsidiary’s assets. Another possible approach would be to just include in the computation the adjusted tax basis of an issuing corporation’s interest in non-corporate equity.
How To Calculate a Corporation’s “Aggregate Gross Assets” for Purposes of the $50 Million Test
General rules. Section 1202(d)(2) provides that “aggregate gross assets” means the amount of cash and the aggregate adjusted basis of other property held by the corporation. We believe that the “adjusted basis of other property” means the corporation’s adjusted tax basis of other property. Note that a balance sheet prepared in accordance with GAAP could be misleading because assets may not be recorded at their adjusted tax basis. Also, a corporation’s enterprise value isn’t relevant unless all of a corporation’s assets have been contributed in a carry-over tax basis transaction such as a Section 351 exchange (which would include the incorporation of a partnership). For example, a corporation valued at $250 million (a value that would include its unrealized goodwill) could nevertheless have less than $50 million of cash and “aggregate gross assets” (looking at the corporation’s tax-based asset balance sheet). Also, the rapid depreciation and amortization of assets for tax purposes could result in a situation where the corporation satisfies the $50 million test in spite of the fact that $200 million was invested over time. But certainly a corporation that has attracted $200 million (in loan proceeds or subscription payments) could easily find itself with too much cash at a given time to remain below Section 1202’s $50 million limit. The lesson is that it might be possible to manage a corporation’s cash infusions and balance sheet to keep its “aggregate gross assets” at any given time below the $50 million mark.
Liabilities are excluded from the calculation. A corporation’s liabilities are excluded from the $50 million calculation (but the cash proceeds of loans is included, if they sit on the corporation’s books). The 1993 House bill subtracted short term liabilities, but the 1993 Conference Agreement eliminated that subtraction from the $50 million computation. Because debt is not offset against assets on the pro forma Section 1202 “balance sheet,” situations can arise where the issuing corporation will have a line of credit, floor plan or other debt facility that ties directly into increasing the assets on the corporation’s balance sheet (e.g., inventory or equipment). For example, a car dealership floor plan ensures that dealers have the capital needed to purchase inventory. When an automobile is purchased and added to the “inventory” number on the balance sheet, the outstanding balance of the dealer’s floor plan increases. For Section 1202 purposes, what this means from a practical standpoint is that the job of monitoring or analyzing whether a corporation nearing the $50 million mark has or will exceed the $50 million mark must include not only looking a cash contributed into the corporation in equity financing rounds but also looking at draws on the corporation’s loan facilities to determine whether there is either additional cash temporarily on the corporation’s books or whether the debt finances the purchase of additional equipment, inventory, supplies or other capitalized expenditures.
Contributed property is valued at fair market value (FMV) not at its historic tax basis. Section 1202(d)(2)(B) requires that for purposes of the $50 million test, the adjusted basis of property contributed to a corporation in a tax-free exchange (e.g., Section 351 exchange or Section 368 reorganization)[ii] is treated as if the basis of such property (immediately after the contribution) is equal to its FMV at the time of contribution. We believe this language means that contributed property goes onto what is essentially a pro forma adjusted gross assets balance sheet (i.e., the Section 1202 asset-side balance sheet) at the assets’ FMV, and thereafter, the tax basis of those assets should be adjusted for purposes of Section 1202 to account for amortization and depreciation based on their initial FMV. We assume as part of this calculation that goodwill included in the FMV amount would be amortized over 15 years, just as purchased goodwill would be amortized over 15 years under Code Section 197. We make these educated guesses, but there is no helpful Section 1202 guidance addressing these issues.
Summarizing the calculation process. There are basically three categories of assets that must be taken into account when making the $50 million test calculation: (1) cash; (2) assets not contributed to the corporation (where the actual adjusted tax basis of the assets is used); and (3) assets contributed in a tax-free transaction (where the FMV at the time of contribution of those assets must be determined for purposes of the $50 million test). Once the assets go onto the hypothetical Section 1202 asset-side balance sheet, they are amortized and depreciated as they would be for tax purposes. As noted above, if a partnership is incorporated in 2018, and the stock being tested is issued in later year, any goodwill included in the 2018 FMV determination would need to be amortized over 15 years as part of the calculation.
How To Document Satisfaction of the $50 Million Test
An IRS agent could theoretically (and perhaps unreasonably) demand that a taxpayer claiming the Section 1202 gain exclusion prove that the $50 million test was satisfied on each day of an issuing corporation’s existence (after December 31, 1992), up to and through the day of the applicable stock issuance (including on that last day the value of the contributed cash or property). Of course, as a practical matter, many corporations issuing QSBS will clearly fall below the $50 million mark before and after the stock issuance being tested. For this “small” corporation, a set of annual financial statements for the applicable period and evidence of the value of any contributed assets should suffice.
If the corporation issuing stock was a good-sized partnership when it was incorporated, has experienced significant tax-free property contributions along the way, has had significant cash on hand at any point as a result of debt or equity financing, or has balance sheets that suggest the corporation is near to or over the $50 million mark, then additional detailed documentation may be necessary to satisfy the taxpayer’s burden of proof. In this case, efforts should be made to create a running (at least periodic) asset-side tax balance sheet, applying Section 1202’s rules with respect to valuing contributed property at FMV, for the period from the corporation’s formation through the applicable stock issuance. If there are significant cash infusions, the taxpayer should have the evidence to support a calculation of the corporation’s “adjusted gross assets” as of each cash infusion.
If the corporation’s assets are significant enough at any point during its life to warrant a potential challenge by the IRS, a close look should be given to what information is available regarding the FMV of any property contributed to the corporation in a tax-free exchange.[iii] In some instances, it may be necessary to hire an independent appraiser to provide support for a FMV number that allows the corporation to remain below the $50 million mark. An important point to remember is that the equity credit given for contributed property is not always close to the actual FMV of the property determined based on the valuation principles applied by an independent appraiser. Once the FMV of any contributed property is determined, the corporation’s financial records can be carefully reviewed to establish whether or not the corporation’s cash plus “aggregate gross assets” ever at any point up to and including the then-current stock issuance exceeded the $50 million mark.
Corporations that want to issue QSBS but risk failing the $50 million test because of property or cash (debt or equity) infusions should focus on managing their Section 1202 tax asset balance sheet, particularly how much cash is infused at any given time and the timing and how that cash would be deployed (i.e., does the cash acquire an asset that goes into the calculation or pay expenses that aren’t capitalized?). Finally, if one of the goals of incorporating is to issue QSBS, it is important for an LLC’s or LP’s management to take the $50 million test into consideration when planning when to convert. If a business considering incorporating will have difficulty satisfying the $50 million test, non-essential assets could be kept outside of the corporation as a way of managing the corporation’s FMV for Section 1202 purposes.
Management of a Corporation’s Aggregate Gross Assets
Depending on the circumstances, there may be avenues available to manage staying below the $50 million mark. In connection with the incorporation of a partnership, or undertaking decisions regarding whether to accept tax-free contributions of additional property, decisions can be made to exclude certain assets. If a partnership engages in multiple separate business activities, consideration could be given to separating those activities into multiple corporations. This strategy may also make sense looking down the road as a part of the exit strategy. It can be a significant problem when a corporation has outstanding QSBS and multiple business activities operating in the corporation that naturally attract different investors, lenders or buyers. Rather than deciding how to separate the activities after they have operated in a single corporation, a better strategy might be to at least consider multiple corporations from the beginning. Another aspect of this planning is where the business owners consider dividing what is actually a single activity into multiple corporations in order to stay below the $50 million mark. This could attract IRS attention if none of the multiple corporations can function independently as an a “complete” activity.
In terms of managing the problem, in some cases, real property and equipment can be leased rather than owned by the corporation. Non-operating assets on the balance sheet can be distributed or sold to get them off the balance sheet. Cash can be spent on deductible items. The intake of cash from equity or debt financing can sometimes be managed to keep the corporation under the $50 million mark.
Because every corporation’s business and balance sheet will be different, the main point here is not to try to anticipate and list every possible way to keep a corporation’s balance sheet below the $50 million mark, but rather to suggest that if an issuing corporation is risking exceeding the $50 million mark wants one or more issuance of common or preferred stock to qualify as QSBS, the problem might be able to be managed with thoughtful attention.
In spite of the potential for extraordinary tax savings, many experienced tax advisors are not familiar with Code Section 1202 and Code Section 1045 planning. Venture capitalists, founders and investors who want to learn more about Code Section 1202 and Code Section 1045 planning opportunities are directed to several articles on the Frost Brown Todd website:
- Section 1202 Qualification Checklist and Planning Pointers
- A Roadmap for Obtaining (and not Losing) the Benefits of Section 1202 Stock
- Maximizing the Section 1202 Gain Exclusion Amount
- View a list of all QSBS Articles
[i]The 1993 legislative history provided that Code Section 1202 “should encourage the flow of capital to small businesses, many of which have difficulty attracting equity financing.”
[ii] A significant example of when this would be relevant would be the incorporation of a partnership.
[iii] One thing to keep in mind in connection with reviewing the financial records of a corporation that has participated in a Section 351 exchange is that the Section 351 regulations require the inclusion of a statement setting forth information about the exchange, including the estimated value of the contribute property.