During the past several years, there has been a marked increase across the country in the use of C corporations as the vehicle for closely-held and 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 are also focusing on structuring investments that qualify for Section 1202’s generous gain exclusion.[i] But to qualify for claiming 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 Section 1202(d)’s $50 million “aggregate gross assets” limitation test (referred to in this article as the “$50 Million Test”).
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. Legislation proposed during 2021 sought to curb Section 1202’s benefits, but that legislation, along with the balance of President Biden’s Build Back Better bill has stalled in Congress, perhaps permanently.
Section 1202’s $50 Million Test
Eligibility for claiming Section 1202’s gain exclusion is limited to stock issued by a domestic C corporation that was a “qualified small business” on the date of issuance of the stock being vetted for eligibility.[ii] A corporation is not a “qualified small business,” unless it can pass the $50 Million Test at the time the QSBS being vetted for Section 1202 eligibility is issued.[iii] In order to pass the $50 Million Test, a corporation’s “aggregate gross assets” (i) cannot have exceeded $50 million at any time prior to the issuance of the QSBS, and (ii) cannot exceed $50 million after taking into account any cash or property paid for the stock being vetted for QSBS eligibility. Fortunately, once the $50 Million Test is passed, the fact that the corporation subsequently has more than $50 million in aggregate gross assets won’t affect the QSBS status of stock previously issued. But once a corporation fails the $50 Million Test, even if only for a day, the corporation can no longer issue QSBS.
Presumably, Congress adopted the $50 Million Test as part of the initial enactment of Section 1202 because the goal was to encourage the flow of capital to small businesses.[iv] Unfortunately, the $50 million aggregate gross assets limitation hasn’t been increased since 1993, in spite of the fact that the aggregate inflation rate from 1993 through 2021 is 88.35%. In 2021 dollars, the $50 million aggregate gross assets limitation would need to be raised to $94,175,000 to stay even with inflation.
How the $50 Million Test Works
The first element of the $50 Million Test. Read literally, a shareholder claiming Section 1202’s gain exclusion must establish that a QSBS issuer did not fail the $50 Million Test on any day prior to the issuance of the stock being vetted for QSBS eligibility. While it seems unrealistic that the IRS could prevail if it demanded that taxpayers establish a corporation’s “aggregate gross assets” did not exceed $50 million on each day during a period that could run for years, there are no tax authorities establishing what constitutes a reasonable level of proof. Obviously, every effort should be made to fully document through financial information that the corporation has passed the $50 Million Test if QSBS is being issued if a corporation’s aggregate gross assets are hovering in the $50 million range.
The second element of the $50 Million Test. A shareholder must also establish that QSBS issuer passed the $50 Million Test immediately after the cash or property contributed in exchange for the QSBS being vetted is aggregated with existing aggregate gross assets. There are no tax authorities providing guidance as to how this requirement functions in the real world. Take for example a situation where QSBS is issued on May 15th, followed by an additional issuance on May 25th. Absent some linkage between these two stock issuances, there appears to be no reason why the two issuances should be aggregated for purposes determining whether the May 15th issuance passed the $50 Million Test. On the other hand, the IRS might argue that the two issuances should be integrated for the $50 Million Test if the two issuances were part of the same financing round, and particularly if the company had in had accepted subscriptions for stock issued on May 25 when it issued stock on May 15. In the absence of Section 1202 tax authorities, the courts are likely to look closely at the applicable facts when applying the “immediately after the issuance” concept to a particular QSBS issuance, perhaps also looking to whether participants have control of a corporation “immediately after the exchange” for purposes of Section 351’s requirements.
Section 1202 does not provide that the “value” of services contributed in exchange for stock being tested should be included in the post-contribution $50 Million Test 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 the $50 Million Test.
The “aggregate gross assets” of all corporations included in QSBS issuer’s “parent-subsidiary controlled group” must be included in the $50 Million Test computation. Section 1202(d)(3) provides that the assets of corporations that are part of the same “parent-subsidiary controlled group” as defined in Section 1563(a)(1) (substituting “more than 50 percent” for “at least 80 percent”) are included when making the $50 Million Test calculation. Because of Section 1202(d)(3), the aggregate gross assets of the QSBS issuer might need to be aggregated with one or more tiers of that corporation’s subsidiaries. Also, the “aggregate gross assets” of the QSBS issuer might need to be aggregated with a C or S corporation stockholder. Finally, if there is a C or S corporation stockholder whose aggregate gross assets must be aggregated with those of the QSBS issuer, that parent corporation might have one or more tiers of subsidiaries whose aggregate gross assets would also need to be included making the $50 Million Test. All of this is possible because of the potential reach of Section 1563’s “parent-subsidiary controlled group.”
Under Section 1563(a)(1) (as modified by Section 1202(d)(3)), two corporations are part of the same “parent-subsidiary controlled group” if a corporate stockholder holds more than 50% of the total combined voting power of all classes of stock entitled to vote or at least 50% of the total value of shares of all classes of stock of a corporate subsidiary. Whether a corporation has the necessary “voting power” generally translates into determining whether it holds stock with the voting power necessary to elect a board of directors. There are instances, however, where voting control isn’t determined merely by the power to elect the board of directors, if certain classes of directors or stockholders have supermajority voting rights.[v] An example of one complicated “parent-subsidiary controlled group” would be the situation where an S corporation holds 75% of the voting stock of the QSBS issuer, giving it the right to elect a majority of the QSBS issuer’s board of directors. In addition, each of the QSBS issuer and the parent corporation holds 75% of the stock of a subsidiary, in each case giving the stockholder corporation the right to elect a majority of the subsidiary’s directors. In this scenario, the QSBS issuer, the parent stockholder, the subsidiary of the QSBS issuer, and the other subsidiary of the parent corporation would all be a part of the same “parent-subsidiary controlled group.”
Section 1202’s 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 a ratable share of the parent corporation’s assets in a “parent-subsidiary controlled group.”
For purposes of the $50 Million Test, the value of a noncontrolling investment in corporate stock should be the issuing corporation’s tax basis in its stock investment. If the QSBS issuer 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. But there are no Section 1202 tax authorities addressing this issue. Another possible approach would be to just include in the $50 Million Test 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. 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 nonrecognition exchange (which would include the incorporation of a partnership). Applying these rules, a corporation valued at $250 million (a value that would include its unrealized goodwill) could nevertheless have “aggregate gross assets” of less than $50 million. Today’s accelerated depreciation and amortization of assets for tax purposes could result in the situation where the corporation passes the $50 Million Test in spite of the fact that $200 million was invested over time in the corporation. Of course, 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 the $50 million mark. The lesson is that it might be possible if you have the knowledge of how the $50 Million Test works to manage a corporation’s cash infusions and balance sheet to keep its “aggregate gross assets” 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 are included, if the proceeds sit as cash the corporation’s books or have been transformed into capitalized assets). The 1993 House bill subtracted short term liabilities, but the 1993 Conference Agreement eliminated that subtraction from the $50 Million Test computation. Because debt is not offset against assets on the pro forma $50 Million Test asset 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 whether a corporation has exceeded or will exceed the $50 million mark must include not only looking a cash contributed 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 nonrecognition exchange, a Section 368 reorganization or a capital contribution governed by Sections 118 and 362) is treated as if the basis of such property (immediately after the contribution) is equal to its FMV at the time of contribution.[vi] We believe this language means that contributed property goes onto what is essentially a pro forma $50 Million Test balance sheet at the properties’ FMV, and thereafter, the tax basis of those assets would be adjusted for purposes of the $50 Million Test 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 Section 197. We are making educated guesses, as 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: (i) cash; (ii) assets not contributed to the corporation (where the actual adjusted tax basis of the assets would be used); and (iii) assets contributed in a nonrecognition transaction (where the FMV at the time of contribution must be determined and used for purposes of the $50 Million Test). Once the assets go onto the $50 Million Test asset-side balance sheet, the assets are amortized and depreciated as they would be for tax purposes. [vii] As noted above, if a partnership is incorporated in 2018 in a nonrecognition exchange, and QSBS is issued in 2022, the goodwill included in the 2018 FMV determination should then be amortized over 15 years for purposes of making the 2022 $50 Million Test calculation.
How To Document Satisfaction of the $50 Million Test
An IRS agent could theoretically (and unreasonably) demand that a taxpayer prove that a QSBS issuer passed the $50 Million Test on each day of its existence prior to the applicable QSBS issuance, along with immediately after the issuance. As a practical matter, many start-ups issuing QSBS will clearly fall below the $50 million mark when founder and early round QSBS is issued. For a corporation sitting comfortably below the $50 million mark, a set of annual financial statements for the applicable period and reasonable evidence of the value of any contributed assets should suffice. But if a corporation issuing QSBS is hovering around the $50 million mark, then additional detailed documentation may be necessary to satisfy the evidentiary burden of proof. In this case, every effort should be made to construct a running $50 Million Test asset-side balance sheet using all available financial information. If the corporation was the beneficiary of past material property contributions, it may be necessary to obtain an appraisal of those assets in order to include them on the $50 Million Test balance sheet at their FMV.[viii] Taxpayers should keep in mind the fact that the equity credit negotiated by the parties for contributed property does not always equate to actual FMV of the contributed property, although this would certainly be a factor an appraiser would take into account.
One example of a complicated $50 Million Test analysis was where a QSBS issuer was well below $50 million at the beginning of a year and well above the $50 million mark at year-end. Stock being vetted for QSBS eligibility was issued in the middle of the year. In order to determine whether the QSBS issuer passed the $50 Million Test, it was necessary to look at month-by-month inventory numbers, as inventory was constantly being added through draws on a line of credit and sold in the ordinary course of the company’s business operations.
Management of a Corporation’s “Aggregate Gross Assets”
If management wants to issue QSBS but the corporation is approaching the $50 million mark, careful attention should be paid to the $50 Million Test balance sheet, in particular how and when cash is infused into the business and how that cash is used (i.e., does the cash acquire an asset that goes into the calculation or pay expenses that aren’t capitalized?). If the owners of a partnership want to incorporate but passing the $50 Million Test appears to be an issue, on strategy is to exclude non-essential assets from the contribution into the corporation.
Depending on the circumstances, there may be a number of approaches available for managing the $50 Million Test “problem.” As noted above, in connection with a partnership incorporation, or making contributions of property to an existing corporation, strategic decisions can be made to exclude certain properties, that can be leased or used through management arrangements. If a partnership engages in multiple separate business activities, consideration could be given to separating those activities into multiple corporations. This strategy often also makes sense in terms of managing exit strategies. It can be a significant planning issue for a corporation to have two separate activities within a one QSBS issuer given the fact that Section 1202’s benefits are triggered only when stock is sold. This fact is a problem where the QSBS issuer has two activities, and a buyer only wants to purchase one of those activities. If a partnership’s value exceeds $50 million, another possible strategy is to separate the partnership into two or more C corporations. This approach could attract IRS attention if the corporations are dependent on each other rather than operating separately. In some cases, real property and equipment can be leased rather than owned by the QSBS issuer. Non-operating assets on a 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.
We are offering the scattershot of planning approaches above to illustrate that there are a variety of planning approaches available for those who understand the workings of the $50 Million Test. Because each company’s properties and business are unique, the goal of the preceding paragraph wasn’t to solve every $50 Million Test problem, but instead to alert readers to the possible benefits of proactive planning to manage the problem.
In spite of the potential for extraordinary tax savings, many experienced tax advisors are not familiar with QSBS planning. Venture capitalists, founders and investors who want to learn more about Sections 1202 and 1045 planning opportunities are directed to several articles on the Frost Brown Todd website:
- Section 1202 Qualification Checklist and Planning Pointers
- Roadmap for Obtaining (and not Losing) the Benefits of Section 1202 Stock
- Maximizing the Section 1202 Gain Exclusion Amount
- Determining the Applicable Section 1202 Exclusion Percentage When Selling Qualified Small Business Stock
- Advanced Section 1045 Planning
- Recapitalizations Involving Qualified Small Business Stock
- Section 1202 and S Corporations
- The 21% Corporate Rate Breathes New Life into IRC § 1202
- View all QSBS Resources
Contact Scott Dolson if you want to discuss any Section 1202 or Section 1045 issues by video or telephone conference.
[i] References to “Sections” are to sections of the Internal Revenue Code of 1986, as amended.
[ii] See Sections 1202(c) through (e).
[iii] This article refers in several places to the stock being vetted for QSBS eligibility as “QSBS.” Obviously, if the corporation fails the $50 Million Test in connection with the issuance of the stock being vetted for QSBS eligibility, the stock issued will not qualify as QSBS.
[iv] The 1993 legislative history provided that Section 1202 “should encourage the flow of capital to small businesses, many of which have difficulty attracting equity financing.”
[v] See Technical Advice Memorandum 9452002 (12/30/1994); Alumax Inc. v. Commissioner, 109 T.C. 133 (1997), aff’d 165 F.3 822 (11th Cir. 1999); Framatome Connectors USA Inc. v. Commissioner, 118 T.C. 32 (2002), aff’d 94 AFTR 2d 2004-5820 (2nd Cir. 2004).
[vi] A significant example of when this would be relevant would be the incorporation of a partnership.
[vii] Note that there is no actual “asset-side balance sheet” referred to in Section 1202 in conjunction with the $50 Million Test. That concept is included in this article to help describe the information required to be compiled to prove whether the corporation has passed or failed the $50 Million Test.
[viii] 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.