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Jan 17, 2024

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BlogsQualified Small Business Stock (QSBS)Tax Law Defined™ Blog

Authors:

Scott W. Dolson

The combination of the 21% corporate federal income tax rate and the possibility of qualifying for Section 1202’s gain exclusion has made operating a business through a C corporation an attractive choice.[1]  This article is one of a series of articles and blogs authored by Scott Dolson addressing planning issues relating to Sections 1202 and 1045.  Additional information regarding qualified small business stock (QSBS) planning and the firm’s tax planning group can be found here and in our QSBS Library and Guidebook.

Section 1202 allows a taxpayer to claim a gain exclusion when QSBS is sold, so long as the taxpayer meets all of Section 1202’s eligibility requirements.  Section 1202 places limits on the amount of gain exclusion that can be claimed by a taxpayer with respect to a corporation’s QSBS.  This article explains how the gain exclusion caps work and provides planning suggestions for increasing the amount of available gain exclusion.

Gain exclusion cap basics (including the standard $10 million per-taxpayer per-issuer cap)

Section 1202(b) provides that, for a specific taxable year, a taxpayer’s aggregate per-issuing corporation gain exclusion is generally limited to the greater of (a) $10 million, minus the aggregate prior Section 1202 gain excluded with respect to such issuer (the “10 Million Cap”), or (b) 10 times the taxpayer’s original adjusted tax basis in the issuer’s QSBS sold during the taxable year (the “10X Basis Cap”).[2]

For purposes of the 10X Basis Cap, a taxpayer’s original adjusted tax basis equals the aggregate cash and fair market value of property exchanged for the shares of QSBS sold during the applicable tax year.  If shares of QSBS sold were originally issued in exchange for services, the original adjusted tax basis would be the value of those shares for Section 83 purposes.[3]  Capital contributions with respect to already issued QSBS are ignored for purposes of calculating the 10X Basis Cap. Therefore, capital contributions without the issuance of additional QSBS should be avoided; instead, additional QSBS should be issued in exchange for each money or property contribution, assuming the issuer is still eligible to issue QSBS.[4]

Several key aspects of Section 1202’s gain exclusion cap are as follows:

  • Each taxpayer has a separate per-issuing corporation Section 1202 gain exclusion and gain exclusion cap, with the exception of married couples (see the discussion below), who are likely to be treated as a single taxpayer for purposes of the gain exclusion cap (e.g., a taxpayer holding shares of QSBS of five corporations calculates the available gain exclusion separately for each corporation).
  • If 10 taxpayers hold the QSBS of Corporation A, each taxpayer would separately claim Section 1202’s gain exclusion and be subject to a separate (per-taxpayer) gain exclusion cap.
  • If a fund with 10 partners or LLC members purchases and later sells QSBS, each partner would separately claim Section 1202’s gain exclusion and be subject to a separate gain exclusion cap (i.e., each partner would have a minimum $10 million available gain exclusion).[5]
  • For most stockholders who do not have significant basis in their QSBS (think founders and early-stage employees), the per-issuer gain exclusion is limited to $10 million (i.e., no tax basis to support a 10X Basis Cap).
  • An investor with an aggregate tax basis in a corporation’s QSBS greater than $1 million should be able to take advantage of the 10X Basis Cap (the investor’s gain exclusion cap exceeds $10 million).
  • A taxpayer can have a different per-share tax basis in different blocks of QSBS (e.g., the taxpayer might hold founder common stock with zero tax basis, preferred stock with $100 per share tax basis, and a second class of preferred stock with $200 per share tax basis). Holding several blocks of QSBS, each with a different per-share tax basis, may be relevant when planning to maximize the amount of available gain exclusion using the 10X Basis Cap.

Calculating the gain exclusion cap under Section 1202(b)

Section 1202(b) determines the aggregate allowable gain exclusion for a specific tax year, specific taxpayer (Taxpayer A), and specific corporation (Corporation X).  For each taxable year during which QSBS is sold, the aggregate Section 1202 gain excluded in prior years with respect to the applicable corporation reduces the $10 Million Cap exclusion amount for this year’s Corporation X gain exclusion.  If Taxpayer A sells all of his Corporation X QSBS in a single taxable year, Section 1202’s gain exclusion will be the greater of (A) $10 million, or (B) the amount calculated using the 10X Basis Cap.[6]  Once Taxpayer A has excluded $10 million of Corporation X’s gain, there will be no additional available gain exclusion amount for Corporation X based on the $10 Million Cap. But gain exclusion in prior taxable years does not reduce the gain exclusion available in the current taxable year applying the 10X Basis Cap, as the exclusion amount is determined based solely on the adjusted tax basis of the QSBS being sold in the current taxable year.

If a taxpayer sells all of his Corporation X QSBS in single taxable year, the standard $10 Million Cap applies unless he sells shares of QSBS during that year with an original adjusted tax basis greater than $1 million.  However, if the taxpayer’s aggregate tax basis in the QSBS sold during the taxable year exceeds $1 million, then the gain exclusion cap will be 10 times the aggregate tax basis of the QSBS sold during that taxable year.

Example 1.  If taxpayer A sells QSBS with an aggregate tax basis of $2 million during 2024, then his gain exclusion cap would be $20 million (10 x $2 million).  But if Taxpayer A first excludes $10 million of gain from Corporation X QSBS sold during 2024, and then sells additional shares of Corporation X QSBS during 2026 that have an aggregate tax basis of $100,000, Taxpayer A would be entitled to claim an additional $1 million gain exclusion for 2026, applying the 10X Gain Cap (10 x $100,000).  The balance of Taxpayer A’s gain for 2026, if any, would be taxed at the 20% long-term capital gains rate.[7]

Strategies for increasing the amount of a taxpayer’s gain exclusion

Although a $10 million cap equates to approximately $2.4 million in federal income tax savings, some taxpayers do hold QSBS worth more than $10 million and are understandably interested in taking reasonable steps to increase their available gain exclusion. The following is a summary of possible strategies to directly or indirectly increase a taxpayer’s Section 1202’s gain exclusion:

Selling QSBS over multiple years.  Many sales of QSBS occur in connection with a sale process and stockholders will be required to sell all of their QSBS during a single calendar year.  But circumstances do arise where a taxpayer’s sale of QSBS occurs over multiple years, which opens the door for some planning opportunities, particularly if the stockholder holds QSBS with low basis (founder stock) and high basis (often preferred stock).  In that case, one strategy would be for the stockholder to sell low basis stock in year one (perhaps in a secondary sale) that applies against and consumes the stockholder’s $10 Million Cap, followed by selling additional QSBS with a higher tax basis in a subsequent year, taking advantage of the 10X Basis Cap.  This strategy works so long as the stockholder has some tax basis in his QSBS.  This strategy might be useful in a situation where a stockholder sells some stock as part of a company sale and later sells stock rolled over under Sections 351 or 368 into buyer QSBS (or non-QSBS) under Section 1202(h)(4).

Example 2. Taxpayer A (founder) holds common stock with zero tax basis and preferred stock with $100 per share tax basis. Taxpayer A sells $10 million worth of common stock in a secondary sale during 2024 and claims a $10 million gain exclusion. Taxpayer A then sells the balance of his QSBS during 2026 and claims a Section 1202 gain exclusion based on the 10X Basis Cap.

Dividing ownership of QSBS among multiple taxpayers (stacking), including gifting QSBS and related trust planning.  Section 1202’s gain exclusion is a per-taxpayer gain exclusion. Since the Internal Revenue Code defines a “taxpayer” as “any person subject to any internal revenue tax,” the door is wide open for strategies involving the dividing of QSBS among multiple taxpayers.  This planning strategy is most effective if it is undertaken in harmony with the balance of a taxpayer’s estate and wealth planning.

Taxpayers should consider dividing the initial ownership of their QSBS among family members and associated family limited partnerships, LLCs and trusts.[8]  Trusts and family entities also facilitate putting in place transfer restrictions and governance arrangements, along with facilitating wealth transfer planning, state income tax planning and asset protection planning.  Beyond mere Section 1202 planning, dividing among family members and affiliated entities the ownership of assets expected to appreciate substantially over time can be a powerful strategy from an estate and gift and federal income tax planning standpoint.  The fact that Section 1202’s gain exclusion is determined on a per-taxpayer basis turbocharges the potential benefits of this strategy.

Example 3.  A founder causes his start-up to issue for nominal consideration founder common stock to his family LP owned by seven family members.  The timing of the issuing of the QSBS minimizes the federal estate and gift tax consequences of the strategy.  When the family LP sells the QSBS, each family member will have a separate $10 million gain exclusion cap. 

In spite of the potential benefits of early-stage planning, the reality is that many stockholders don’t pursue planning until they hold highly appreciated QSBS obviously meriting the effort and expense.  In the typical case, there are several strategies available to increase a taxpayer’s aggregate Section 1202 exclusion.  Obviously, wealth transfer planning is more complicated once the stockholder holds highly appreciated stock.  Under Section 1202, gifting QSBS is permissible as an exception to the general rule that the original holder must sell the QSBS in order to take advantage of the Section 1202 gain exclusion.[9]  The recipient of the gift will step into the taxpayer’s shoes with respect to the tax basis and holding period for the QSBS and have separate gain exclusion caps.[10]  Theoretically, QSBS could be gifted to an unlimited number of separate taxpayers, each of whom would have a separate $10 Million Cap and 10X Basis Cap.

Example 4. Taxpayer A is holding $20 million of QSBS. He can gift $10 million worth of the QSBS to his parents who will have a separate $10 million gain exclusion cap when they sell the QSBS.  Also, his parents would inherit his per-share tax basis for purposes of the 10X Gain Cap.

Example 5. Continuing the base facts from Example 4, Taxpayer A should not transfer QSBS to a family limited partnership or limited liability company in exchange for an interest as that would not be treated as a “gift” for federal income tax purposes.  The transfer in exchange for a capital interest in the partnership would be tax-free under Section 721 but would terminate the QSBS status of the contributed shares.

To the extent possible, QSBS should be gifted when the value is low, and hopefully well before the QSBS is sold.[11]  Completed gifts of QSBS will be subject to the gift tax rules and gift tax return reporting requirements. Holders of QSBS can take advantage of annual gifting and the lifetime unified gift and estate tax exemption ($13.61 million for 2024), or structure the terms of the trust so that it is a non-grantor trust for income tax purposes but not a completed gift for gift and estate tax purposes.  A taxpayer engaged in federal income tax planning should also factor in consider federal and state wealth transfer planning and state income tax planning issues.

If a taxpayer is gifting QSBS to an irrevocable trust, consideration should be given to reserving a special limited power to appoint the trust principal to beneficiaries other than the grantor. This transfer of assets to a trust would be structured as a gift of QSBS for Section 1202 purposes but would be treated as an incomplete gift for gift tax purposes. The taxpayer would not pay gift taxes or file or a gift tax return, but here again, the assets of the trust would be included in the taxpayer’s estate.[12]

Taxpayers should take into consideration how their state of residence treats these various planning ideas for state income, gift and estate tax purposes. Not all states follow the federal income tax treatment of QSBS, and certainly not all states follow the federal gift and estate tax rules and exclusion limits.  It may be possible to create non-grantor trusts in states such as Delaware or Nevada that provide state income tax benefits, in addition to providing asset protection planning and federal income tax planning benefits.

As discussed below, there are arguments based on applicable tax authorities that married couples filing jointly each have a separate $10 Million Cap, based on the conclusion that each spouse is a separate taxpayer for Section 1202 purposes.

Another way to potentially expand Section 1202’s exclusion cap is to leave QSBS to two or more beneficiaries, as transfers at death are permitted under Section 1202.

Planning with DINGS and NINGS.  A taxpayer can also make a gift to a non-grantor trust established for the benefit of recipients who qualify as appropriate transferees for purposes of making a “gift” for federal income tax purposes.  Gifting QSBS to a Delaware incomplete-gift non-grantor (DING) trusts or a Nevada incomplete-gift non-grantor (NING) trust, or acquiring QSBS from the issuing corporation through a DING or NING has increased dramatically in popularity in recent years as more taxpayers have pursued QSBS business and tax planning. The intent, purpose and terms of a trust agreement and the timing of gifts to trusts must be carefully considered. Founders and investors utilize DINGS and NINGS for a variety of mixed tax, business and personal reasons. Trusts can be a useful vehicle through which to engage in asset protection planning, shielding assets from beneficiaries or protecting assets from poor investment decisions through the use of professional asset management. Trusts are also a useful tool for advanced estate and gift tax and non-tax planning (for example, trust planning often centers around taking advantage of more favorable state laws for the administration of trusts). At least in theory, if a taxpayer creates multiple non-grantor trusts, each non-grantor trust will be treated as a separate taxpayer with its own standard $10 Million Cap and 10X Basis Cap.[13]  Careful attention will need to be paid to firmly establish the bona-fide business (personal) non-tax reasons for establishing DINGS and NINGS, and consideration must be duly given to the potential impact of the IRS’s ability to pursue trust consolidation under authority of Section 643(f).[14]

Strategies involving the 10X Basis Cap—waiting for property to appreciate before contributing it to a corporation in exchange for QSBS (including incorporating a partnership).  When property (other than money or stock) is contributed to a corporation in exchange for QSBS, Section 1202(i)(B) provides that the basis of the QSBS issued in exchange for the contributed property is no less than the fair market value of the property exchanged.  This provision impacts the amount of Section 1202 gain exclusion in two important ways.  First, since the tax basis for purposes of Section 1202 is equal to the fair market value of the property at the time of the contribution, any spread between the tax basis of the contributed property and its fair market value at the time of contribution would not qualify for Section 1202’s gain exclusion.  Second, an amount equal to the fair market value of the contributed property would be the applicable tax basis for purposes of determining the 10X Gain Cap. 

Example 6. Taxpayer contributes property with a tax basis of zero and fair market value of $10 million in a Section 351 nonrecognition exchange into a C corporation in exchange for QSBS. More than 5 years later, the QSBS is later sold for $75 million, the first $10 million does not qualify for Section 1202’s gain exclusion but the next $65 million would qualify applying the 10X Gain Cap.

Section 1202(i)(B)’s tax basis for contributed property rule creates a planning opportunity.  Business owners can operate their business as a limited partnership or LLC until the assets have attained sufficient value to make the 10X Gain Cap work (i.e., in excess of $1 million), and then incorporate.[15]  A partnership whose assets are worth $45 million can incorporate, creating the potential down the road for a $450 million ($45 million x 10) gain exclusion.  Note that there are potential downsides to this strategy.  First, the spread between the tax basis and fair market value at the time of incorporation will not qualify for Section 1202’s gain exclusion.  If a partnership is incorporated when its assets are worth $2 million (with a zero basis) and the corporation’s QSBS is ultimately sold for $10 million, waiting to incorporate will not have paid off since the gain exclusion will be $8 million rather than $10 million.  Second, the five-year holding period required for qualifying for Section 1202’s gain exclusion will not commence until incorporation.[16]  Finally, a corporation cannot issue QSBS if the aggregate value of the assets contributed upon incorporation exceed $50 million.

Strategies involving the 10X Basis Cap—“packing” the corporation with money, contributed property, or services.  Taking advantage of the 10X Basis Cap can result in a stockholder’s aggregate gain exclusion exceeding $10 million.[17]  As mentioned above, if a stockholder has an aggregate tax basis exceeding $1 million in QSBS, then the 10X Basis Cap will allow for an aggregate gain exclusion exceeding $10 million. The 10X Basis Cap will result in a greater overall gain exclusion if it makes good business (and tax) sense to operate a business in the early start-up years as a partnership (i.e., limited partnership or multi-member limited liability company), and the business is incorporated at a point where the value of the company’s assets deemed to be contributed by the stockholder exceeds $1 million.  Careful attention should be paid to avoiding failing Section 1202’s $50 million test.[18]

Founders can contribute intellectual property in exchange of QSBS, but the obtaining of an appraisal is recommended to support the future gain exclusion based on the 10X Basis Cap.

QSBS can be issued for services and the tax basis of a service provider in stock issued for services is the aggregate of the amount paid for the stock plus the amount of compensation income triggered by the issuance of the stock if it is unrestricted stock, or if it is restricted stock, when the stock vests or upon issuance if a Section 83(b) election is filed.  The parties involved should make sure that they document bona-fide business reasons for the payment of compensation, not including efforts to generate QSBS tax basis, in order to support both using the tax basis in the calculation of the 10X Basis Cap and the employer’s Section 83(h) deduction for compensation paid to the recipient of the QSBS.

The 10X Basic Cap requires an aggregate rather than per-share look at tax basis, which means that situations can arise where a taxpayer has substantial gain in founder common stock and little or no gain in the preferred stock, but the additional tax basis in the preferred stock nevertheless supports excluding gain on the common stock. The most significant planning opportunity arises because Section 1202 looks at the aggregate tax basis for all QSBS sold by a taxpayer’s in a given taxable year, not merely those shares that qualify for claiming Section 1202’s gain exclusion (i.e., shares that have met the holding period requirement).  As a result, one way to potentially increase a taxpayer’s gain exclusion might be to “pack” the corporation with additional money or property in exchange for the issuance of additional QSBS.[19]  We believe that any use of this approach should be supported with evidence that are bona-fide business reasons (other than tax benefit) for the contribution of money or property to the corporation, along with contemporaneous evidence that fair values for property were used for determining the value of any contributed property.[20]  For purposes of Section 1202, the “tax basis” for contributed property is fair market value rather than the historic tax basis of the property, which is beneficial when the goal is to increase tax basis for purposes of the 10X Gain Basis Cap.

Reinvesting QSBS sales proceeds in replacement QSBS under Section 1045

Section 1045 allows stockholders to sell an original investment in QSBS and reinvest some or all of the proceeds in replacement QSBS on a tax-free basis.  Tax authorities (including Sections 1202 and 1045) do not appear to restrict the ability of stockholders to sell their original QSBS (perhaps claiming Section 1202’s gain exclusion with respect to some of the original QSBS sales proceeds) followed by the reinvestment of sales proceeds in one or more replacement QSBS investments, later followed by claiming Section 1202’s gain exclusion with a separate gain exclusion cap for each separate replacement QSBS investment.   Sections 1202 and 1045 do not aggregate the gain exclusions taken with respect to the original QSBS and the replacement QSBS for purposes of calculating the applicable gain exclusion cap.

Is a married couple limited to a single $10 million gain exclusion cap?

Section 1202(b)(1) provides that if a taxpayer has eligible gain, that gain is subject to the gain exclusion caps discussed elsewhere in this article. There is no question that spouses filing a joint return are each treated as separate “taxpayers” for various purposes the Internal Revenue Code.[21]  The combination of reference to “taxpayer” in Section 1202 and the status of spouses as separate taxpayers for certain purposes under the Internal Revenue Code has been cited as support for the argument that each spouse should be treated as a separate taxpayer for Section 1202 purposes, with each spouse having a separate gain exclusion cap (i.e., with each spouse having a separate $10 Million Cap). Section 1202(b)(1)(A), which provides that the $10 Million Cap is separated into two $5 million gain exclusion caps if a married couple files separately, can be cited to refute this argument, although it could be argued that Congress may have intended to limit the aggregate Section 1202 gain exclusion cap for spouses filing jointly to a single $10 Million Cap, but failed to adequately address that intention in the language of Section 1202.

If the issue of whether a married couple is limited to one $10 million gain exclusion or has two separate per-spouse $10 million gain exclusions were litigated, the taxpayers could argue that the US Supreme Court has held that when Congress passes a statute whose plain text gives a taxpayer the benefit of a “double windfall”, the statute should nevertheless be given effect, in spite of the IRS arguments to the contrary.[22]  As a rebuttal, the IRS might argue that the adoption of the separate “taxpayer” argument would give married couples an unintended windfall.  The Board of Tax Appeals (predecessor to the Tax Court) decision in Marvin L. Levy, 46 BTA 1145 (1942) might shed some light on how the courts today would view Section 1202’s marriage penalty issue.  In that old case, a married couple argued that each spouse should be entitled to a separate net capital loss limit, instead of one combined net capital loss limit. The Board concluded that the reason for filing a joint return is to amalgamate tax items of two spouses, potentially resulting in offsets unavailable in individual returns. The Board felt that with a joint return there were no longer two individuals with their own rights to deductions, but instead an integrated whole (including an integrated [single] capital loss limitation).  In his dissent, Judge Kern argued that spouses are separate taxpayers with separate net capital loss limits. Judge Kern discussed the Supreme Court cases cited by the majority and noted that he could find no justification in those cases or the statute supporting the majority’s conclusions.  The Levy decision suggests that a taxpayer would have an uphill battle in Tax Court making the separate taxpayer argument, but Judge Kern’s dissent does provide some ammunition for a contrary position.

There are other tax authorities that support the position that both spouses are entitled to a separate $10 million gain exclusion.  The Tax Court has held that “it is a long recognized legal maxim that a husband and wife are separate and distinct taxpayers notwithstanding the fact that they have filed joint Federal income tax returns”[23] and the IRS itself concluded that for purposes of the $5 million limitation of Section 453A, the taxpayer and his spouse are not considered a single taxpayer.  In reaching that conclusion, the IRS stated that “In particular, if Congress had intended that married individuals be treated as one taxpayer for purposes of applying the $5,000,000 limitation set out in section 453A, it could have easily provided for this attribution in express terms rather than resort to a strained and unlikely interpretation of and sections 52 and 1563. In fact, in numerous other Code provisions, Congress has specifically provided for the allocation of various limitations among married individuals. See, e.g., section 38(c)(3) (limitation on the general business credit); section 163(h) (limitations on amounts treated as acquisition or home equity indebtedness); section 179(b)(4) (limitation on election to expense certain depreciable business assets); section 1211(b) (limitation on capital losses). Where Congress is silent on this point, as in section 453A, we do not believe that an allocation between married individuals can be implied.”[24]

Another unanswered question is how to treat the situation where the husband, prior to marriage, claimed $10 million of gain exclusion with respect to Corporation A, and then after marriage, the wife sold an additional $10 million of Corporation A’s QSBS.  Should a marriage penalty apply here be that the couple has no additional gain exclusion?  Or should the wife be entitled to claim take advantage of the gain exclusion?  Or is there an argument here that the husband and wife are a different “taxpayer” than the husband was prior to marriage and that this married couple would have its own separate $10 million gain exclusion?  Perhaps the fair result would be that the husband would go into the marriage with no additional gain exclusion with respect to Corporation A but the wife would still retain her full $10 million gain exclusion.

Given the absence of Section 1202 tax authorities addressing the issue beyond the language of Section 1202 itself, a reasonable approach would be to engage in gifting/stacking rather than planning for taking the position that each spouse has a separate $10 million gain exclusion.  If gifting opportunities have been exhausted and there remains more than $10 million in QSBS of an issuer held by the married couple, then the decision comes down to risk tolerance, the opinion of the taxpayer’s tax advisor and whether to disclose the position on a Form 8275.  Unless the couple lives in a community property state, it would be necessary, of course, for each spouse to separate sell shares of QSBS if the decision is made to pursue this strategy. Everyone would probably agree that limiting a married couple to a single $10 million gain exclusion represents perhaps the single largest marriage penalty imposed by the Internal Revenue Code.[25]

Closing remarks

Engaging in one or more of the planning strategies outlined will often have tax, business and often personal consequences for the parties involved beyond the realm of Section 1202 planning. All of these factors and consequences should be taken into account as part of the process.  Taxpayers engaged in advanced QSBS tax planning should consider seeking the advice of tax professionals who regularly work with Sections 1202 and 1045. In particular, taxpayers should consider the tax authorities supporting their intended return positions.

More resources

Despite the potential for extraordinary tax savings, many experienced tax advisors are not familiar with Section 1202 and Section 1045 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:  Download Guidebook

Contact Scott Dolson if you want to discuss QSBS issues by telephone or video conference.

[1]    References to Section are to sections of the Internal Revenue Code of 1986, as amended. This article assumes that the stockholder is eligible for Section 1202’s 100% gain exclusion. The gain exclusion cap is $5 million for married individuals filing separately.

[2]    1202(b):  Per-issuer limitation on taxpayer’s eligible gain.

(1)   In general. If the taxpayer has eligible gain for the taxable year from 1 or more dispositions of stock issued by any corporation, the aggregate amount of such gain from dispositions of stock issued by such corporation which may be taken into account under subsection (a) for the taxable year shall not exceed the greater of—

(A)   $10,000,000 reduced by the aggregate amount of eligible gain taken into account by the taxpayer under subsection (a) for prior taxable years and attributable to dispositions of stock issued by such corporation, or

(B)   10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year. For purposes of subparagraph (B), the adjusted basis of any stock shall be determined without regard to any addition to basis after the date on which such stock was originally issued.

(2)   Eligible gain. For purposes of this subsection, the term “eligible gain” means any gain from the sale or exchange of qualified small business stock held for more than 5 years.

(3)   Treatment of married individuals.

(A)   Separate returns. In the case of a separate return by a married individual, paragraph (1)(A) shall be applied by substituting “$5,000,000” for “$10,000,000.”

(B)   Allocation of exclusion. In the case of any joint return, the amount of gain taken into account under subsection (a) shall be allocated equally between the spouses for purposes of applying this subsection to subsequent taxable years.

(C)   Marital status. For purposes of this subsection, marital status shall be determined under section 7703.

[3]    An employee’s tax basis in a share of QSBS would be the value of QSBS when it vests for purposes of Section 83, or at the time of issuance if a Section 83(b) election is made (the value should equal the aggregate of the per share amount paid and compensation).  Unvested shares (shares subject to substantial risk of forfeiture under Section 83) are not eligible for Section 1202’s gain exclusion when sold.

[4]    Section 1202(b)(1)(B) provides that for purposes of the 10X Basis Cap, “the adjusted basis of any stock shall be determined without regard to any addition to basis after the date on which such stock was originally issued.”  Section 1202(i)(2) provides, however, that “[i]f the adjusted basis of any qualified small business stock is adjusted by reason of any contribution to capital after the date on which such stock was originally issued, in determining the amount of the adjustment by reason of such contribution, the basis of the contributed property shall in no event be treated as less than its fair market value on the date of the contribution.” It is unclear how to reconcile these two provisions. What is the point of the second rule if contributions to capital don’t affect the 10X Basis Cap computation?  The main takeaway from these two provisions should nevertheless be that you should never make capital contributions with respect to QSBS, instead, you should always acquire additional shares of QSBS in exchange for additional capital. Section 1202(b)(1)(B) clearly establishes the rule for purposes of the functioning of the 10X Basis Cap., and the rule doesn’t work favorably for those who make additional capital contributions.

[5]    There are somewhat complicated rules regarding the sharing of Section 1202’s gain exclusion among partners when the     partnership sells QSBS.

[6]    This example and others throughout this article assume for purposes of illustration that all of Section 1202’s eligibility requirements are satisfied when the applicable QSBS was sold.

[7]     Plus, the federal 3.8% investment income tax and applicable state income taxes.

[8]    If the trust is a grantor trust, the “taxpayer” is the grantor and is treated as the owner of the QSBS for Section 1202 purposes. If the trust is a non-grantor trust, the “taxpayer” is the trust, and the trust is treated as the owner of the QSBS for Section 1202 purposes.

[9]    The transfer of QSBS must qualify as a “gift” for federal income tax purposes. A transfer of QSBS for value will end the treatment of the stock as QSBS. A transfer of QSBS by an employer or another stockholder on behalf of the corporation to another stockholder generally won’t qualify as a “gift.” A transfer undertaken in connection with a business transfer also won’t generally qualify as a “gift.”  Tax authorities note that what constitutes a gift for federal income tax purposes may not qualify as a gift for federal gift and estate tax purposes, and vice versa. A transfer of QSBS into a non-grantor trust is generally treated as a gift for federal income tax purposes. A transfer by Taxpayer A into a family limited partnership or limited liability company in exchange for an interest is generally not a gift for federal income tax purposes (the transferor receives a capital interest in the exchange).

[10]   This result assumes that the gift is made before there is a binding contract to sell the QSBS, thereby avoiding an argument that the gift should not be respected based on an assignment of income argument.

[11]   QSBS should be gifted before there is a binding contract to sell the QSBS to avoid an “assignment of income” argument by the IRS.

[12]   This incomplete gift, non-grantor trust is referred to generally as an ING (a DING in Delaware and NING in Nevada).

[13]   Referred to by some as “stacking” (multiplying) trusts for Federal income tax planning purposes. There are no tax authorities addressing the use of non-grantor trusts in connection with Section 1202 tax planning, but see Treasury Regulation § 1.199A-6(d)(3)(vii) which provides that that a trust formed with a principal purpose of avoiding, or of using more than one, threshold amount for purposes of calculating the deduction under Section 199A will not be respected as a separate trust for purposes of determining the threshold amount for purposes of Section 199A and Treasury Regulation § 1.643(f)-1 which provides that “two or more trusts will be aggregated and treated as a single trust if such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and if a principal purpose for establishing one or more of such trusts or for contributing additional cash or other property to such trusts is the avoidance of Federal income tax. For purposes of this rule, spouses will be treated as one person.”

[14]   Section 643(f) provides that “2 or more trusts shall be treated as 1 trust if — such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries and a principal purpose of such trusts is the avoidance of the tax Imposed by this chapter.”

[15]   The pre-incorporation business could also be operated as a sole proprietorship.

[16]   QSBS must have been held for more than five years when sold in order to qualify for claiming Section 1202’s gain exclusion.

[17]   A taxpayer could have tax basis for Section 1202 by contributing cash or property to the issuing corporation in exchange for QSBS.

[18]   When appreciated property is contributed into an issuer of QSBS on a tax-free basis under Section 351 nonrecognition exchange, including upon incorporation of a partnership, the tax basis of the property for purposes of Section 1202, including the 10X Basis Cap, is the fair market value of the property rather than its historic tax basis. Deferring the date that a partnership is incorporated could backfire if the greater than five year holding period requirement becomes an issue down the road.

[19] See Paul S. Lee, L. Joseph Comeau, Julie Miraglia Kwon and Syida C. Long, Tax Notes Federal, Qualified Small Business Stock:  Quest for Quantum Exclusions, Special Report, and Daniel Mayo, Withum, Smith+Brown, Stacking and Packing — Strategies to Maximize the Section 1202 Exclusion.

[20]   For example, if there are contemporaneous Section 409A valuations or other valuations of the corporation, those should be taken into account in determining the amount and economic features of the newly-issued QSBS. Section 1202(k) provides that the IRS may issue regulations to prevent “the avoidance of the purposes of [Section 1202] through split-ups, shell corporations, partnerships, or otherwise.” To date, the IRS hasn’t addressed Section 1202 income tax avoidance schemes through regulations, but the potential focus on “shell corporations” is there.

[21]   A husband and wife filing a joint return are persons who are jointly and severally subject to a tax, and therefore, each is a taxpayer within the meaning of the Internal Revenue Code. Section 7701(a)(14) defines a taxpayer to be “any person subject to any internal revenue tax” and that under Section 6013(d)(3), each spouse has joint and several liability for the tax shown on a joint return.

[22]   Gitlitz v. Commissioner, 531 U.S. 206 (2001).

[23] Nell v. Commissioner, T.C. Memo 1982-228 (citing Dolan v. Commissioner, 44 T.C. 420, 428 (1965)).

[24] TAM 9853002.

[25]   A marriage penalty occurs in situations where two persons filing as single filers would be entitled to separate tax benefits, but if they marry, then they would only be entitled to a single benefit.  In the context of Section 1202, if you are single, you have a $10 Million Cap with respect to the sale of XYZ Corp QSBS, and so does your significant other.  But if you marry your significant other, then as a married couple, you would only be entitled to a single $10 Million Cap with respect to XYZ Corp QSBS.