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Tip of the Qualified Small Business Stock Iceberg

Posted on Apr. 10, 2023
Nathaniel S. Pollock
Nathaniel S. Pollock

Nathaniel S. Pollock is a partner with SouthBank Legal in Washington, D.C. Previously, he was a senior-level attorney in the appellate section of the Department of Justice’s Tax Division.

In this article, Pollock examines recent litigation over the contours of the qualified small business stock income tax exclusion, including a recent case in which the Justice Department successfully challenged an exclusion for stock issued by an LLC that converted to a C corporation.

Qualified small business stock (QSBS) litigation is about to get big. IRC section 1202 allows holders of this kind of stock to exclude at least $10 million from taxable income when they sell it. Although section 1202 was enacted in 1993, it recently became a far more attractive tax benefit, primarily because the Tax Cuts and Jobs Act reduced the corporate tax rate to 21 percent. Because of that change, many more start-ups were organized as C corporations. And being organized as a C corporation is one of the requirements for issuing QSBS.1

Background

There are several other requirements: To issue QSBS, a corporation must have less than $50 million in aggregate gross assets before, during, and immediately after it issues the stock.2 The corporation must meet the statute’s “active business requirement,” which means that the corporation must (subject to conditions and exceptions) use at least 80 percent of its assets in actively conducting its business.3 The corporation must be engaged in a qualified trade or business, and the statute sets out a list of activities — including performing legal services, banking, and farming — that are not qualified.4 Some stock buybacks may eliminate the QSBS status of the corporation’s stock, either in the hands of a particular taxpayer or altogether in the case of a significant buyback.5

There are also shareholder requirements. For QSBS issued after enactment of the Creating Small Business Jobs Act of 2010, noncorporate shareholders can exclude 100 percent of the gain from the sale or exchange of the stock up to $10 million.6 And the exclusion is higher for shareholders with more than $1 million basis in the stock.7 But certain limitations apply. For instance, shareholders may not hold an offsetting short position with respect to the QSBS.8 They also must hold the QSBS for more than five years to take advantage of the section 1202 exclusion.9

Section 1202 Litigation

This hold-for-five-years requirement is a big reason section 1202 is gaining prominence. The five-year period recently elapsed for taxpayers who hold stock in businesses that were organized as C corporations after the TCJA. And that helps to explain why few courts have thus far interpreted section 1202.

Older Section 1202 Cases

Until recently, the few decisions construing section 1202 were anodyne. In Owen10 the Tax Court ruled that a jeweler who used only 8 percent of his capital to buy inventory did not meet section 1202(e)’s active business requirement, which mandates using 80 percent of assets to actively conduct business. In Natkunanathan11 the Tax Court determined that the taxpayer failed to substantiate his claims that the stock-issuing company’s status was a qualified small business and that he had held the stock for five years. More interestingly, the court concluded that, even if these requirements had been met, the stock could not be QSBS because the taxpayer held stock options and the statutory meaning of QSBS does not include “options to acquire such stock.” In Holmes12 the Tax Court likewise determined that the taxpayer failed to show he met the statutory requirements for exclusion.

The Leto Case

But a more interesting recent decision portends what’s to come. In Leto13 Judge Dominic W. Lanza of the U.S. District Court for the District of Arizona granted the government’s motion for judgment on the pleadings in a tax refund suit. The court also granted Michael R. Leto leave to amend his complaint, and the case later settled. Leto addresses whether an LLC that converted to a C corporation issued QSBS. The business, GlobalTranz Enterprises, was originally formed in 2003 as an Arizona LLC.14 In 2011, the business was refounded as a C corporation called GlobalTranz Enterprises Inc. To accomplish the transition, the old LLC and the new C corporation merged, the LLC dissolved, and the members of the LLC received C corporation stock as compensation for their interests in the LLC.15 Five years after obtaining the stock, Leto sold it.16 He did not initially claim a section 1202 exclusion on the sale.17 But he later claimed the exclusion on an amended return and sought a refund of $528,099.18 The IRS rejected the refund claim and Leto filed suit in the district court.19

The pivotal fact in the case is that before it became a C corporation, GlobalTranz Enterprises LLC had elected to be treated as an S corporation for federal tax law purposes.20 The Justice Department argued that, in so electing, the LLC consented to having its membership interests treated as stock for federal tax purposes.21 Because the LLC membership interests were “stock” for federal tax purposes, the conversion of the LLC to a C corporation was — according to the Justice Department — a stock-for-stock exchange. Under section 1202(c)(1)(B), stock must be acquired either “in exchange for money or other property (not including stock)” or “as compensation for services” (emphasis added). Leto responded that the LLC membership interests were not stock because Arizona, like other states, does not treat them as stock.22 Leto also noted that GlobalTranz Enterprises was never an S corporation; rather, it was an LLC that elected to be taxed as an S corporation.23

The district court agreed with the government. Its reasoning was straightforward. First, the meaning of stock in section 1202(c)(1)(B) is determined by federal law, not by state law.24 Second, “the term ‘stock’ includes shares in an association, joint-stock company, or insurance company” and those entities are all examples of corporations as distinguished from partnerships.25 Third, the court did not need to “decide whether a membership interest in an LLC should, in general, be considered ‘stock’ for purposes of” the tax code; it only needed to decide whether a membership interest in an LLC that elected to be taxed as an S corporation should be considered stock.26 Thus, LLCs taxed as S corporations issue stock because, under reg. section 301.7701-3(g)(1)(i), when an LLC elects to be taxed as an S corporation it is deemed to be a partnership that contributed all its assets in exchange for stock and then liquidates by distributing all the stock to the partners.27 In other words, part of electing to be taxed as an S corporation is electing to be treated as having issued stock.

The court rejected Leto’s attempt to distinguish between being taxed as an S corporation and being an S corporation. It explained that the regulation that allows LLCs to choose to be taxed as S corporations (rather than their default treatment as partnerships) states that the election applies “for federal tax purposes.”28 Thus, the election applies to the LLC’s treatment under section 1202, and every other IRC provision.29 The court accordingly granted the government’s motion for judgment on the pleadings, though it also gave Leto leave to amend his complaint to pursue an alternative theory based on facts not set out in his initial complaint.

More Section 1202 Litigation to Come

This is the tip of the QSBS iceberg. In the coming years, many more taxpayers will claim substantial section 1202 exclusions. Likely issues in future section 1202 litigation include: the contours of the definition of qualified trade or business under section 1202(e)(3);30 whether stockholders can stack exclusions by giving QSBS to family members or trusts;31 and the meaning of section 1202(c)(2)(A)’s condition that the active business requirement must be met “during substantially all of the taxpayer’s holding period.” Taxpayers who intend to claim section 1202 exclusions should carefully evaluate the likelihood of the IRS (or the Justice Department in refund litigation) challenging the exclusions and interpreting the statute narrowly, and may want to consider obtaining a tax opinion letter or seeking a private letter ruling.

FOOTNOTES

1 Section 1202(d)(1).

2 Id.

3 Section 1202(e).

4 Section 1202(e)(1) and (3).

5 Section 1202(c)(3).

6 Section 1202(a)(1) and (4), (b)(1). Taxpayers can exclude either 50 or 60 percent of the gain from a disposition of QSBS issued between section 1202’s enactment and February 17, 2009 (depending on whether the issuer was an empowerment zone business). See section 1202(a); American Recovery and Reinvestment Act of 2009, P.L. 111-5, section 1241. Taxpayers can exclude 75 percent of the gain from a disposition of QSBS issued from February 17, 2009, to September 27, 2010. See section 1202(a); Small Business Jobs Act of 2010, P.L. 111-240, section 2011.

7 Section 1202(b)(1)(B).

8 Section 1202(j).

9 Section 1202(b)(2).

10 Owen v. Commissioner, T.C. Memo. 2012-21.

11 Natkunanathan v. Commissioner, T.C. Memo. 2010-15, aff’d, 479 F. App’x 775 (9th Cir. 2012).

12 Holmes v. Commissioner, T.C. Memo. 2012-251, aff’d, 593 F. App’x 693 (9th Cir. 2015).

13 Leto v. United States, No. CV-20-02180-PHX-DWL (D. Ariz. 2022).

14 Id. at 1.

15 Id. at 2.

16 Id.

17 Id.

18 Id.

19 Id.

20 Id. at 1.

21 Id. at 5.

22 Id. at 6.

23 Id.

24 Id. at 9.

25 Id. at 9 (quoting section 7701(a)(2), (3), and (7)).

26 Id. at 10.

27 Id. at 11.

28 Id. at 12 (quoting reg. section 301.7701-3(a)).

29 The district court also dispatched Leto’s argument that section 1202(h)(4), which preserves the tax exclusion notwithstanding exchanges of QSBS for unqualified stock, can somehow operate in reverse to qualify unqualified stock. Id. at 14-15.

30 See ILM 202204007 (Jan. 28, 2022) (determining that a business that facilitates the leasing of property through an online platform — that is, without any human brokers — provided “brokerage services within the meaning of [section] 1202(e)(3)(A)”).

31 See Alexander M. Stephenson, “Stacking the Chips: Qualified Small Business Stock Exclusion,” 76 Tax Law. 419, 444-446 (2023) (contending that the government should interpret the statute to disallow stacking section 1202 exclusions via gifts to family members or trusts).

END FOOTNOTES

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