Subchapter “C” corporations are like pit bulls or prostate exams; while they carry quite the stigma, they’re not nearly as bad as they’re made out to be.
Long thought of as “the entity choice of last resort” — due to the corporate level tax and resulting potential for double taxation (shameless plug!) upon distribution or liquidation — in reality C corporations offer certain opportunities that S corporations and partnerships simply can’t match.
For example, only C corporation stock meets the definition of “qualified small business stock” under the meaning of Section 1202. And through the end of 2011 — barring an extension of the law — noncorporate taxpayers who invest in such “qualified business stock” can sell the stock after five years and exclude the entire gain from taxable income and AMT (subject to limitations, discussed below.)
Section 1202, In General
Prior to 2010, if a noncorporate taxpayer sold “qualified small business stock” that had been issued after August 10, 1993 and held for more than five years, 50% of the gain was excluded under Section 1202. The remaining 50% of the gain was subject to tax at 28%, however, meaning the tax rate on the total gain was 14%. This offered only a 1% benefit over the long-term capital gain rate of 15%, and coupled with the fact that 7% of the gain was also treated as an AMT preference item, made Section 1202 a rather useless provision.
Two recent law changes have reincarnated Section 1202, however, providing special rules for “qualified small business stock” acquired after September 27, 2010, and before January 1, 2012. For such stock, 100 percent of the gain is excluded under Section 1202(a) and no portion of the exclusion is treated as a tax preference item for purposes of the alternative minimum tax. This presents a unique opportunity for noncorporate taxpayers to invest in Section 1202 stock for the next two weeks and enjoy the benefit of tax-free gain on a subsequent sale of the stock five years down the road.
Requirements for Section 1202 Stock
Qualified small business stock is stock that meets the following requirements:
1. It is issued by a corporation that at the date of issuance is a domestic C corporation with cash and other assets totaling $50 million or less, based on adjusted basis, at all times from August 10, 1993 to immediately after the stock is issued.
2. The shareholder acquires it in an original issue in exchange for money or other property or as compensation [certain tax-free transfers and exchanges can also qualify- see IRC Sec. 1202(f) and (h)].
3. It is issued by a C corporation that meets an active business requirement—at least 80% of the value of the corporation’s assets are used in a qualified trade or business[1] during substantially all of the taxpayer’s holding period for such stock and the corporation is an eligible corporation.
Converting a partnership into a C corporation to take advantage of the Section 1202 rules:
With the 100% exclusion set to expire at the end of the month, Section 1202 should clearly be given consideration by any new business forming over the next two weeks. Of course, the potential impact of Section 1202 should not drive the choice of entity decision, but it must be factored into any analysis.
Less obvious, however, is the opportunity that exists to convert an existing partnership into a C corporation with qualifying Section 1202 stock by year end. Provided the conversion is structured in the correct manner — and provided the C corporation stock meets the requirements discussed above to qualify as Section 1202 stock — any former noncorporate partners of the converted partnership will be entitled to sell the stock after holding it for five years free from income tax (subject to limitations, discussed below.)
Revenue Ruling 84-111 provides three options for a partnership-to-corporation conversion:
1. “Assets Over:” the partnership contributes its assets and liabilities to the new corporation in exchange for stock in the corporation qualifying under Section 351, followed by a liquidation of the partnership in which the stock of the corporation is distributed to the partners in a nontaxable Section 731 transaction.
2. “Assets Up:” the partnership first liquidates, followed by a transfer by the partners of the assets of the partnership to the new corporation in a nontaxable Section 351 transaction (subject to Section 357(c)).
3. “Interests Over:” The partners transfer their partnership interests to the corporation in a nontaxable Section 351 transaction. The corporation can then “liquidate” the single-member LLC or leave it as is.
In order to insure that the stock received in a partnership conversion will qualify as Section 1202 stock, care must be given to which of the three options are chosen under Rev. Rul. 84-111. Option 1, which happens to be the default option, results in the partnership, rather than the partners being the original owner of the corporation stock, thus failing to satisfy the “original isseu” requirement for Section 1202 stock. For the partners to be treated as having received the stock directly from the corporation, Option 2 (Assets Up) or Option 3 (Interests Over) must be used to incorporate the partnership.
Computational Limitations
Importantly, Section 1202(b)(1) limits the exclusion to the greater of (1) $10 million ($5 million for married taxpayers filing separately), minus any amount excluded with respect to that corporation’s stock in prior years, or (2) ten times the aggregate basis of stock of the qualified corporation sold during the year.
The following example illustrates the operation of Section 1202:
Assume that an investor paid $4 million for 800,000 shares in a qualified small business and six years later sold the stock for $25 million, realizing a gain of $21 million. The ceiling on excluded gain is $40 million (the greater of $10 million or ten times the $4 million basis). Accordingly, the entire gain is excluded.
If the taxpayer’s basis for the stock were only $200,000, however, the gain would be $24.8 million. Ten times the taxpayer’s basis is $2 million, which is less than $10 million. Thus, the exclusion is limited to $10 million, and $14.8 million of the gain must be included in taxable income. Note, this gain is not taxed at 28%, but rather the 15% long term rate.
Cautions:
- Note, however, that while the exclusion exists for stock issued in 2011, because of the five year holding period requirement, the holder of stock won’t actually enjoy the benefits of the zero percent tax rate on a sale of the stock until 2016 at the earliest.
- On a stock sale, the buyer is likely to negotiate a lower purchase price than on an asset sale.
[1] A qualified trade or business excludes: 1. any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, etc.; 2. banking, insurance, financing, leasing, investing, or similar business; 3. farming (including the business of raising or harvesting trees); 4. the production or extraction of products subject to percentage depletion; and 5. a hotel, motel, restaurant, or similar business.
