Tony Nitti for Forbes writes: Subchapter C corporations are like pit bulls or prostate exams — they
carry quite the stigma, but 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 the resulting potential for double taxation 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 2013 — 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. While that sounds wonderful, the remaining 50% of the gain was subject to tax at 28%, 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% that was in place at the time. Couple this with the fact that 7% of the gain was also treated as an AMT preference item, and Section 1202 was rendered 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, 2014.
First, for stock acquired during this period, once the stock has been held for five years, 100 percent of any gain from the sale of the stock is excluded under Section 1202(a). Sweetening the pot further, 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.
In addition, assuming tax rates remain the same for the next five years, the 100% exclusion will be much more valuable that pre-2008 iterations of Section 1202 in that it will be offsetting tax rates that significantly exceed the 15% maximum rate on long-term capital gains that existed prior to 2013. Remember, after January 1, 2013, the maximum rate on such gains has increased to 23.8% for those taxpayers with both AGI in excess of $250,000 (if MFJ, $200,000 if single, as this makes this subject to the additional 3.8% Obamcare surtax on net investment income of Section 1411), and taxable income in excess of $450,000 (if MFJ, $200,000 if single, as this is where the maximum rate on long-term capital gains under Section 1 jumps to 20%). This obviously makes the benefit of Section 1202 more attractive, as taxpayers can now keep income taxed at 23.8% — rather than 15% — off of their tax return.
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 Section 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 during substantially all of the taxpayer’s holding period for such stock and the corporation is an eligible corporation. 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.
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, once again 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 in a tax-free transaction 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.
It’s important to note, however, that because Revenue Ruling 84-111 gives you the choice on how to structure a partnership incorporation, the partnership will bear the consequences of its chosen alternative. To illustrate the downside of this freedom, if the partnership chooses an Assets Over form and the liabilities of the partnership exceed the tax basis of the assets deemed contributed to the new corporation, Section 357(c) will kick in and the partnership will recognize income to the extent of the excess.
Germane to Section 1202, the manner in which a partnership is incorporated shouldn’t matter; all three options should permit the partners to hold the C corporation stock as Section 1202 stock provided all the requirements are met regarding an active trade or business and the size of assets. Options 2 and 3 pose no problem, because in both cases the partners are the original recipients of the corporate stock, and thus satisfy the “original issuance” requirement.
I wrote should in italics in the paragraph above because there is some school of thought that Option 1 – Assets Over – could be problematic, because it results in the partnership rather than the partners being the original owner of the corporation stock, thus failing to satisfy the “original issuance” requirement for Section 1202 stock. That concern should be alleviated by Section 1202(h)(2)(C), however, which provides that if a partnership transfers stock to a partner, the partner is treated as having acquired the stock in the same manner as did the partnership. Stated in another way, because the partnership received the stock in the corporation’s original issuance, that fulfilled requirement for Section 1202 should be attributed to the partners receiving the stock in the deemed liquidation of the partnership. As a firm believer of the “better safe than sorry” approach to tax planning, however, I would recommend using Options 2 or 3 to incorporating a partnership if Section 1202 qualification is your primary goal.
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 this limitation:
Assume that A paid $2 million for shares of qualified small business stock in 2013. In 2019, he sells the stock for $15 million, realizing a gain of $13 million. The ceiling on excluded gain is $20million (the greater of $10 million or ten times the $2 million basis). Accordingly, the entire gain is excluded from both A’s net income and his AMT computation.
If A’s basis for the stock were only $200,000, however, the gain would be $14.8 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 $4.8 million of the gain must be included in taxable income.
Cautions:
Understand, while the exclusion exists for stock acquired in 2013, 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 2018 at the earliest.
To benefit from Section 1202, the shareholder must eventually sell the stock of the corporation. A sale of the corporation’s assets won’t qualify. This is relevant, because most buyers prefer to purchase assets, and a buyer is likely to negotiate a lower purchase price on a stock sale than on an asset sale.
Long thought of as “the entity choice of last resort” — due to the corporate level tax and the resulting potential for double taxation 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 2013 — 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. While that sounds wonderful, the remaining 50% of the gain was subject to tax at 28%, 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% that was in place at the time. Couple this with the fact that 7% of the gain was also treated as an AMT preference item, and Section 1202 was rendered 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, 2014.
First, for stock acquired during this period, once the stock has been held for five years, 100 percent of any gain from the sale of the stock is excluded under Section 1202(a). Sweetening the pot further, 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.
In addition, assuming tax rates remain the same for the next five years, the 100% exclusion will be much more valuable that pre-2008 iterations of Section 1202 in that it will be offsetting tax rates that significantly exceed the 15% maximum rate on long-term capital gains that existed prior to 2013. Remember, after January 1, 2013, the maximum rate on such gains has increased to 23.8% for those taxpayers with both AGI in excess of $250,000 (if MFJ, $200,000 if single, as this makes this subject to the additional 3.8% Obamcare surtax on net investment income of Section 1411), and taxable income in excess of $450,000 (if MFJ, $200,000 if single, as this is where the maximum rate on long-term capital gains under Section 1 jumps to 20%). This obviously makes the benefit of Section 1202 more attractive, as taxpayers can now keep income taxed at 23.8% — rather than 15% — off of their tax return.
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 Section 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 during substantially all of the taxpayer’s holding period for such stock and the corporation is an eligible corporation. 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.
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, once again 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 in a tax-free transaction 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.
It’s important to note, however, that because Revenue Ruling 84-111 gives you the choice on how to structure a partnership incorporation, the partnership will bear the consequences of its chosen alternative. To illustrate the downside of this freedom, if the partnership chooses an Assets Over form and the liabilities of the partnership exceed the tax basis of the assets deemed contributed to the new corporation, Section 357(c) will kick in and the partnership will recognize income to the extent of the excess.
Germane to Section 1202, the manner in which a partnership is incorporated shouldn’t matter; all three options should permit the partners to hold the C corporation stock as Section 1202 stock provided all the requirements are met regarding an active trade or business and the size of assets. Options 2 and 3 pose no problem, because in both cases the partners are the original recipients of the corporate stock, and thus satisfy the “original issuance” requirement.
I wrote should in italics in the paragraph above because there is some school of thought that Option 1 – Assets Over – could be problematic, because it results in the partnership rather than the partners being the original owner of the corporation stock, thus failing to satisfy the “original issuance” requirement for Section 1202 stock. That concern should be alleviated by Section 1202(h)(2)(C), however, which provides that if a partnership transfers stock to a partner, the partner is treated as having acquired the stock in the same manner as did the partnership. Stated in another way, because the partnership received the stock in the corporation’s original issuance, that fulfilled requirement for Section 1202 should be attributed to the partners receiving the stock in the deemed liquidation of the partnership. As a firm believer of the “better safe than sorry” approach to tax planning, however, I would recommend using Options 2 or 3 to incorporating a partnership if Section 1202 qualification is your primary goal.
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 this limitation:
Assume that A paid $2 million for shares of qualified small business stock in 2013. In 2019, he sells the stock for $15 million, realizing a gain of $13 million. The ceiling on excluded gain is $20million (the greater of $10 million or ten times the $2 million basis). Accordingly, the entire gain is excluded from both A’s net income and his AMT computation.
If A’s basis for the stock were only $200,000, however, the gain would be $14.8 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 $4.8 million of the gain must be included in taxable income.
Cautions:
Understand, while the exclusion exists for stock acquired in 2013, 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 2018 at the earliest.
To benefit from Section 1202, the shareholder must eventually sell the stock of the corporation. A sale of the corporation’s assets won’t qualify. This is relevant, because most buyers prefer to purchase assets, and a buyer is likely to negotiate a lower purchase price on a stock sale than on an asset sale.
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