Why Founders and Investors Need to Consider Qualified Small Business Stock During Formation

Many founders and investors are already familiar with the qualified small business stock (“QSBS”) gain exclusion provisions of IRC Section 1202, which permit certain taxpayers to exclude up to 100% of any gain from the sale or exchange of QSBS held for more than five years from their gross income. The exclusion is limited to the greater of $10,000,000 or ten times the taxpayer’s adjusted basis in the stock sold. For example, a taxpayer who sells their zero tax basis stock for $15,000,000 may exclude $10,000,000 of that gain for federal income (and certain state income) tax purposes. Despite its being enacted in 1993, to date, very few authorities have interpreted section 1202. So, when a court addresses section 1202, it’s worth paying attention.

In a recent U.S. District Court opinion granting the government’s motion to dismiss, Leto v. U.S., No. CV-20-02180-PHX-DWL (D. Ariz. 2022), a taxpayer was denied a refund for taxes paid on the sale of stock in a C corporation because his stock was held to not be QSBS. The District Court permitted the taxpayer to amend his complaint, and the case ultimately settled.  See Pollock, Tip of the Qualified Small Business Stock Iceberg, 108 Tax Notes State 121 (Apr. 10, 2023).  

In Leto, the taxpayer originally invested in an LLC that elected to be treated as an S corporation for federal income tax purposes.  Subsequently, the LLC merged with a newly formed C corporation, at which point the taxpayer exchanged their LLC interests for stock in the C corporation.  Five years later, the taxpayer sold their C corporation stock, and filed an amended return claiming a refund under the section 1202 exclusion for that sale.  

The District Court concluded that the QSBS treatment was not available under section 1202(c)(1)(B), which, with certain exceptions, denies QSBS treatment to stock received in exchange for other stock. The District Court spent some time analyzing whether LLC interests constituted “stock” for this purpose, and ultimately concluded that they did. The Court particularly focused on the fact that the LLC was classified as an S corporation for federal income tax purposes, and thus, under federal tax statutes, the interests in the LLC were converted into stock for federal income tax purposes when the LLC elected S corporation tax treatment and were not QSBS. Because of this, the taxpayer’s argument regarding the entity’s structure under state law was essentially irrelevant.

The District Court also addressed the potential application of the merger exception under section 1202(h)(4), which allows non-qualified stock that is received in a stock-for-stock exchange to take the characteristics of the qualified stock that is being exchanged. The Court concluded that it did not help the taxpayer because it does not apply when the stock that is given up in the exchange is not QSBS. 

The conclusion in Leto is arguably not surprising.  Well-advised taxpayers should be aware that it takes careful planning to restructure a business operated by an S corporation into a form that might qualify under section 1202.  One alternative might be a holding company structure, although careful attention should be paid to the relevant requirements. The bigger take-away for taxpayers is that it is important to engage a trusted, professional tax advisor to assist in and advise on any entity restructurings, conversions, or reorganizations in order to create, protect, and preserve the availability of section 1202.

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