Recent IRC Sec. 1202 Case Highlights the Importance of Timing and Proper Documentation

A recent U.S. Court of Federal Claims decision highlights the intricacies of the IRC Sec. 1202 requirements and the importance of documentation. Under IRC Sec. 1202, taxpayers may exclude some or all of the gain realized from the sale of qualified small business stock (“QSBS”), provided they meet the requirements. The Court of Federal Claims held in Ju v. United States that the taxpayer failed to prove that the requirements of IRC Sec. 1202 were met, and as such, was ruled ineligible to exclude the gain from the sale of the stock.  

IRC Sec. 1202 Explained

The qualified small business stock exclusion under IRC Sec. 1202 is a taxpayer-favorable provision of the tax code for certain eligible stockholders. It allows taxpayers to exclude up to 100% of gain realized from the sale of qualified small business stock, provided that:

• The taxpayer held the stock for more than five years,
• The stock was issued directly from the qualified small business to the shareholder, and
• The qualified small business had aggregate gross assets of $50 million or less from the date of incorporation through the day after the issuance of the qualified stock.

Background

Dr. Ju was a university employee who developed several patents while employed. The university licensed these patents in 2003 to a company, Selexys, in exchange for 583,921 shares of common stock. Dr. Ju received an additional 18,017 shares of common stock. Dr. Ju disputed his number of shares in 2015, and he and the university reached a settlement which resulted in 53,441 shares of common stock being reissued to Dr. Ju instead of the university.  

Dr. Ju sold the stock in 2016 and reported the gain on his 2016 tax returns. He subsequently filed an amended return claiming a tax refund on the basis that the stock qualified for the IRC Sec. 1202 exclusion due to his legal claim to the shares beginning in 2003. Both the taxpayer and the government moved for summary judgement in their favor on the issues. The Court examined the shares received in 2003 and the shares received in 2015 separately, looking to both the holding period requirement and the aggregate gross assets test.

Holding Period Requirement

To claim the exclusion, the taxpayer must have held the stock for at least five years. Dr. Ju claimed that his legal claim to the stock shares began in 2003 and  he thus met this requirement. However, Dr. Ju was only able to produce stock certificates dated from 2015. The Court held that Ju did not have ownership of the shares of stock until 2015, and therefore was not eligible for the exclusion under IRC Sec. 1202.

Aggregate Gross Assets Test

The taxpayer also bears the burden of proving that the corporation met the aggregate gross assets test. While Dr. Ju was able to show that he held the 18,017 shares of stock in 2003, he was not able to provide documentation showing the corporation was a qualified small business with aggregate gross assets of $50 million or less. Dr. Ju produced some documentation showing the business met that definition from 2009-2011, but not for the correct period of 2003. The Court held that while he had held these shares for at least five years, the taxpayer did not prove that the company had met the aggregate gross assets requirements based on the documentation provided.

Next Steps in the Case

This is not the end of the road for the taxpayer. While the Court held that the taxpayer did not prove he was entitled to the small business stock exclusion, the Court did not grant summary judgement to the government either. If the case goes to trial, it could give the taxpayer more opportunities to provide substantiation that the 18,017 shares of stock he received in 2003 were qualified under the aggregate gross assets test.

This case highlights the importance of documentation and substantiation when claiming the QSBS exclusion. Taxpayers should engage a trusted tax advisor to determine whether they are eligible to take advantage of IRC Sec. 1202.