Maximizing The Qualified Small Business Stock Exclusion | Section 1202

Something that again doesn't get a lot of attention is a sister section to 1202, 1045 rollovers. We're going to do a deep dive in that and then the interplay with certain things we're seeing with that operating losses and other consideration. Then we'll hopefully have time to Q&A if not during the polling questions. So, buckle in. I think you're going to find this very illuminating. To kick it off, we got Ben who's going to take you through the qualifications. Welcome, Ben.

Ben Aspir: Thank you, Jeff. Thank you, everyone, for joining us today. Whenever I explain the Section 1202 to people, it sounds almost too good to be true, because what Section 1202 allows is an eligible shareholder, assuming they meet all the requirements, which we're going to talk about today and give you examples. It allows an eligible shareholder or QSBS or Qualified Small Business Stock to exclude the greater of $10 million, which is a lifetime limit, or 10 times their adjusted basis. 1202 was enacted in the early '90s by Congress to spur investment in small business corporations and there've been many iterations of Section 1202.

It was largely ignored for the first, I would say, almost 10 years, because the exclusion ratio on Section 1202 and the exclusion ratio for 1202 is from 50 to 100% as you see on your screen. It depends on when the stock is acquired, not when it's sold. Today, we get a lot of questions about holding options or warrants, whether that's eligible 1202, we'll get to that a little bit later. The 1202 exclusion, which like I mentioned, is $10 million or 10 times their basis. It's per company. So, a person could invest in multiple qualified small business corporations and receive the benefit multiple times. There's also planning that could be done around it, likely a future 1202 webinar around the gift planning by maximizing the $10 million lifetime limit, because it's per shareholder.

So, there's gifting that could be done to multiply that lifetime limit. There's also planning that could be done not related to gifting, whereby if a shareholder has low basis shares and high basis shares, would they sell the low basis shares first, use up their $10 million lifetime limit, and then in subsequent years sell their high basis shares and use up their 10 times limit? Because that's an annual limit that could be used multiple times. Additionally, a question we receive a lot is for a couple married filing jointly, is there a 1202 exclusion double to $20 million? However, the tax code specifically mentions for couples that are married filing separately, it's $5 million a spouse. Therefore, the prevailing opinion is $5 million a spouse for filing jointly as well as $10 million and not $20 million.

So, at a high level, what are the requirements for this wonderful benefit of Section 1202? There are corporate level requirements and then there are shareholder level requirements. So, here's a corporate level requirement. The corporation must have less than $50 million in assets tax basis at any time prior and immediately after issuance of the stock. There's an exception if properties contributed to a corporation. Jeff will talk about that a little bit later. It was very important that a company monitors their tax basis of their assets. A company can issue eligible Qualified Small Business Stock, and then in the future, it breaches the $50 million asset test. The prior issued shares are grandfathered in.

They're not tainted, but any shares issued once the $50 million test is breached, those shares are not eligible for Qualified Small Business Stock and the corporation can no longer issue new Qualified Small Business Stock. But like I mentioned, the prior issued shares are grandfathered in. Another corporate level requirement, and I'll talk about it a little deeper shortly, shares must be issued by a corporation with at least $50 million of its assets in an active trader business other than personal services. It must be held by a non-corporate taxpayer.

However, and Jeff's going to talk about this also, the Qualified Small Business Stock can be held by a partnership or an S corporation as long as the partner or shareholder are partners or shareholder in the partnership or corporation when the Qualified Small Business Stock is purchased. It must be acquired on original issuance. So, it can't be acquired from a third-party broker or from another person. It has to be issued directly by the corporation and held by the shareholder. Lastly, this is a shareholder level requirement. The stock must be held for a minimum of five years and we'll talk about when the clock actually starts ticking if you're not dealing with traditional stocks such as options and warrants, verbal notes.

Like I mentioned, the active business requirement, this is a crucial test. For substantially all of the holding period, we don't know exactly, there's no exact guidance of what the holding period is. Prevailing opinion is about 80% of the holding period at least. At least 80% by value, the assets of the corporation must be used in the act of conduct of one or more qualified trades or businesses. There are exceptions for reasonable working capital needs, for research and development expenses, and for startup expenses. When we do our 1202 analysis for our clients, this is one of the items we are very diligent to check to make sure that this is not an issue. There's a 10% limit on portfolio securities by value. I have seen clients get tripped up on this.

They have a significant amount of portfolio securities, that extra cash. They bought securities, and unfortunately, it hurt the 1202 status. Lastly, it can hold no more than the 10% maximum real estate holdings by value. Qualified trade or business, this is another area we get lots of questions on and the 1202 doesn't say which businesses are eligible. It does say which businesses are ineligible and you'll see a theme on all these bullet points. It's any personal services type of business, accounting. We're not eligible. This is a bit of a mouthful, but principal asset of such trade or business is the reputation or skill of one or more employees.

So, there's no guidance on lots of areas of 1202, but section 199A, which passed the coming on over six years ago, copied and pasted some of this language and they issued guidance on 199A. The example they use related to 199A is for example, you have a celebrity chef that sells pasta sauce in the supermarket and their picture is on the jar of sauce, something like that where they're using their likeness to sell something. So, something like that would be ineligible for 199A. While 199A and 1202 are unrelated, it does give us insight into what the IRS may be thinking when it comes to that provision. Any banking, financial services, farming, oil and gas, any hospitality businesses. There were a couple of letter rulings related to 1202 that came out over the last year.

This is notable for a couple of reasons, because guidance on 1202 is far and few between and it's always good to see what the IRS's insight into 1202. Well, it's important to note that letter rulings are binding only to the taxpayer that requested it. They can only use that. It was a cloud software company. Both letter rulings are related to trade or business. They asked the question on whether their company is eligible for 1202 and the IRS ruled in their favor, because they said on the first letter ruling that the training that the company gave was specialized only to that company. The employees cannot leave and use that same training elsewhere.

On the second one, the company asked if they were under the consulting clause if that would change the total to stock. Essentially what they said was the advice and counsel was ancillary and they said that on the invoicing to their clients, they did not bill separately for it. So, that's a potential planning tool if a company is concerned whether they're in the field of consulting to not bill separately for advice and counsel. Lastly, the original issuance requirement. It must be issued for money, property, or compensation. Like I mentioned, the holding period begins on the date of issuance. Now, we're going to move on to our next polling question.

Astrid Garcia: Polling Question #2

Kayla Konovitch: So Ben, while we're waiting, I'm just going to point out a note on your last point where the stock needs to be original issuance. If you're buying the stock in a secondary market, it typically would not qualify. I want to point out specifically if you're receiving a K1 with a footnote that details you may be eligible for the exclusion, it's very important to determine if you as the partner in the partnership are actually eligible, because many times they just pass the footnotes along, but that determination of the original issuance is at the individual level.

So, you need to make sure that you were a partner at the time the partnership acquired that portfolio company, that stock. So, you just have to look at that test on your own. The footnote would typically give you the date of acquisition when the partnership made that purchase. So, you can determine if you're eligible. So, it's important to look at that. It's the footnote said, so let's go with it, but actually look at that.

Ben Aspir: That's an excellent point, Kayla.

Kayla Konovitch: Thank you.

Ben Aspir: We received the question, can a single member LLC qualify as holder of the shares? Jeff's going to elaborate that a little later when he talks about transfers, but single member LLC generally can hold QSBS.

Astrid Garcia: Perfect. I will now be closing the polling question. Please make sure you submitted your answer. All right, back to you guys.

Ben Aspir: Oh, excellent.

Jeffrey Kelson: Yeah, we've got two-thirds that have some familiarity, and the rest, this will be new. So, we move along, Ben.

Ben Aspir: So a lot of the questions we get are surrounding options and warrants or convertible debt. They do not qualify for 1202 until they're exercised or converted. It's very important to note that. The holding period does not start until the exercise or the conversion. Additionally, there has to be a look back for the period of while the shareholder was holding their option or the warrant, whether the company still qualified under 1202.

Additionally, restrictive stock, there's some plan that could be done around to make an 83(b) election. If an 83(b) election is made, it's the time the elections made as far as the holding period. Otherwise, the clock does not start ticking until the date of vesting. SAFE notes, stay tuned. Kayla's going to talk about that in depth and I'm going to turn it over to Jeff to talk about the property contributions.

Jeffrey Kelson: Thank you, Ben. So, I think we went ahead. All right, property contribution. So, if this property that is contributed other than money or stock in exchange for the QSBS stock, it's treated as having been acquired by the taxpayer on that date. That makes sense, right? The basis of the stock for QSBS purposes will be not less than the fair market value of the property exchange. That would be different than your tax basis. Your tax basis could be zero, but when you contribute to property and say it's $2 million, that would be your basis. Why that's important is QSBS gives you that 10 times the basis or $10 million, the greater of and $10 million is $10 million. That's a lifetime, but annually, it's 10 times the basis.

So, if your fair market value, what you contribute is $2 million, you can see that it can get up to $20 million. So, that's important benefit in transferring property. However, to bear in mind, any previous unrecognized gain, that means it's a built-in gain in the property itself that is carried over to the QSBS stock will be taxed and fall at the time there's an exit event. So, you don't get built-in gains as a pass-through or while your own property and get that magically transformed into QSBS excludable gain, because that was not earned while you worked QSBS. But it does allow that benefit for the 10 times the basis. Very nice. We're going to give an example, an LLC converting to a C corp and also S corp. So, let's talk about this for a second.

A partnership has a benefit here. If a partnership is operating and wants to form to be a C corp, they can do a state law conversion or they can check the box and form 832. Under those rules, they would be deemed to have issue shares and you would meet that requirement at least of the Qualified Small Business Stock. So, partnerships can go to a C corp status and qualify for the QSBS merely by checking the box, right? That's big benefit, simple. QSBS holding period, of course, would begin at the time of that conversion to the C corp. So, that would start measuring the five years. You would've a $50 million gross asset test and that would be measured by the value of the assets.

So, if you contributed assets to $30 million or let's say you contributed assets to $60 million, that wouldn't work. If you contribute assets to $30 million, you would have to add the tax basis to the assets that's already presently in the QSBS to see if you meet the $50 million test. So, it works both ways, this value, right? It helps you for the basis, but it could hurt you for the $50 million. So, your mileage might vary, but it has to be determined. Of course, as it bears repeating, only post-conversion appreciation would be eligible, meaning only appreciation while it's in a QSBS would be qualified for the excludable gain. Not any built-in appreciation. You can't magically transform built-in appreciation as a partnership into the C corp and get that covered too. Okay? Makes sense. S corps, all right.

Unfortunately, S corps are not as easy to transform into a C corp and qualify for a QSBS status. For instance, revoking your S election, terminating an S election, it's not an issuance of shares for QSBS purposes. You can't merely just terminate your asset selection and become a C. You're going to have to have some capital restructuring in order. We see a lot in the F reorg, where you might set up a holding company and hold the S as a subsidiary and the holding company would be a C corp and making the subsidiary S a C corp as well. A lot of practitioners have looked at F reorgs but bear in mind that the reorg provisions must have a business purpose.

Even though F reorgs and business purpose haven't had a lot of cases or rulings about it, when you're trying to qualify for 1202, it could be a line in the sand for the IRS and really see what was the business purpose other than qualifying for Qualified Small Business Stock. It probably makes sense to keep the subsidiary in existence because there was just a district case in Arizona, the Leto case, where an LLC checked the box to be an S corp and then merged into a C corp, merged that S corp into a C corp and try to qualify for Qualified Small Business Stock and sued for a refund and they lost. What the judge said was, first of all, an S corp merging into a C corp is merely just a conversion like terminating your S election.

Also, just because you formed as an LLC and you don't have shares in the traditional sense, you do if you elected S, because for tax purposes, those are deemed shares. You can't say you didn't transfer shares. You did. For both of those reasons, Leto lost. I think they're looking to appeal by this 2022 case, and I don't know if I haven't seen an appeal. So, the IRS is taking a tougher view of S corp transformations in the C corp, because it doesn't have that easy check the box way to have an issuance of shares. Also, the holding period would begin again at the time if you are able to qualify the S corp as a C corp through some restructuring. That would begin your five-year holding period. You $50 million gross asset test has to be measured as well.

So, if the S corp had more than $50 million in value, you wouldn't qualify. Again, only the post-conversion appreciation would be eligible. The QSBS exclusion, not any built-in gain as an S corp, that is not eligible, only the post-depreciation while you are owner of the stock of the QSBS. Let's get some facts here. It's always good to have examples. We're accountants. We like examples. So, Jane and John form a 50/50 partnership, ABC LLC. They hold it three and a half years and then they converted to a C corp, say they check the box or do a state law conversion and that works. Assuming they meet all the other qualifications, active trade of business, qualified business, whatever, the fair market value in this example is $7 million and the tax basis of the assets is zero.

That's where the entire partnership. ABC Corp mentioned, assuming meets all the requirements, and then what happened? On October 1st, 2023, more than nine years after they converted to a C, so they met the five-year test, Jane sells an entire 50% share of ABC Corp for $50 million, big windfall. What happens? How is she taxed? What's excluded? What's not excluded? Well, here's the result. We all know there's a long-term gain of $50 million, $50 million proceed, zero basis in this stock, but what gain is excluded? Well, as we mentioned, it's a lifetime exclusion of $10 million or the greater of 10 times your basis. Well, her basis, although it's zero for tax bases, the QSBS basis is $3.5 million because they contributed the LLC that was worth $7 million. She was a 50% owner.

So, that's what you pivot off of. It's great. It's a nice benefit. So, she can exclude 10 times $3.5 million or $35 million, much higher than the $10 million, because remember it's a greater row. Jane must pay tax on the first $3.5 million dollars a gain. Why? Because that was the built-in gain she had while it was an LLC. That doesn't get 1202 exclusions. So, okay, she has to pay tax in the 3.5. She then excludes the $35 million as I showed you above and she pays tax in the remainder of the gain, because that's above and beyond the $35 million. That's $11.5 million. So, total, Jane will pay tax on $15 million. That's the 3.5 that was built in as an LLC, 11.5 that was over the 35 million she can exclude, pays tax in $15 million but excludes $35 million. Tax savings at 23.8% of $8.3 million.

So, it's a big windfall for Jane, a big tax savings. That's because of the partnership. Property contributions get basis for Qualified Small Business Stock measured on the value, not on the tax basis of the shareholders or members. So, now Kayla will take us through very controversial area, Kayla, I would say. The carried interest rules and how that applies to Qualified Small Business Stocks. Take it away.

Kayla Konovitch: All right. Thank you, Jeff. So, yes, this is a very highly discussed and controversial topic in particular for the private equity and venture capital fund space as a fundamental component of payment to the general partners consists of carried interest, right, where the fund manager is allocated a share of the fund's profits. So, what if the profits that are being allocated to the fund is a carried interest of capital gain. It's coming through as capital gain but from carried interest. So, is that carried interest eligible for this exclusion? So when we're looking at a partnership interest, Ben mentioned before, you have to be a partner in the partnership at the time the partnership of the stock and throughout the holding period.

However, there is a limitation to the amount that could be excluded and that limitation requires that the excluded amount that it's limited is that amount which is allocable to the interest that's held at the time the partnership acquires the stock. Again, it's the interest held at the time the partnership acquired the stock. So, the question is, well what does that mean, interest held, right? How is that defined? Is that a capital interest? Does that cover a carried interest? Because at the time the partnership acquired the stock, it was zero, right? The carried interest is a future right to potentially a 20% carried interest depending on their agreement, but it's a future right. So, what is the interest that's held at the time the partnership acquired the stock?

So there's a big question here and the code itself doesn't elaborate on this point. So, it is unclear whether a carried interest is eligible for this exclusion. Now, if we look at the companion provision, Section 1045 rollover, which I'll go into a little bit more later, you're looking at that provision for the Qualified Small Business Stock. When you're rolling it over under that election, there are regulations that specify and say that only a capital interest is eligible and only the smallest percentage of a capital interest that you held over that holding period. So, there it's pretty clear that a carried interest is not eligible for the rollover, but the question still remains, do you have to apply that to Section 1202 for Qualified Small Business Stock? So there's a lot of commentators on both sides.

Some say yes, some say no. It's definitely a gray area and I think what we need to focus on is, is there substantial authority to take the position and say that the carried interest gains are eligible for Qualified Small Business Stock? So if you believe it comes up to a 40% chance of success based on its merits, then you could sign the return and you would not need to disclose the position on the return. However, if you feel that there's only a 20 to 30% chance of success based on the merits rate that there is some authority here, then that would just be considered reasonable basis. In that case, to sign the return, you would actually have to disclose the position on the tax return.

So, what we recommend our clients is that you have a discussion with the taxpayer, with the client, and the advisor to see what comfort level you feel on this issue and whether you can take the position and if you have to disclose or not. So, that's something just it really should be discussed with the advisor. I also want to mention that we're only talking about vested carry. If it's unvested carry, then we don't see how that would be eligible, but assuming you have vested carry, there's still a question, are you eligible for this exclusion? So definitely discuss it with your advisor.

Jeffrey Kelson: Of course, get you out of the penalties. That's the benefit.

Kayla Konovitch: Yeah. Jeff, if you want to walk us through the redemptions, which is actually the only regulation that was issued under 1202.

Jeffrey Kelson: So it doesn't get a lot of attention but can trip up either corporation or shareholders. There's certain redemptions that can disqualify QSBS status either to the shareholders or to the company. One is there's two provisions. One for the shareholder, if there's more than de minimis amount of stock within two years period, really a four-year period, two years before and two years after, to the redeemed shareholders related party. What they talk about de minimis is if the aggregate amount paid for all shares redeemed during that four-year period doesn't exceed the greater of 10,000 with 2% of the outstanding stock in the court.

So, if it does exceed both of those numbers, then for that period, that shareholder were not qualified if he got redeemed and then that shareholder or related party bought into the company, that would not qualify that particular shareholders for QSBS. So, that's how it applies to the shareholders. How it applies to the company is called the significant redemption. So, that's a two-year period, one year before and one year after. If the corporation redeemed shares with an aggregate value, an excess of 5% of the value the corporation shares at the beginning of that two-year period. So, that's a year before the purchase. All shares issued during that two-year period are ineligible for a 1202 exclusion.

So, it's a two-year period where nobody can qualify because the corporation's been tainted because it redeemed 5% of the value of the corporation shares at the beginning of that two-year period. So, there's like a two-year blackout period in essence. These don't get enough attention and they have to be looked at to make sure. I always got to check for any redemption. So, a lot of times, you have to climb and go, "Yes, actually, we did have a redemption." You have to see if that taints any of the issues during that period. However, there are some exclusions for these redemption. They're ignored if the redemption was connected to a termination of services, death, disability, or mental incompetency or divorce. So, there are some exclusions to these redemption provisions.

So, there might be some ways out of it under certain circumstances, but please look at the redemptions. I think they get overlooked a lot and trapped for the unwarranted as they say in business. So, I got a little chart here. Entity-related transfers, and I think this chart's very illuminating. Let's say you have QSBS stock and you contributed it to a partnership. You say, "Hey, that shouldn't be a problem, right? Because I qualified. Now I contributed to a partnership. I should pass through." No, it taints it so you lose it. So, if you take your QSBS stock and you contributed to a partnership, you've just in effect disqualified it. However, getting a distribution from the partnership to a partner of QSBS stock, it's fine.

So, going from the partnership down to the partner is fine, but a partner or an individual setting up a partnership to hold the QSBS stock would violate. Contribution to a disregarded entity is fine because it's disregarded. A bequest of QSBS stock is also fine, gifts. So, that doesn't taint it. Let's look at an S corp, a distribution from an S corp to a shareholder. First of all, it could be a taxable transaction, the 311B or if it's in liquidation. There's a lot of gray area around this. So, the best rule of thumb, probably not to distribute it, because not only can you invoke a tax, but you can taint the status of the QSBS. Contribution to an S doesn't work, same as a partnership. So, you don't have QSBS stock.

An S corp can own C corp stock, but however, if you contributed to an S corp, you would taint your QSBS status. Conversion of a disregarded LLC to a partnership, the disregarded LLC held QSBS stock but now was converted to a partnership. That would be tainted just like in the first one. Contribution to a partnership would violate it. So, you have to be very careful when you qualify not to do anything that would taint it. Okay, I think that's the takeaway here.

Depending on the entity, that's different rules. So, polling question, do you currently own stock that may be eligible for Section 1202? Yes, no, unsure. Of course, you might not. We're getting a whole lot of questions. That means you guys are very engaged and we really super appreciate it, but we'll answer what we can. It's just a mountain of them.

Ben Aspir: Jeff, the reasoning you can't contribute QSBS into a partnership and an S corp is it would violate the original issuance requirement that we mentioned earlier.

Jeffrey Kelson: Right. Thank you. That's the rationale. There's just so many questions, I don't even know where to begin. I'm just picking them at random, so please bear with me. In the partnership conversion example, there's a $7 million value asset, includes self-created good. Well, yeah, the value is the value no matter how it's determined within the company. So, when you contribute it, that would be your starting point but also be a measuring according for the $50 million test.

Ben Aspir: We got a question that's a good question. Do valuations affect the total of two setups? The answer is as it usually is with tax, it depends. If property has been contributed, then it matters. If no property has been contributed, it's generally just the tax basis for the $50 million asset test.

Jeffrey Kelson: Yeah, normally, you look at tax basis. The only time you look at values was just a contribution of property and converting a partnership or having an S corp restructuring would be deemed to be a valued one. You'd have to measure that in value, which is good and bad. Bad for the $50 million, good for your tax basis for purposes that. There's so much to unpack in this area. Are we done with the polling? We got the results?

Astrid Garcia: Yes. Let's make sure everyone has submitted their questions before we close it. Make sure you hit that submit button and I will close it now. There you go. Back to you guys.

Jeffrey Kelson: Yeah, I just want to answer one quick question. Somebody said, "There's original issues. Please define. Would it be the original stock issue time reformation?" No, it's issued to a shareholder directly from the corporation. It doesn't have to be at the time of formation. All right. I love that you guys are engaged, so please. I understand this is a hot area. Okay. Kayla, now you're going to take us through the SAFE.

Kayla Konovitch: Okay. So, we've been receiving a lot of questions regarding SAFE agreements. So, we wanted to spend some time first of all just to understand what a SAFE agreement is and then discuss the tax treatment and ultimately if it's eligible for Qualified Small Business Stock treatment. So, the SAFE agreement is a simplified agreement for future equity and was first introduced back in 2013 by Y Combinator. Essentially, what this was, the objective is similar to really what convertible debt is, where you have a contract between a startup and an investor with a right to receive equity in the future, or obviously, with a convertible debt, it would convert into equity.

So, the SAFE agreement, typically, there's a triggering event that it would actually be considered equity when there's a future equity financing or if you sold the company. Historically, we were seeing a lot of pre-money valuation agreements. Now we're seeing a lot of post-money valuation agreements, which actually values the company with the cash that the investors are putting in. Those agreements, the terms we're seeing are much more equity-like, which is a good factor. It's actually for 1202. So, we'll touch on that a bit momentarily. So, SAFE agreements, they generally do not have a maturity date and they do not accrue interest.

Typically, the investors will receive the right to the equity, but usually, it's at a lower pricing and they don't actually receive interest. It just remains outstanding until one of these triggering events actually occur. That's pretty standard with any SAFE agreement. Then there's also some important terms and rights like conversion, repurchase rights, dissolution, voting rights, and other terms that you'll find in the agreement. But what I want to point out is that these are templates that people use and it's supposed to be very simple. It is from a legal and economic perspective, but from a tax perspective, it is a little trickier. So, if you are modifying terms of the template, just keep in mind that actually could change the characterization of the instrument. So, that's important to note.

So, a SAFE agreement, there are three ways that it could be characterized for tax purposes. One is it could be considered debt. It could be considered to be equity or a variable prepaid forward contract. So, in our discussion here, we're not going to get into the full details of determining which one it is, but once you determine what the instrument is, then we can talk about what the treatment is. Determining debt versus equity is a very fact-based analysis that needs to be done and you need to look through the actual terms to make this determination. There is the Revenue Ruling 83-98 that does go through 10 factors that assist us in determining whether this instrument is debt or equity.

If there's principal or maturity or interest accruing or no compulsion to actually pay it, then those are certain things that may point to debt. So, there are some factors here to look at to help us make that determination. So, once we get there and we say, "Okay, well, this is treated as debt, then it follows the typical where when you're making payment those cash proceeds, that's not taxable." Of course, the interest income that you're accruing is taxable or sometimes there's even imputed interest that needs to be calculated and taxed. Of course, the issuer will have an interest expense subject to certain limitations, but overall, if the SAFE agreement is determined to be a debt instrument, then you would treat it as debt, not equity.

Ultimately, there will not be eligibility for Qualified Small Business Stock. Now if you did the analysis and determined based on the terms and the features of the SAFE agreement, it is equity, then that's really important, because that will then determine the holding period that could affect your long-term and short-term gain treatment, right? In order to get the long-term gain treatment, you want the holding period to begin right away. It also tells us that if it's equity, then as soon as the SAFE agreement is issued, that's when your holding period is going to begin, for the testing and for that holding period to reach that more than five-year holding period. So, it is really important to make this determination. Is this instrument debt or is it equity? When does the holding period begin?

Also, note that we have seen there are times that a partnership might issue a SAFE agreement, which is fine, they can do that, but I just want to note that having an investment in a partnership interest, you wouldn't be eligible for Qualified Small Business Stock exclusion, because again, Ben mentioned in the beginning, it has to be an investment in a C corporation. So, if you have a SAFE that's in a partnership, the rules are different there. So, the third option is where the SAFE agreement is treated as a variable prepaid forward contract. Here, Revenue Ruling 2003-7, are the typical terms or features that we would see to determine and say that this is a variable prepaid forward contract, where it's essentially, an advance.

They're paying cash right away, but the actual shares are not delivered until a later date. If these certain features that are listed here, it may be considered a variable prepaid forward contract. It's important, because if it is, then there's different tax rules and different treatment. If that's the case, then when you're making that payment, it's really just considered an advance. It's like a deposit and it's not taxable to either party. It's when the shares are settled that you're considered to actually have a sell transaction and that's when the holding period would begin. That's important for us, because that's when it's considered too that you're actually holding equity, you own it.

A holding period begins and then you can determine Qualified Small Business Stock exclusion and any preferential tax rates. So, again, when you first make that payment, it's not an immediate taxable event. It's when the shares were actually delivered that it would be taxable. So, we wanted to just go into the SAFE agreements. It's coming up a lot, especially in the venture arena, and it's important to understand the terms to determine how this should be treated for tax purposes. The good news is that most of the post-money valuation notes, which we've been reviewing lately, seem to point to equity treatment. They'll write in the terms that both parties are agreeing to treat this as equity and that it would also be eligible for Qualified Small Business Stock.

So, definitely look out for that and we read all the agreements to make sure that we're comfortable taking the position and that it's treated through equity, which will impact the Qualified Small Business Stock exclusion. Okay, so the next topic we want to discuss is Section 1045 rollover. Again, this is an area where we've been seeing a lot more attention than we have seen in the past and it's actually quite surprising because it's not easy to accomplish. In order to make this election with a rollover provision, you have to be holding good Qualified Small Business Stock for more than six months, sell it, and reinvest those proceeds within 60 days into a replacement Qualified Small Business Stock in order to qualify.

So, that's not easy to do, but we are seeing it and I'm seeing it come up more in the venture fund space where they allow recycled capital. They will get the timeline right to actually reinvest within 60 days. But if they can, then this is the opportunity where you have the original Qualified Small Business Stock, but you didn't yet hold it for the five-year period. This allows you to continue and potentially receive that exclusion in the back end and make a rollover investment. So, I want to just focus here for a minute. Just because you do this rollover, not necessarily will be 100% deferred.

If you don't reinvest the full proceeds, there is a limitation and it says here, "There's recognition of gain to the extent that the amount realized or sell proceeds exceed the cost of your replacement stock." So we have to be careful and there is a calculation to be done to determine the amount that is tax deferred and the amount that may be taxable. So, let's just go over an example just to illustrate this point. So, in example one, January 2022, A purchased eligible Qualified Small Business Stock for $2 million. Eight months later, which again, that's key, because that means he held the stock for more than six months. So, we're eligible now to make the rollover potentially. A sold that stock for $3 million.

So, A is going to have a gain of $1 million. He got $3 million of proceeds, less $2 million of basis. So, he has a $1 million realized gain. Now, within 60 days, A rolled over the investments, the proceeds, and purchased a new Qualified Small Business Stock investment for $3 million. So, he met that the original stock was held more than six months, and within 60 days, he made this rollover investment. So, if he makes the selection, what amount could A defer and not have to pay taxes in the current year in 2022? That amount would be $1 million tax deferral, because A received $3 million of proceeds less the replacement stock, which was for the full $3 million, $3 million proceeds less $3 million cost replacement stock is zero.

So, there'd be no recognition, no current recognition, and the full $1 million gain would be able to be deferred. It gets deferred into new stock, which we'll talk about in a moment. So, here they got 100% deferral. Now, if we're looking at example two, it's the same facts as before, except that now he purchased new Qualified Small Business Stock for only $2.5 million. So, in this example here, again, if you're taking the $3 million of proceeds less the replacement cost of $2.5 million, he would have to recognize tax gain of $500,000. Of the $1 million realized gain, $500,000 would be tax deferred and $500,000 would be taxable currently. So, there's that limitation and you need to do the calculation.

Now there's some other requirements in 1045, where of course, you have to be eligible taxpayer, the same Section 1202. You have to actually file and make this election with your tax return. Section 1202 that's actually made, it's an exclusion that you take at the back end when you're selling, but this election has to be made up front in the year that you're going to have this gain deferral. There is no limit to how much you can roll over and you can even have a sell of stock and roll it into multiple replacement Qualified Small Business Stock. Now, similar to like-kind exchanges, there is a basis adjustment that has to be done when there's non-recognition, when there's a deferral of gain.

So, a gain that is not recognized because of this rollover provision, that gain is applied to reduce the basis of the replacement stock preserving any gain similar to 1031 exchanges. So, in our same facts, the same example, if we had $1 million that was deferred, we would have to adjust our tax basis by $1 million. So, if the replacement stock costed $3 million, then less the $1 million of tax deferral, your adjusted basis will be $2 million. So, that's how the gain is preserved and you would have to track that. Your rollover basis would be reduced for potential future calculation of gain, unless you actually have the exclusion in the backend and now you meet the 1202 rules, the Qualified Small Business Stock.

Here's another example with multiple replacement Qualified Small Business Stock basis on all those subsequent new replacement stock, but you can read that on their own. So, we keep moving along. Another important factor is the holding period. So, the amount that's non-recognized for this gain, the amount that was sold, the taxpayer's holding period in the old stock and the replacement stock are determined based on Section 1223, the holding period of property. It has here in exception under 1223 and I put the excerpt out here that specifies and says that for under 1045 for this rollover provision, the non-recognition of any gain that was realized on this property, it shall be included the period for which such other property has been held as the date of such sale.

What that means is that you actually get a tack on holding period from the original stock to the replacement stock, which is really beneficial, right? If you only held the stock for two years and now you're selling, you would roll that holding period into replacement stock. They only need more than three years to go to ultimately get the 1202 exclusion. So, that's important there. Also, the six-month holding period for the original stock that can't tack on. So, be careful with that. Serves your exclusion for qualified-to-own business stock was purchased before September 2010, where maybe it was only 50% or a 75% exclusion. This actually is what preserves that percentage eligibility of exclusion.

In addition, under the holding period rules, it says that when you're measuring the replacement stock's qualification, in particular for the active trade or business requirement, you only measure the first six months of the holding period for the active trade or business requirement, which is a good fact, because the active trade or business requirement is not measured at one point in time. That is actually measured over substantially all of the holding period of the stock. So, what the rules say is you only have to look at the first six months for that trade or business activity qualification. Then if you meet it for those six months, you can roll over and have the deferral on the 1045 rollover. Okay.

Here's another example that's a comprehensive example going over all of this, but you can read that on your own time. I just want to mention that under the code, the Section 1045 code itself is very brief, but there's a really long regulation, very comprehensive regulation that was put out as it applies to partnerships. So, I just referenced some takeaways over here. A partnership that owns Qualified Small Business Stock, the 1045 election. So, they can do that as long as they're following certain procedures and notifies the partners in the partnership. Then the partners could be eligible to defer the 1045 gain as well. Another important factor is that even if the partnership doesn't make the election, the partner can still elect in.

You can have a partnership that sells Qualified Small Business Stock and its partners can purchase replacement Qualified Small Business Stock or vice versa, where the individual is selling stock and then within 60 days the partnership is making that investment. So, there is opportunity here. You can see here in example one, ABC partnership sells Qualified Small Business Stock, and the individual partner who's a partner in that partnership, they sell it in the partnership and then he takes those proceeds. He reinvested individually on his own into replacement Qualified Small Business Stock. He can do that as long as it's meeting the 60-day criteria. That's a possibility. Or you can have an example too.

Sam is a partner in ABC partnership and he sells the Qualified Small Business Stock. He's a partner in ABC partnership. If they purchase replacement Qualified Small Business Stock, he also can be eligible for this rollover provision. So, it's very comprehensive regulation here and this is just the super brief highlights, but it's pretty mechanical at the partnership level. Now, just really two points I want to point out here.

In the regulations for 1045, it actually tells you specifically that the non-recognition limitation, it says here, the amount of gain than eligible partner may defer cannot exceed the partner's smallest percentage interest in the partnership's capital from the Qualified Small Business Stock that was acquired until the time it was sold, multiplied by the partnership's realization of gain. This is actually what I'm pointing to. Remember when I mentioned the carried interest provision? Under 1045 in the regulations, it specifies only a capital interest is eligible for this rollover and it's the smallest interest in that holding period. So, carried interest definitely is not eligible for the rollover provision.

We still have the question on 1202 generally if it would qualify, but here it's very clear that it does not qualify. Now, another item that has come up in reality while we're doing this work for clients is where you have installment sales. When you have installment sales, the interesting fact is if you want to make the gain and deferred gain and you want to do the 100% deferral, you need to then reinvest 100% of the proceeds. But on installment sale, you're not receiving 100% of the proceeds in that year.

So, how is it done? So you're going to have to have the cash to come up somehow with the cash and they don't actually trace it to make the 100% deferral, even though it's on installment and you're not receiving some cash until a later date. So, just look out for that. If there's any milestones or earnouts, you just have to use your best estimate to determine the gross proceeds there. I know that was a lot. Jeff, I'm going to hand it over to you to tell us about some cautionary tales.

Jeffrey Kelson: Yeah, so thank you, Kayla. Wow, that's deep dive into a lot of areas I don't see a lot of day a lot in the tax press. So, here's some traps for the unwary. There's a $50 million asset test that we keep referring to, the tax basis of the assets and less of contribution of property. As you know, R&D expenses have to be capitalized beginning in 2022 on the 174. So, that might now raise the basis of assets where you wouldn't have been able to expense them before and not have it factor in. But by the way, and same for bonus depreciation face outs, but there's a bill right now, as of yesterday, that I saw a bipartisan bill that's interactively trying to get the 174 deduction reinstated for 2023 as well as the bonus depreciation phase out to be eliminated for 2023. Stay tuned.

We're in the wacky world of taxes. Anything can change, but yes, that has hurt the qualification of 1202 for $50 million. Net operating losses, this gets very little discussion. There's a Section 172(d)(2)(B), that says if you recognize a 1202 gain in the year, you have a NOL carry forward. To the extent you have an NOL carry forward, you wouldn't be allowed to benefit from the 1202. So, the saying that you can't have that then be offset, it would be offset by the NOL basically. Also, if you incur or realize the 1202 gain in the year you have a loss, to the extent you have a loss that limits your 1202 recognition. Two traps for the unwary in that provision, in that code section. Yeah. Also, be aware of the state treatment of Qualified Small Business Stocks.

Certain states do not follow it like California, New Jersey, for example, where New York does. So, your knowledge might vary in the state treatment, but always check what the states are. Future legislation, there's been attempts to limit 1202 benefits. Some of it even retroactively, but nothing has passed, but they constantly nip at it and look at it. So, you also have to monitor legislation and be aware that when you do have a taxable portion of your 1202 because you're held to stock before 2010 runs out, 75% exclusion of 50%, the taxable amount is taxed at collectibles rate at 28%.

So, yeah, you would think it's at 20, but it's at 28. So, be careful of that if you do have stock that was owned prior to 2010, before it was 100% exclusion. It's 100% exclusion, you don't have those issues. So, polling question, what industry you're currently in. You can read them. We have so many questions, I can't even begin to tell you. I try to answer some specifically and some of my other team here, but yeah.

Ben Aspir: Jeff, we got a question.

Kayla Konovitch: Go, Ben. Go for it.

Ben Aspir: No, I was going to say we've got a question. Do asset sales qualify for 1202? The answer is it qualifies at the second level, not at the corporate level. You won't get an exclusion at corporate level, but it would potentially benefit at the shareholder level, second level taxation.

Jeffrey Kelson:It doesn't avoid the corporate tax, it avoids the shareholder tax. So, yes, that's something. So, normally, the buyer wants to buy assets, but if you do that, you are bringing to play the 21% that is not excluded. It's only the shareholder gain when you distribute in liquidity in that situation.

Ben Aspir: It's a home run when it's a stock sale.

Jeffrey Kelson: Go ahead, Kayla.

Kayla Konovitch: Yeah, there's a comment here about if we've heard anything from Washington on eliminating this exclusion. This is something that every few years is back on the chopping board, but I have not heard anything lately to eliminate it.

Ben Aspir: Yeah, they tried to water it down to build back better, I believe. They tried to water it down, 1202. That didn't pass.

Kayla Konovitch: But it didn't go through. No, it's still in play. Still in play. I saw a question here about warehousing and investment, if that would be eligible for Qualified Small Business Stock. That's a really great question. It's not so simple, because when you're warehousing it, sometimes it's warehoused in the GP or an SPV vehicle. Again, there's a question of the original issuance and it may not qualify once it's transferred to the fund. You had to have been a partner in the partnership at the time that it was issued. So, there's a big question here, and we would have to look at the facts of each case's possibility to receive the exclusion.

Again, I see a number here, a question about post-money SAFE. I can't say 100%, but more and more often, we are seeing that the post-money valuation SAFE agreements are eligible for 1202 where they are treated as equity. But again, it has to meet multiple determinations. It's not just one factor and you have to look at all of that qualification. Any other questions that we can take care? I know we're past 1:00.

Astrid Garcia: All right. I'll be closing the polling questions soon. Make sure anyone that's missing to submit their answer hits the submit button. Give it a few more seconds.

Thank you, Astrid and Megan. Kayla and Ben, that was sensational. I learned from these guys. So, great job. 1202 is a gift that keeps giving, but you have to be very careful and you really got to do a deep dive into the rules. So, we got national service, professional services, nice mix.

Ben Aspir: Yeah, nice mix. Like Jeff said, we tried to answer as many questions as we can. If we haven't, we'll go back to you afterwards.

Jeffrey Kelson: Yeah, we appreciate the engagement. It means you guys are interested in the subject and we appreciate it. It's a lot to unpack.

Astrid Garcia: Wonderful. Well, thank you so much.

Kayla Konovitch: Thank you, everyone.

Ben Aspir: Thank you, everybody.

^{Transcribed by Rev.com}