Maximizing The Qualified Small Business Stock Exclusion | Section 1202

Our position is if they're married filing jointly, most likely it does not double. It's $10 million for a couple because the code specifically says it's $5 million per spouse. The exclusion for 1202 is dependent on when the stock is acquired. As you see on your chart in front of you, it goes from 50% all the way up to a hundred percent. If the stock is acquired in the 50% or the 75% bucket, the part that's not excluded is taxed at 28% at a high level. Here are the requirements to be eligible for 1202, and if you look at numbers one and two, those are the corporate level requirements and three through five are the shareholder level requirements. It must be issued by a domestic corporation with less than 50 million in assets tax basis. And we'll actually talk about, Jeff will talk about if you have contributed assets. This is treated differently. It must be issued by a corporation that uses at least 80% of its assets in active trader business. Number three, it must be held by a non-corporate taxpayer, so another C corporation cannot hold it. However, and we'll talk about this in further detail later. Partnerships and S corporations qualify potentially as holders of QSBS. Number four, it must be acquired by the taxpayer on original issuance. And last shareholder level requirement is it must be held for more than five years.

The active visit requirement is an area we see some taxpayers get tripped up on, and it has to be monitored throughout the holding period of the QSBS. At least 80% by value must be used. The assets must be used by the corporation and the active conduct of one or more trader businesses. And I'll go into greater detail what a qualified trader business is, but if a company is holding significant amounts of cash, they could get tripped up by this revision. There are carve outs for reasonable working capital needs, RD or startup expenses. There are also limitations on portfolio securities, 10% limit and real estate holdings. We're going to move on to our second polling question. Do you currently own or plan to invest in stock that may be eligible for the section 12 two exclusion? Yes. No. Or are you unsure? I'm seeing lots of good questions here. Some of it we'll be answering as we go further on.

Jeff Kelson: Can the holder be a trust in addition to a partnership S corp? Yes, can be yes. Would a gift to these stock allow the person receive the gift to shares to be qualified? Generally speaking, yes. We cover that later on.

Kayla Konovitch: There's a question here. Can a non-US person qualify for the exclusion? Typically, capital gains are sourced to the residency country, so they're not usually taxed taxable here in the us so then they wouldn't need the exclusion, but we should look at it. But generally for non-US, you wouldn't need the exclusion.

Ben Aspir: This is also image fairly across the board qualified trader business. This is one of the areas we get lots of questions on and what the tax code doesn't tell us is which businesses are eligible. It tells us which business aren't ineligible. And you'll see a theme throughout these bullet points is primarily service type of businesses like accounting, US law firms, engineering, hospitality businesses, hotels and motels and restaurants, businesses such as oil and gas, many in the finance area. A lot of this is nuanced and there've been letter rulings talking about whether business are qualified or a qualified trader business.

So whenever we get rulings in the 1202 area, we get excited. There's very little guidance on 1202. While these private letter rulings are requested by specific taxpayers and it's only binding to them, they can only use that for their position. It does give us guidance to the IRS's thinking on a potentially gray area. These last two letter rulings we might not see much for a while based on this revenue procedure 2024 dash three, and they actually said they're going to stop issuing letter rulings on the active trader business requirement until the IRS issues either revenue rulings, procedures or regulations. So these two letter rulings, the first one on top, both were favorable. Like I mentioned, the IRS ruled that they were not a consulting business which made them eligible. It was a staffing company and an executive search company. And since even though they, even though its services were used to implement business plans, they didn't have any control over the employees. And so the IRS ruled favorably for them. And the second one, it was a medical diagnostic company and since they were not making any diagnosis or treatment and they were not giving medical advice, the IRS ruled that even though they were in the medical space, they were not an ineligible company performing health services.

The original issuance requirement, it must be stock issued directly from the company. You can't purchase it from another shareholder. Obviously you're allowed to do gifts, we'll talk about that. And it has to be acquired in exchange from money property or compensation from services. And the holding period begins on the date of issuance. So another area, we get a lot of questions on stock options. Stock options do not qualify as QSBS until they're exercised and the period prior to exercise needs to be tested to make sure they eligible that it met all the requirements for 1202 with restricted stock until the shareholder has the unrestricted right to the shares. The clock does not start ticking on 1202. However, if they make an 83 B election as a potential planning tool, once the A three B election is made, the holding period tick starts to tick. Safe notes, kale is going to talk about that. Stay tuned. And if you convert convertible preferred stock, the common stock, the holding period tax as well, I'm going to turn it over now to Jeff to talk about property contributions.

Jeff Kelson: Thank you Ben. So property contributions, let's talk about that for a second because you get tax basis when you contribute property to a company is a carryover basis. But for, and that's still the rule, right? But for 1202 things come into play when you make property contributions. One is that the basis of the stock will not be less than the fair market value. The property you say, Jeff, you just said the tax basis is your basis. Yeah, but for 1202 purposes, 1202 basis, you get the fair market value, which means you can go 10 times when you have the limitation, the greater of 10 million to 10 times your basis. This would represent basis for purposes of the 10 times rule. It's very favorable rule, but that's the flip side. It's also for the purposes of the 50 million test, usually you look at the tax basis of the assets, but when you contribute property to A-Q-S-B-S, you look at the fair market value of that property and determining whether you're over the 50 million in addition to the assets already on hand, which might be tax basis.

So you're adding fair market value of this contribution to tax basis to determine if you're over to 50 million. So it has a good function and it also can trip you up over to 50 million. Also, bear in mind that that delta, and we'll cover it in an example between your basis and the fair market value, that if you ultimately sell that QSBS, you will recognize that gain on that built-in gain in the property, you don't get it excluded because you contributed it itself on the general tax rules. And so you see this a lot when an LLC converts to a C corp by check the box. This is where a lot of the property that's deemed to be a property contribution. Let's go to the next slide. So let's get into this. All right, this is where the rubber hits the road. Should you convert a patch through entity?

Let's talk about partnerships for a second. How you do it first of all is either do a state law conversion into a C corp or check the box in a form 88, 32. Pretty straightforward for partnerships, LLCs. But bear in mind that at that moment is when your QSBS holding period begins. So if you held the LLC for 15 years, but then you check the box, the running of the five years begins at the time of checking of the box, you don't get tacked on to just your ownership of the LLC. The 50 million gross asset test must be considered because as I mentioned in the previous slide, when you convert your LLC to a C corp, it's measured by the value of the property, the value of the LLC upon conversion. So you'd have to get a valuation to make sure you're under the 50 million. In addition, that's important.

And also that also, like I said, the good part of that is that you get your basis for 1202 purposes for purposes of doing the 10 times basis exclusion at fair market value, not your tax basis. That's the normal rules, but for just 1202 basis for claiming additional exclusions and in addition, very important, but you only measure only eligible for 1202 exclusion from the moment you convert the LLC to a C corp to the data's sold. So you don't get any built-in gain at the LLC. It's only the appreciation after the conversion. Let's look at S-corp. Not a straightforward, you revoke your S election and become a C-corp. That's not an original issuance in the partnerships. It is original issuance when you check the box, but not for S-corp when you revoke the election. So you got to do more scrambling and there was a court case letter case where a S corp merged into a newly formed C corp and they said that was akin to revoking your election.

That's not a new issuance to shares and therefore you do not qualify. So to convert your S corp to a qualified small business stock usually involves more structuring, maybe an F reorganization where you set up a NewCo. So just bear in mind that simply revoking your S selection is not deemed to be an issuance, original issuance of shares and the S corporation, you have to go through a few steps and again, like the partnership, the holding period begins at the time of the conversion for the five years. And the $50 million test also would include the value of the S-corp that you're converting, not their tax basis. And again, only post conversion appreciation is eligible, not any built in gain that the S corp is ahead. So that's the rules. Now let's talk about whether you should do it or not, right? First we got an example.

I think this is a good example. In January of 2010, Jane and John, a former 50 partnership, ABC LLC, pretty straightforward. And four and a half years later they decide to convert to a C corp, want to be a qualified small business stock. And normally by the way, when you and I mentioned the F reorg for the S corp, you usually have to have a business purpose other than tax. But okay, let's get back to this. So here as an LLC, they convert, check the box, and now the fair market value, the time that they check the box is 7 million and they had no tax basis. Alright? So it's a $7 million built-in gain. So a b, C stock assume we assume meets all the requirements. 1202 has an active traded business, has a qualified traded business, and then 10 years later, all the 10 years later from their conversion it sells, Jane sells her share the stock in the ABC corp for $50 million.

So for tax purposes she has a $50 million gain. You all agree to that, she has no basis and sold it for 50. But what happens? Well she has a 50 million long-term gain, but what's eligible for exclusion? First you look at 10 million, the higher off 10 million or 10 times her 1202 basis section 1202 basis not tax basis. Well her 1202 basis was 7 million, excuse me, half is 7 million, three and a half million. She was 50 50. So she can exclude up to $35 million. That's higher than 10 million. So she'll go with that number. So what happens first she must pay tax in the first three and a half million a gain. Why? Because when she made that contribution, she had a zero basis for tax and a three and a half million dollar value that is not eligible for 1202 exclusion, as I said in a few times already.

So she has to pay tax into three and a half million because that was not appreciated while she held QSBS stock, she could then exclude her 35 million, right? That's good. And then that should limit, right? So then anything else is taxable. So she's already picked up 38 and a half million, three and a half that you're paying tax on 35 that's excluded and there's 50 million of overall gain. So she'll pay tax on the additional 11 and a half million. So overall she saves tax of 8.3 million, which is the $35 million exclusion at 23.8, which is a 20% long-term capital gain rate and the 3.8 investment income tax. So that's how it works. So you see, this is a good example illustrating that the built-in gain doesn't apply, then you apply the exclusion and then if you're limited on your exclusion, the rest is tax. Now if she had an installment sale, which you typically see in m and a where she's receiving funds and following years, maybe they're guaranteed to receive them or it's based on symmetric, there is some gray area around whether you would assign the QSBS to the monies received in the first year like in a FFO basis or whether you would pick it up pro ratta over the installment sale.

So there is sort of a gray area in that. And so that's generally how it works in an example, which is always good to see.

Now, now I come to should you or shouldn't you? So should you remain a pass through some occasions the answer is yes. Some occasions the answer is no, but let's go through what's the questions? Will you sell the stock on an exit? Why is that important? Because 1202 only exempts the outside gain from tax to the extent you're eligible. The inside gain, since it's a C corp and the current tax rate is 21%, that's permanent right now unless they change it, is still going to pay tax inside. So it's not a protection of both gains, it just shelters the outside gain.

So you see if you have an asset sale, which a lot of buyers want or desire because they get a step up in basis, there is a tax to pay inside. Could you have gotten a QBI deduction? Most likely if you're qualify for 1202, you probably qualify for this what we call this qualified business income deduction section 1 99 cap A, which could reduce your pass through tax from a high of 37.6 to just under 30%. So that's a benefit to remaining a pass through in a way also as a pass through any undistributed income, taxable income increases your basis. You don't get that in the C corp, right? It just stays in the C corp and that's life. You don't get an increase in basis if there's any distributions coming out of a pass through, it's a return of basis and LLC or an S-corp, right?

To the extent you have basis in a C-corp, it's a taxable dividend subject to current tax at 23.8. If you're an active owner in an LLC or an S-corp and you have liquidity event, you may only pay 20% tax right now capital gains because if you're active, you're not subject to the net investment income tax right now. So that's not a bad result paying 20%, especially with the things I just mentioned before, getting that reduced rate on the QBI getting basis step up from a distributed income, but we understand the individual rate is 37%, so it's higher than the C-corp rate of 21, but like I said, that might be lower because A QBI and you might be getting step up in basis through various mechanisms I discussed and you could have a bad scenario if you convert a pass through to A-Q-S-B-S. Think about this, you convert it, you have a sale of assets in less than five years sale of assets and you don't roll it over into 10 45, you might result in a double tax, the inside 21% and the outside tax at 23.8.

So it could be a bad result. Also be mindful that losses in C corporations only can carry forward, whereas pass through owners can enjoy the losses subject to certain limitations on the 4 61 L. And there's also when you're selling LLC, there is a bit of hot asset recapture cash basis receivables and recapture depreciation. It's not applicable to C corp. So there's a lot to think about. It's not like a black and white issue. It's something that if you're going to convert, you really have to think through these questions, maybe even model it out. So yeah, that's on the converting of a path, not setting up a company initially. Setting it up initially might be easier to go straight to qualified small business stock. But again, you might have to consider the benefits of pass throughs. So this is not the best thing that ever happened. It's a very good 1202 is a very good section for certain individuals taxpayers, but it's not for everybody. So poll number three, that's contribution of appreciated property with no tax basis create section 1202 basis for purposes of the 10 times basis limitation, yes or no. So I know we're getting a lot of questions coming in. If anybody

Ben Aspir: Here, we got a question about single member LLCs. Yes, a single member LLC can hold qualified small business stock. You just need to be careful if you add a partner, it could ruin the 1202 status.

Jeff Kelson: It has somebody, what happens to a shareholder that contributes cashed after the first year? We're going to discuss that a bit in what we call packing, but you must get more stock for that. It could increase your basis for 10 times.

Kayla Konovitch: We have a great question here on what documentation do you need to support Qualifi business stock? That's actually a really good one because we have been seeing lots more audits coming in on QSBS than we have seen historically and it usually starts at the individual level where they're taking the exclusion and it's pretty robust. They want to see eligibility that's showing that they meet the $50 million test. They want to see balance sheets at least on an annual basis to prove, well multiple tests, you would have to look at the balance sheet for, they're pretty, they want to see the original purchase stock purchase agreement. They would also want to know which shares you actually sold because they know that you may own other shares. So they want you to identify with shares. They're pretty specific in looking over QSBS. So it really is important to document,

Jeff Kelson: I guess a rule of thumb is to get your qualification contemporaneous, meaning when you embark upon the QSBS that you get a nice memorandum that goes through all the tests to make sure you qualify. And then there's a maintenance rules later on. Ben and Caleb be discussing that. Make sure that you continue to qualify. Do we have the results on this almost yet? And the answer is yes. Almost two thirds got it right? Yes, it is sort of a unique twist after 1202 purposes. If you contribute property, it goes at fair market value and that helps in the 10 times basis, but it can also break the camel's back if it's over $50 million. So it can kind of go both ways with you, but as far as a 10 times basis, it definitely helps.

So I just want to give some words to the why's or things to be mindful of. While qualified small business stock is great and you own it, if you contributed to a partnership, you taint the entire qualification because in section 1202 it prohibits transfers to partnerships. So you might think you're doing a good thing putting it into a partnership, maybe taking on some other folks even though they weren't qualified because they weren't there when you bought it. But in essence you've tainted it, it's a very bad result. So be very careful about contributing qualified small business stock to a partnership also. But however, if you get a distribution from a partnership to a partner of qualified small business stock, that would be okay because getting closer to the source, to the individual. So that works. Just don't put it into a partnership. You can take it out of a partnership and there's a lot of stuff to consider in that.

Anyway, contribution to a disregarded entity is okay because it's disregarded bequests gifts, that's okay upon death or making a gift that retains its qualified small business stock. I'm not going to spend a lot of time in distribution to s from and to S-corp because you probably wouldn't want to distribute appreciated property from an S-corp because that invokes a gain contribution to an S-corp. I would not. You don't want to fool around with qualified small business stock. If you have it in an individual's hand, don't be contributing except if it's gift or that's okay and a conversion of a disregarded LLC to a partnership, you would also not retain QSBS because that's akin to contributing to a partnership see the first line. So be very careful what you do with the qualified home business stock. Okay, and

Kayla Konovitch: So

Jeff Kelson: Now we've got Kayla's going to take you through the rest.

Kayla Konovitch: Okay, so carried interest is a key component in the alternative investment space, right? For private equity funds and venture funds, carried interest is essentially a share of profits from an investment that is paid to the fund manager as an incentive. So the question here is if you receive an allocation of capital gain that is carried interest, is it eligible for this exclusion? Now if you recall earlier, Ben actually mentioned that you could be a partner in a partnership and qualify for this exclusion and it says that partners, right? If you hold a partnership interest, you can be entitled to a pro ratta portion of the gain. And if you were a partner at the time, the partnership acquired the stock and through the holding period until the date of sale. So it seems that a partner can qualify. Now when it says when you have a partner that has an interest in a partnership, there is no definition on what a partnership interest is.

Does that cover a profit's interest or is that really just a capital interest? So that is a question here specifically on section 1202. Again, the language is ambiguous. There are no regulations or a case law on it. And if we look to the sister provision section 10 45 where you sold good qualified small business stock and you rolled it into another qualified transaction, the treasury regulations there, and we'll cover this a little bit more later, but the treasury regulations there clearly say that only a capital interest is eligible for the rollover exclusion. So do we have to apply that or is that the intent of what they intended on the 1202? There are a lot of questions here if it's eligible or not. It's definitely a gray area and there's commentary out there. Some say it qualify, some say it doesn't. Ultimately it comes down to what level of position do you believe you have to take this position.

If there is substantial authority, which is about a 40% chance of success, then you could take the position, sign the return and you're okay. I mean, it doesn't mean you won't be challenged, but you don't have to disclose. However, if you believe this only comes up to a reasonable basis, which is approximately 20% success rate, then you would actually have to disclose on the tax return in order to sign. So it comes down to a comfort level and where do you fall in on the level of the position on the return. And I want to point out this is not a position taken on the partnership return, it's the fund manager. They should have a discussion between the fund manager and their individual tax advisor because the exclusion is taken on the personal tax return. So that's an important, another item to note is that many times write the general partner, the fund manager may be entitled to carry interest, but it's on, there's a vesting schedule. So when you're looking at this, the carry would have to have been vested at the time that the fund acquired that company, that qualified small business stock. So it's important to also look at what is the vested carry for that acquisition.

Okay. Now another area where we have seen quite a bit of opportunity is when you may own stock in a company and you own it, you've purchased it over time, so you have multiple lots. There is an opportunity here really to optimize and determine if you're going to do a partial exit, which shares should you sell right By default. The method is that you would do first in first out, but what if the earlier shares they didn't yet hit the five-year period? And if you're going to sell those first, those are the ones that are soonest to hit the five-year mark. So you might want to optimize and sell shares that you bought at a later point in time. Now you have to be careful and model out in a couple of different scenarios because there could be shares you bought more recently and they have a higher cost basis.

So there wouldn't be as much gain if you sold those now, which may be helpful, but maybe it's also going to be short term. So you have to really do an analysis to figure out which tranche of stock does it make sense to sell in order to preserve qualified small business stock. And again, at the time of the transaction, you would have to specify and identify those specific shares and they need to be documented. And we've seen the IRS inquire about this. So it's important to have the documentation. Now what this can do is really multiple levels of strategy is that you're optimizing the five year holding period to preserve that piece. You can also do an analysis on the 10 times the basis. Ben mentioned this earlier in the overview, 10 times your basis or you can get a 10 million lifetime exclusion. So there's certain planning and opportunity here in order to maximize the exclusion. So it's important that you do some sort of scenario modeling to maximize this exclusion.

Okay, the safe agreement safe is a simplified agreement for future equity. This is a very common instrument that's used in the venture capital space. This was put out by the Y Combinator back in 2013. And essentially what it gives is an easy way for a startup company to fundraise. It's essentially a contract between the startup company and the investor where the investor pays them money upfront and they receive, the investor receive shares at a later date either upon an equity financing or the sell of a company. This has become very popular and as much as it's super simple from a legal perspective, it is more involved from a tax perspective. So the safe agreements, they generally do not have a maturity date and they do not accrue interest. And that's important because that's part of the analysis to determine is this debt or is this equity?

I have seen some, I've heard that some people have added on some sort of signed letter agreement with the safe to actually charge interest. So important that we're really looking at it because that can actually then change the character of what this agreement is. So it's important to look over the features, what are the terms, what are the rights of this agreement so that you can then determine what the characterization is. So the three general ways to classify this for tax purposes are either it can be debt, it can be equity, or it could be a variable prepaid forward contract. And depending on what the characterization is, that's what we can then next determine. Is this an instrument that's eligible for qualified small business stock? So debt versus equity, it's in a fact-based analysis and there is a revenue ruling that goes through 10 different factors that help you determine whether it's debt or equity. Obviously things like a fixed maturity or enforcement to pay and interest are indicators that it may be it's debt, but you do need to look through all the features in order to determine this analysis of debt versus equity. If you determine that this instrument is debt, then there wouldn't be QSBS eligibility because it is a debt instrument and you don't actually own equity in the company A.

Now if you're doing the analysis and based on the features, you determine that it's equity, suppose it may have rights to dividends or it clearly shows that they're junior to any debt holders and other factors that point to more equity like features. You potentially can make a case and say that this instrument should be treated as equity. And that's really important because if you get to a position that it's equity, then first of all for holding period to get to long-term capital gains, you can get there sooner. And for QSBS, essentially that's at the time of grant of this note is when you would actually consider to hold the investment and that's when you do the testing of qualified small business testing and the holding period would begin. So it is pretty key, right? We want to start the clock right away. So it is key to determine if this agreement is really equity.

More and more we're seeing when we're reviewing these agreements that most of them are based on post money valuations and the features are much more equity like. So we're seeing more of these that are equity. There's actually also sometimes you'll see a provision at the end of the agreement that actually says that both parties intend to treat this as equity. So that's good, but that's not determinative that this is equity. You still need to go through all the features of the note to determine that it supports that equity position, but we are seeing more of this now.

And then the third option is, is it a variable prepaid forward contract? And there specifically, there was a revenue ruling on it that actually said if it's a variable prepaid forward contract, then it's not considered to have a sell upon the issuance. Meaning when you paid the money, it was just upfront, it was more of a deposit and at a later date is when the sale actually occurred, when you actually receive the shares of the company. So essentially when you're paying it, it's really in advance or a deposit, it's not a taxable event, but once you actually receive the shares, that's when you own equity. So again, that's important because from a qualified small business stock perspective, then if you have a safe that's really considered to be a forward contract, you wouldn't have eligibility on that date. It would only be that you would test once you actually receive the shares of stock. So it really in summary here, either it can be debt, but then there's no QSBS eligibility. If you get to position of equity, that's when you do the testing and the holding period for QSBS. And if it's a board contract, then again at that time you're paying the cash. No style occurred and there's no QSBS eligibility until you look at it at the time of receipt of the shares.

Ben Aspir: So redemptions redemption is an area where we've seen shareholders and corporations, they've made it through 95% of the marathon and then we find out that they've made redemptions that may disqualify all the shares issued or shares issued during the time period. So there's two types of disqualifying redemptions. Essentially this is an anti-abuse rule. They don't want shareholders swapping out non QSBS for QS based on the corporation, the first type, there's a four year testing period, two years before and two years after. And more than 2% of the shares are redeemed by value and the greater of 10, $10,000 or 2% by value, all those shares are tainted and are not 1202. The scarier one, the second one is a significant redemption if during a two year testing period one year before and one year after more than 5% of the value of the shares are redeemed during that time period, all the shares, regardless if they weren't redeemed, all the shares during that two year testing period are tainted and ruin their 1202 status. So this is an area we also get a lot of questions on and certainly to be aware of if you're considering any sort of redemption redemptions related to termination of services or death, disability or divorce, those are ignored and would not taint the QSB status. I'll turn it over to Jeff to talk about stacking and packing.

Jeff Kelson: Thanks Ben. Stacking and packing besides rhyming, they have some impact on 1202 planning. So stacking stands for stacking the $10 million exclusion. So say you own and you limited the 10 million. There is a methodology where you can make gifts to eligible individuals in certain types of trusts where that the separate taxpayer would get their own $10 million exclusion. So say a child. So you could have the parent and the child getting $10 million each, or if there's two children giving certain types of qualifying trust to each child might be able to get 30 million. That's called stacking the ability to stack the $10 million exclusion. Packing is packing more into the basis, so you might have someone who owns the stock and makes additional contributions of property to the stock for additional shares. Now there are 10 times multiples now increase of course, but if a market value of that second property contributed, but of course the holding period for those shares would begin on that date.

You'd have to start the five years. Where we see that there's opportunities is you might have someone with two qualified small business stock, one has already crystallized and it's been over five years and the other one and has a big gain and the other one isn't really done much. If you sell both in the same year, you can combine both bases for purposes of excluding on the bigger gain. So if you have 2,000,001 QSBS, it had a $30 million gain, you have 2 million and another one that's not even met to five years, not even appreciated. You sell both, you can use the 4 million and exclude 40 million of the gain on the bigger one that's called packing. So there's a lot of planning around exits. So just bear that in mind. Kayla, I was going to take you through the 10 45 rollover.

Kayla Konovitch: So thanks Jeff. So as I mentioned earlier, section 10 45, so this essentially is when you have good qualified small business stock, you held it for more than six months, but you sold it before you hit the five year period. So you're not quite there yet with the five years. However, if there is an opportunity, if you make an election and you reinvest those proceeds into another qualified small business within 60 days, then you actually can have two benefits. One is you can get a tax deferral and two is that you could continue the holding period will tack to the replacement stock and you could potentially get the exclusion on the backend. So this is a really great provision. Honestly, it is not easy to effectuate because you have 60 days to close your next deal and reinvest the proceeds. But we do see it every now and then coming up in the venture capital space where we have a venture fund and they do have a provision that allows them to recycle capital.

So in the early years, maybe it's year one, two, and three, they're still in the investment period and they had an early exit, they may take those proceeds and immediately reinvest it in another qualified small business. So there is an opportunity there, we've seen it on some of our funds. But it's also important to note that just because you reinvest the proceeds, it doesn't mean you get a hundred percent deferral in order. There is a limitation. So to get the a hundred percent deferral, you have to reinvest the full sale proceeds into the replacement qualified small business stock. And if it's not the full amount, then there may only be a partial deferral there.

Okay? And then also as I mentioned before, under section 10 45, there is a clear distinction that qualified small business stock to do this rollover provision, you're only eligible on this rollover on a capital interest. So clearly a profits interest would not be eligible for this rollover provision. So it's very clear here and that's why part of what begs the question on the carried interest. But for 10 45, it's definitely not eligible on profits interest or carried interest. It must be a capital interest and it's your smallest percentage holding of the capital interest throughout that holding period. So keep that in mind as well. Another nuance here is if you're doing this rollover provision and you had a sell that is utilizing the installment cell method, in order to get a hundred percent deferral, you would have to reinvest a hundred percent of the proceeds. However, because it's installment cell, you didn't receive all the proceeds yet. So there's a little bit of an outlay of cash that has to happen, but there is no tracing rule. So you can take cash from another investment or somewhere else that you have the cash and roll it over into this new qualified small business to get the a hundred percent deferral. So that's a key item to look out for to maximize the rollover provision.

And we have a polling question. Are you considering converting a pass through entity to qualify for QSBS? Yes, no or undecided. Looking over here at some questions that were submitted, going back to the safe agreement for a moment in order, the first thing you need to determine is what is this instrument? There are questions on which date do you use the date of the instrument when it was granted to you or in the conversion date when it converts to shares. So the starting point first is the safe agreement considered debt if it's debt and then you have a conversion. Ben mentioned earlier that the date of the conversion is when you will look at the measuring and the holding period. But again, if you're determining that the safe agreement is considered to be equity on the date of grant, then your holding period begins immediately and that's when the testing is done. So that's why it's important first to understand what instrument you have, what's it considered to be, and then you'll figure out the holding period from there.

Ben Aspir: Someone asked, is there a difference between redemptions and a share Buyback likely, not likely would be treated the same way if the share buyback the redemption rules would apply. If one holds 1202 and the company goes public with the 1202 qualification remains a very good question. Depending how the IPO was structured, it could still retain its 1202 status. There's some high profile could companies that went public and the original shareholders ended up excluding a significant amount of capital gains from their taxes,

Jeff Kelson: You would still qualify up to the date that it possibly went public, right? That would still be available. Worst case.

Kayla Konovitch:

Okay, so most of you yes, are not considering, yeah, conversion.

Jeff Kelson: I scare 'em.

Kayla Konovitch: See where?

Jeff Kelson: All right, so we're going to spend just some time on traps for the unwary things to be on the lookout for. Then we're going to look at some of the questions and the panel's going to try to answer a few of them to help give some more color. The $50 million asset test now is becoming a little harder to qualify for because remember, assuming that everything was put into the company at say cash, your tax asset basis cannot be more than 50 million right now you're required to capitalize RD expenses. So that could make your tax basis higher than it used to be before TCJA. So that could make you break or pass through to $50 million threshold quicker. That's started in 2022. Same with the bonus depreciation being phased out. Now for five years, you might find that the fixed asset basis of your assets, fixed assets might get quicker up two to $50 million threshold, especially combined with the RD and of course additional capital infusions.

So you always have to be where the 50 million asset test and remember that contribution to property does not go into a tax basis. It goes in a fair market value like LLC conversions, some other things as I keep beating on this horse, but whether you're going to have a stock sale, ultimately an asset sale would be very determinative whether you want to go for qualified small business stock qualification. And something I haven't gotten a question on I see, but we haven't mentioned is that operating loss carryovers. This comes some traps in 1202 that aren't actually in section 1202. There are section 1 72 where if you have a exit of a qualified small business stock and also the individual has NOL carryovers that you might find that you're not getting the full benefit of the NLS because to the extent that you have 1202 gain, the NLS get absorbed and you don't get to carry it forward.

So even though the 1202 gain is not taxed, it absorbs the NOL carry forward trap for the n wary. Also, if you have a loss in the year that you have a 1202 realization event, you might find that that would limit your loss coming out of the year. So you got to be very careful in timing sales of qualified small business stock with certain individuals who might have situations where they have NOL carryover to the year or LS incurred in the years that they might not get the full benefit of that 1202 stocks. They've done everything perfect until it just happened to be a bad year to sell it. State treatment, as Ben mentioned, you want to make sure that some of the states, what they do with 1202 like New York allows excludes 1202. California does not. So many states, I think the preponderance of the states follow, but there's many that do not.

New Jersey is another one that does not follow 1202 Pennsylvania as well. Keep on the lookout for future legislation. There was an attempt to sort of retroactively terminate 1202 that never got passed, of course. And right now in the legislation, I don't see it on the horizon, but you never know. And one other thing that we didn't spend a lot of time on, if you have a qualified small business stock that goes back before the year 2010 and you're not getting a full 100% exclusion, you're getting 75% exclusion to 50, you might find that it's not 75 or 50 because the portion of this tax is taxed at the higher 28% tax rate rather than 20. So you might find that an exclusion is not really a 50% exclusion. It's like 30% of taxes to you at the collectibles rate, like artwork or something, just quirk in the rule and the 1202. So certain things to look forward, look out at this is traps for the unwary and things to be very mindful of. So you want to go with some questions, Kayla?

Ben Aspir: Yeah, someone asked about convertible notes. The five-year holding period does not start until the note is actually converted. What else do we got?

Jeff Kelson: Pre-conversion? Can you only use debt to reduce the fair market value? Yeah, but you're also putting less putting into the QSBS, so there's a price to pay for that. But yes, that would limit, and we've seen that. We've seen companies take out assets of what they're contributing to A-Q-S-B-S or converting to make sure that they do not violate the $50 million. So yes, it is good planning

Ben Aspir: And we like to point out that 1202 is not an election, it's an exclusion. So if it's missed and you're out of the statute, you're out of luck. Whereas 10 45, which Kayla spoke about, is an affirmative election that they have to make on their tax return.

Kayla Konovitch: And in terms of documentation, we have another question here that we're focusing on the entity, what's the backup documentation at the individual level? The entity itself, again is not the one that takes the exclusion, like Ben just said, it's at the individual level that you're taking the exclusion, but in order to support the position, it's important really that some sort of analysis and memo is done in order to support the position. Again, we are also seeing the IRS auditing this and as we know, the burden of proof is always on the taxpayer. It's hard for the individual just to be able to document all of this. You're going to need the help from the company. A lot of these tests are tests that are measured at the company level. The tests that are measured at the individual level is did you meet the five-year holding period? Did you meet the original issuance test? So you're going to need, this analysis has to be done in conjunction with the company.

Jeff Kelson: Yes. And what's good housekeeping is to have the company yet a memorandum from a good firm like us or others that they qualify and meet the tests and that not only do they qualify on the date that this individual got issued the shares, but also that they continue to qualify. They didn't have any disqualifying redemptions as been mentioned, or they maintained an active trade of business. There's a lot that maintenance is not a one and done on that. So it's very important that the company gets, some have vetted that they do qualify and continue to qualify.

Kayla Konovitch: Yeah. Another question on a safe agreement. When does the five-year holding period begin? When the safe is signed or when the actual shares are issued? So this goes back to at the time of grant of the safe agreement determining is this debt, is this equity, is it a forward contract? So if it is considered to be equity, then it's on the date of the safe issuance that the holding period would begin. And that's why it's very key because that's the earlier date. If it's considered to be equity, sorry, a prepaid forward contract or even debt, then only until the actual conversion, the shares are actually received, that's when the holding period begin. That's typically done at a later date. So that's why we have this benefit if you can actually get to position that is treated as equity.

Jeff Kelson: Can A-Q-S-B-S eligible security be transferred to an irrevocable trust for estate planning purposes? Yes. We said certain trust. And in other words, is the five year holding period not violated? Correct. Because the gift you would tack on the holding period. That's why you see a lot of stacking, but bear in mind that they're making a gift. It's calm down to someone else, not the original owner.

Ben Aspir: Yeah. Preferred stock was converted to stock as the measurement period when the preferred stock was issued, correct? Yep. The holding period still taxed if you convert it or preferred it to common.

Kayla Konovitch: Okay. And a question here, has the IRS issued any guidance on the treatment of safes? I'm not aware that they have. And the second follow up question is, is the safe, is it more conservative to treat as debt or equity? From a QSBS perspective, if you're treating as debt, then your holding period won't begin until you have the shares. So it's more conservative so to speak. But I don't know if I would focus it in on that at what we try to do is reach each safe agreement to figure out if we feel this is equity so that we know the treatment and the holding period and we can monitor a maximize exclusion.

Jeff Kelson: Objection 10 45. Anything a seller needs to do to segregate the proceeds? No, they just have to invest or reinvest those proceeds into another QSBS. It doesn't have to be earmarked. It could be from anywhere. Just that it equals the amount. Kay. You can take us home.

Kayla Konovitch: Okay. Yeah, there's another question actually on the gross asset test. They're asking about the valuation. The gross asset test is actually, it's the tax basis of the assets. It's not based on the value. So that is a big significant difference. It's based on tax basis and that also provides for more opportunity because of depreciation, your tax basis of the assets may actually be lower, so you may be able to get under the $50 million threshold. So just another key item to focus in on. Yeah, we definitely have some more questions here, but a

Jeff Kelson: VC fund one for you here. If an LP joined at a later closing and the fund had already invested in the convertible debt, the LP be eligible.

Kayla Konovitch: So the way it works is that you have to have original issuance. You have to have been a partner at the time the partnership acquired the QSBS. So whenever that measurement is, that's when you're going to decide on figuring out eligibility and the holding period and original issuance and then separate carry and trust because there's a gp, I think if that answered your question. Okay. So yeah, to wrap up, I just want to thank everybody for joining us today and I hope you found this session to be enlightening and useful and feel free to reach out to us with any further questions or contact is listed over here on this screen, so feel free to reach out

^{Transcribed by Rev.com AI}