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Foreign. Welcome to the 18th episode of How Tax Works. I'm Matt Foreman. In this episode, I will discuss the exclusion of gain from the sale of qualified small business stock under section 1202 of the Internal Revenue Code. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising, and it is not legal advice. Please, please, please hire an attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to help demystify how taxes shape the financial and business choices that we all make. Right, before we get started, let's do some administrative stuff. Episodes in two weeks. All this one's two weeks plus a day, right? And the next one's probably going to be out. I mean, is based on how I broke this out. Qsbs Qualified small business stock again. I know, I know. How exciting, right? If you have any questions, comments, or constructive criticism, you can email me at my FRB email address. You can find that via your favorite search engine. February 17, 1 to 3pm Post Meridian, Eastern Standard Time. I know that's not a holiday, but here we are. Presidents would love you to learn more about how laws shape your life. Right? Revenue ruling 989-5996. If you listen to the podcast, you'll love this two hours. One of the other panelists is Michelle Cable, who's an associate at our firm in the tax group. She's dynamite. Stratford cle. I think you get CP2. There's a link on the How Tax Works website. Now, we got a lot of information. I'm already like a minute in, two minutes in, I guess, whatever it is of yammering. So let's. Let's ride, right? So we're talking about qualified small business stock, okay? So remember, remember, this is an exclusion of income. Ten times your basis or $10 million greater of the two. So it's big. It's really big, right? Let's talk about the original issuance requirement. Ooh, exciting, right? It is issued, as in sold or granted by a corporation. Corporation must be a C corp, right? You cannot purchase it from other shareholders. People are like, oh, well, that's no problem. I got this. I have figured everything out. I am smarter than Congress. I do not doubt that you are smarter than most people in Congress. I do think that Congress has already figured you out, right? What if you do the redemption, right? There's two ways that redemptions won't work. So this is what people say they're going to do. All right, here's what we're going to do. They're going to sell the stock to me. I give them my 100 bucks and use that. A hundred bucks, Boom. Because you can do that. Corporations, you know, companies don't pay tax when they sell their own equity. Then they're going to use that money to redeem these other people. And Congress went, no, no, no, not so fast. There's two ways it doesn't work. One, redemption from a person that is related to the buying taxpayer related under section 267B or 707B. I got the citations right. Definitely 267 and 707. Right. How that works and I'll get into it in a second. But basically what you know, assume related, right? Actually legally related. Children, grandchildren, you know, first cousin once removed I think is as far as. It's probably further than it goes. I think it's just children, grandchildren, siblings, maybe nieces and nephews. I never remember. But I always double check because they're complex. Right. Basically you take the day that the issuance happens and you check two years before and two years after. So it's really four years in one day is a full period. And if there's a redemption from a related person of any amount, there's a de minimis exception. Get to that in a second. But if there's a redemption in any amount, Right. Then you lose QSBS status for any stock issued during that period. Okay, so you look two years before, you look two years after. Right? Four years, a day total, then you're fine. There's a de minimis exception in 1202. One point treasury eggs 1.1202 dash two a one and a two. And if you have multiple redemptions, you know, you look at, you basically add the redemptions together because you want to beef them up. Doing one a day won't really work. This isn't like eins, you can't do one a day. Right. So de minimis exception is the amount paid for in the redemption exceeds $10,000 and more than 2% of the stock held by the taxpayer and the related person is acquired. Right. So if you look at the related person and they sell, you know, $8,000 worth of stock, you're golden, don't worry about it, you're fine. The other exception for a redemption is what's called a significant redemption. Significant, not substantial. Significant probably mean the same thing. But here we are. There's a two year period beginning one year before the significant redemption. So it's really two years, one year before one Year after. Right. Significant means the aggregate value of the redemption exceeds. Exceeds. So 5%'s fine. But exceeds 5% of the aggregate value of the issuer stock as of the beginning of the two year period. Let's pause. Let's pause. For related use the fair market value at the time of the redemption or redemptions. But this one for significant redemption uses the fair market value fair market value of all the stock a year ago. So this is a huge issue. If you have a value spike, you had a value spike, you're in trouble. You have a value huge value drop. Right. Year later you could be in trouble. You know, no value drop. Probably not definitely value spike, right. Could be an issue. So you buy 1% for a hundred thousand dollars implied value of 10 million. But a year ago the company's only worth a hundred thousand dollars. Congratulations. You have a significant redemption. Right. But there's a de minimis exception, right? There is a de minimis exception to the significant redemption rule. Say that three times past, right? If the aggregate purchase price is 10,000 or less and more than 2% of the outstanding stock is purchased. Right. So you have to sell more than two redeem more than 2% of the of the stock total and the purchase price must be $10,000. You'll notice my accept my one used $100,000 redemption but it only says 1%. Haha. That's the key. You're fine. Another issue that you can run into, section 304 redemption. It's a purchase by a related corporation. It's treated as a redemption. It's sort of hard to explain but if a related corp. Basically you're buying more. Not good. You can do 304 and S Corps. There are some, you know, other ones. There's some prohibitions in the redemption rules, you know that you can do so certain section A3 transactions. So transfer from shareholders or employee. That's that's permitted a redemption. If you know if the redemption is required due to a fired employee or divorce or retirement, you can ignore that. Don't worry about that Redemption. That's fine. Gotten a couple minutes in. Let's take a quick music break. We're going to talk about some more status preserving transactions. So status preserving transactions. So this is treated as if you meet the original issuance requirement even though a holder was not the one who actually acquired it. Generally speaking. Right. Gift or inheritance. That's fine. Do H2 Cap A and Cap B. Inheritance is less helpful than a step up basis generally in 1014. And remember inheritance increase basis. You don't get that for 1202 purposes, but it can decrease your gain generally. So you know you might have $20 million of gain, right? Computing under 1202 rules, you can shelter 10. Generally speaking, right? Depends on the rules. $10 million is excluded, but you know, your basis may have stepped up pretty much the whole way. So it could still work out. Still not bad. But for a gift, you just get pure transfer, transferor, same basis as the prior person, same holding period, tax, you're good to go. Partnerships. If partnership distributes the QRSPs to the partner, that's fine. 1202-B2C. Think about a liquidating distribution. People talk about a liquidating distribution. That's fine. You may get additional basis as a result. You get that for 1001 purposes. You don't get it for 1202 purposes. That's another situation. Or the additional basis you get, like 54, for example, or 1014, you don't get additional basis for 1202. You keep your basis. You actually might have different bases in that situation. What about a contribution to a partnership? No, no, no. Treasury Reg. 1.10451 F721 will burn you. Section 1202 H3 says you keep QSBS status if you do certain transactions under section 1244. D2DOG2. All right. Stock dividends, right? So you know, stock dividends with C Corp. Or an S Corp distributes up a company. You know, an S Corp basically distributes C Corp. Stock. You can do that. There's other taxes there, but you're gonna keep your QRSPs stocks. That's cool. An E reorg recapitalization or an F reorg change in identity, form or place, or reorganization. There's a lot of different F reorgs. We talk about F reorgs in the context of a sale, you know, where people don't, you know, can't sell and can't sell. S Corp. Can't sell an S Corp. You want to have a rollover, Some people do it, but there's other F reworks. You can move from state to state. You can just recapitalize, put a new S Corp on top, have a Q sub below, et cetera, et cetera. And that's fine. That'll keep your. Your transaction. 368 or 351. I talked about this earlier, I think in the last episode, so I'm not doing it again. Those will keep. Those will keep your QSPs. Sometimes they cap it, sometimes they don't. I talked about that and the last one is converting qsbs stock into other stock of the same core, different class. For example. This is fine even if the corporation is no longer a qualified small business. So that's cool. Have a recapitalization or you're just giving up. You know, sometimes you see this, especially with ones where you'll have like six classes of stock. You want to clear the deck a bit and they move some of the, you know, class E into class A and they're kind of the same thing anyway. Sometimes they just have different classes because they're different times and want to change the cap table that much. Fine. No issue. That'll keep you qsb. Another point I want to make. Look, don't have short positions in a corporation that you have QSP stock. And I'll tell you why. Because QSB stock is basically a bet that you're going to make a billion dollars, right? You're going to have a huge exit, but you're taking a short position in it. Look, there are weird rules about short positions can cancel out QSP status if you have them at the same time. So just do it. Just don't do it. I should say just do it. Avoid the avoid shorts. Don't be a short. 1202 is an upside play. Don't do it. All right, let's get some music in. And then we're going to talk about the qualified small business requirement. All right, we're gonna talk about the qualified small business requirement, right? Has to be a domestic court. Must be a qualified small business. How do you meet that? Right? There are two gross asset tests. Two gross asset tests. We're not talking about ACIV yet. Not gonna talk about what businesses you can be. We're gonna talk about the gross asset test, right? It's under 1202 D1, and you need both. The aggregate gross assets must not have exceeded 50 million on or after August 10, 1993. And after the issuance, the aggregate Garrus assets of the corporation, including money from the issuance, cannot be more than $10 million. So. Or, excuse me, $50 million. I got that one pretty wrong, right? They're both 50 million. So look, just, just. If the company has ever had aggregate gross assets in excess of 50 million, we should talk about it. Walk through in real detail. Really, really, really, really, really, really, really, really nice matters. Okay, but this is really important. And this is something I think about, not think about, but this is something I have to analyze for clients, right? Look, if you. If your company's worth $48 million and you raised $3 million. Congratulations, it's worth 51 million. That's not QSP stock. So you'll see these companies that are getting up around 50 million do another capital raise. They'll do a capital raise to like $49.8 million, you know, so that they get to a couple hundred thousand short. I don't like being that close. Valuation fights happen, but that's it Anyway, so for the gross asset test, you need to define the aggregate gross assets. Right? So it's really important is the cash plus the aggregate adjusted basis of the property held by the corp. However, if property was contributed then for this purpose, the fair market value of the property is the basis for aggregate assets purposes. So it's really the basis the bases. So it tends to be a little lower. But you know, a lot of times you have fair market value and has bases and stuff like that. So it's a value. What about corporations with subsidiaries? So it's all one for gross asset test consolidated. There's rules. I did not go into this. Thought about going into this one. Really didn't. If you own 50, 51%, you bring in a certain amount. If you own 38%, you don't. If you own part of a partnership, you bring that part of that in. If you own an LLC in whole. Right. Disregarded entity, then you bring in the whole. Whole king caboodle. Right. So there's things you bring in partially and whole not going into it, but there's rules on that. So if it's not just a C corp and just own stuff, you should talk. So if you have qsp, the corporation and shareholders must agree, and this is important, must agree. In order to be a qualifying small business, the corporation itself and the shareholders must each agree to submit reports to the IRS saying it qualifies. I'm not really sure what this means. I've never actually dealt with it. Don't actually know what this means. Right. I keep saying I don't know what this means. There's a reason for that. I don't actually know what this means. But you have to say you do. So what I think's going on here is what they don't want is for a shareholder to say, oh yeah, we meet qsb. And then the corporation itself is like, I don't know, I'm not telling you, I don't really care. Or the corporation is liquidated and all the old shareholders are gone and they're like, oh, you got to talk to the corporation. I don't have records. Guess What? Not going to win that argument. Not going to win it. You're going to lose. Because there's a requirement in 1202. Basically you have to comply. It's interesting, right? Maybe one day they'll require people to file reports. I doubt it. Sounds pretty awful. I'm not sure what they would do with it anyway. All right, let's move on to what I think is one of the most interesting parts of this. I probably could say about nine things. One of those people that go, that's really interesting. Oh, that's really interesting. So let's talk about the active business requirement. Right. During substantially all of the period the taxpayer held the stock, the corporation must be a C corp. And the corporation meets an active business requirement. Right. Substantially all, not defined. Going to get into this a little more later but basically I say at least 80%. Whole lot of code sections deal with at least 80%. Some say 90. There's some 70. Look, if you're 90, you're great, right? Otherwise, right. You know, keep it, keep it high. A lot of these start as C Corps anyway, so it's not a big deal. I have seen people say, or heard, I suppose people say, oh, I use 60% for substantially all. Does the 60% sound like substantially all? No, 60% sounds like, you know, most more likely than not, but a little better. It's not, it's not substantially all. Don't do it. 86, there's. What's an 86? Things like that. I think that's really important. There's some code sections that are some way lower for substantially all. You know that that's not it. I want at least 80% there. I think it's really, really important. One comment I do want to make is if you have like a partnership, llc, tax partnership or disgruntled entity and you reincorporate as a C corp or check the box, don't worry about that period. You held it before. You just have a five year period. You held it. Basically the start period starts when you do a 351 contribution. So I think that's really important. All right, so let's talk about the active business requirement. There's a requirement that you must use your assets in a certain way. At least 80% of the assets by, by market value. Right. Fair market value are used in the active conduct of one or more qualified trader businesses and the corporation is an eligible corp. Right. So theoretically you could have two QSBs right to qualified small businesses under the same C Corp. Heck of a situation. As long as you're at 80%, at least 80%, right? 80 or more. For one of them, you're golden, you're good. Don't worry about it. So let's talk about what is an active trade or business. All right, this is the one time where I'm really going to tell you. Just read 1202 E3. Okay? So I'm going to go through it in a little bit of detail. You can read it, right? Qualified trader business needs any trader business other than. Okay, so it's everything. But. So it's really everything I was saying, excluding accepting whatever. And there's five categories. If you are familiar with section 199, cap A, you're generally familiar with these. But there were some changes. Right. The first one is a trader business involving the performance of services. All right? Performance of services. And that's the key. So there's a list of number of services which we'll get into in a second. Or performance of services or a trade or business with a principal asset of that trade or business is the reputation or skill of one or more of its employees. Right? So basically if. If you have a person who's like, I don't know, just like everything you're ever doing, man, Jimmy, you gotta go to Jim. He knows his stuff, right? You gotta go to Amy, she's the best. She does it. That's it. That's why the business exists. Even if you're producing widgets. No, no, no, no. We want services. Performance and services. Health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage, services. Right. Basically any services really gets broad, intentional, you know, so. So no services. The second one, the second one. That's excluded, right. Other than. Right. Banking, insurance, financing, leasing, investing are similar. No financial services. Third, any farming business, including the business of raising or harvesting trees. I. I guess I never really thought of, you know, a Christmas tree farm as a farm. Right. But I guess it is, right? Oh, I'm not. I'm not a farmer. I harvest trees. I raise trees. I don't know. Never really thought about what it was. Guess. Cause I've never done it. Right. So no farming, Right. Mining. Right. The next one I think is. I call this one mining. But you know, the production or extraction of. Of products with a character that you can. You can. I believe it's depletion of 6 13, 613 Cafe. So watch out for that. Right. And the last one, I love the last one. Any business of operating a hotel, motel, restaurant or similar business. What did they have out for them, Right. So no hotel, no motel, no Holiday Inn. Right. Maybe I should have gone Airbnb, I don't know. But you know, look like they had something against that industry. I don't know why they wanted to exclude it. Never really understood it. I guess in the early 90s they were just crushing it. They're like, you know, you know what hotel business, you don't need our help. You can do it. Right? So that's what you're going to do. There is very little guidance. There's a couple PLRs, but as of 1 1, 20, 24, can't get any more. They said, look, oh, there should be regulations on it. Yeah, treasury man, treasury is just like, you got no regulations to write, you know, So I don't think this is going to come out. I always wonder if 122 is going to go. Any go be gone anyway. But it seems safe for now. But you never know. You never never. You know, I had a client who was insane. You never, never know. Right. The Brooklyn vernacular. So, you know, we'll see what happens with it. The tax court has dealt with the question of whether the principal asset of a trade or business is the reputation or skill of employees. Owen, TC memo 20, I think 2017-21. My handwriting is messy, so I can't totally read it. I'm not going to go into it. It's super fact specific. So whether, you know, the principal asset is. Is the reputation or skill of one or more employees depends upon. Right. The facts. Oh, that's helpful. I appreciate that. Great job. But it's true. Read it, read it. Owen's an interesting case. There's some stuff under the 199Cap A. Obviously they reference it. They took out some stuff dealing with real estate, which is interesting, but it's different. So it's analogous at best. Not perfect. At least 80% by value. Okay, so we're going back, right. At least 80% of the assets by value. Right. When do you test that 80%? Right. So we're like, oh, I just, I test. Whenever someone makes an investment, I test. At this time, I don't know what the answer is. Right. Continuously. Do you do it? Average it over a period, do you do it? Oh, once a year. You do it or you do it Only when granted. The answer is probably continuously for most companies, Right. You can track it, you know, get pretty close. Just watch out for. There are very few companies that go from like $8,000 of, of asset value to 752 million. Right. So you kind of Know what had happened, figure it out. It only really matters when you grant stock or when you sell stock. You know, something like that, right? It's. It's the issuance, the issuance of stock. So you know, look, I tell people just do it every time you issue check. Oh, we went over. Well when did you go over, you know, talk about that, right? Again, look through subs. If you own more than 50% of vote core value, you're going to look through it. Even if it's a corp. Partnerships very different. Basically peers through you get a pro rata portion. Really interesting stuff are the assets, how they're brought in, if they are startup or research expenses, right? So for startup expenses or research expenses, they're treated as if they're used in the active conduct of a qualified trader business. So for startup activities, section 195 or R&D activities under 174 the deduction or 41, you're going to get it. Those assets are still good. So even if you're not receiving income from those assets, but the assets are being developed as part of it, right? Think about a software developer. You're a software company, you're developing code so that you know trains run better. You know, that kind of thing that you can definitely sell, right? That's a piece of software you're going to sell qsb, but you have no product. You're sitting there knocking out section 41, taking your credits, not doing a whole lot with them because they don't have wages but. But you're sitting there maybe one day, right, you're going to use it. So that's really important. There's also a really, really, really important distinction and it's really important one about working capital, right? Everyone knows working capital is capital is cash you have to have in the business for the ongoing needs, salaries, rent, whatever, right? You can have a reasonable working capital and that's treated as used in the active conduct of a qualified trade or business. So that's active. But how much is working capital? Man? If you've ever done a sale of a business, you know that working capital is a fight. People like well my formula says this, I'm like well, my formula says this. And then you know what they do? They reach a number, they get annoyed about it, then they shake hands, move on, that's it. So don't hoard cash. If you have more cash and working capital, that's problematic. You can knock yourself below the 80% requirement, but if a business is less than two years old, you can hold cash to use within those two years. So if you raise like, you know, $6 million that you're going to use over two years, that's fine. Just use it over those two years. Right? If a business is more than two years old, no more than 50% of your assets can be working capital. So you can't be kind of is like, oh, geez, you know, we have $30 million. We use $30 million for working capital. That's bonkers. I mean, I guess, unless you're Uber, right? You know, but you're still, you still need other things. You need to actually develop. Developed software or whatever. That's what Uber did. Just burn cash. I think it's profitable now anyway. Not relevant. So remember, 80%, only 80% of your assets have to be active. So you can carry like 20% cash. That's not working capital and you're still fine. That seems high. I don't make the rules. That's what it says. That's what the code says. So computer software royalties. This is a total non zequitur. But if your computer software royalties, you qualify, it's under a 543D, right? That qualifies as an active asset. What is that? I don't know. Doesn't really matter. There are a number of disqualified. Well, it matters, but I'm not going into it because I don't have to do it. I do enough non sequiturs in here anyway, right? So let's talk about disqualifying assets, right? There's so, so many, right? More than 10% of the fair market value of a corporation's assets are portfolio, stock or securities, right? So like, if you happen to hold a little bit of Nvidia, like, that's cool, that's fine. But if Nvidia does what it did this year, I mean, that's great. That's the problem you want to have. You gotta watch out for that. Can't do it. Or else that stuff's out can blow your whole thing. If more than 10% of the fair market value of a corporation's assets is real property that's not used in active conduct for trade or business, right? That's bad. That can disqualify you, right? A building that houses your business, that's okay, right? So let's say you're, you're a company, you manufacture widgets, right? That's fine. That can be a qsb. You need to have a building. So you buy a building. 30% of your 40% of your total business, the value of the business Is that. Is that building? That's fine. That's an active asset because that building is being actively used to manufacture the widgets, Design the widgets, to throw the widgets out and hit people. Okay, don't do that. But that's something that's happened, right? What about an eligible corporation? Right? So we're talking about all this stuff and people are like, oh, what's an eligible corporation? It is a domestic corporation. So if you have a foreign corporation that doesn't work, right. It can be a B corp as well, right? Can't be an S Corp because that's a different tax status. B corp's not a tax status. So you can have a B Corp. It's QSPs. I've never seen it. So maybe that's the unicorn, right? Maybe that's the person who's four, seven and can dunk. But that's what we're looking for, right? A disk or former disk. If you don't know what they are, that's fine. You don't have to worry about it. They really don't exist anymore for a variety of reasons. Ricks, REITs, and Remix don't know what they are also, okay? That means you probably don't have a problem. And cooperatives, you know, you can't have a cooperative that owns it. Trying to think of what that would be, but heck of a fact pattern, right? And finally, you know, again, one more point. I'm going to make substantially all requirement, 80% at least, right? You're like, well, what about 79? Like, you know, knock it off. Hey, don't do that. Don't be stupid. People are like, oh, you want to be aggressive on it? Maybe, I guess. I don't know. All right, we are now hitting the end of episode 18. That was the 18th episode of How Tax Works. I hope you learned something. I really, really did. We back in two. Two short weeks, right? Minus or plus one day with the 19th episode, which is also going to be talking about quote, qualified small business stock. Now, now for the very, very much greatest, greatest, greatest, greatest song of all time.