How Tax Works Podcast

Host: Matthew Foreman, Co-Chair of Taxation Practice Group, Falcon Rappaport & Berkman LLP
Episode: Qualified Small Business Stock (IRC 1202): Part II
Date: February 3, 2025

Episode Overview

In this episode, Matthew Foreman dives deeper into Section 1202 of the Internal Revenue Code, focusing on the exclusion of gain from the sale of Qualified Small Business Stock (QSBS). He systematically unpacks the requirements, pitfalls, and nuances of preserving QSBS status, using practical explanations, humor, and real-world examples. The episode is tailor-made for accountants, lawyers, business owners, and anyone looking to navigate or leverage QSBS rules for tax planning.

Key Discussion Points & Insights

A. Recap of QSBS Exclusion

• Generous Exclusion Limits:
  • “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?” (03:00)
  • The focus is on the significant federal tax benefit: up to a $10M+ gain exclusion when selling QSBS if requirements are met.

B. Original Issuance and Redemption Traps

• Stock Must Be Original Issue:
  • “Corporation must be a C corp, right? You cannot purchase it from other shareholders.” (03:30)
• Redemption Limitations:
  • Two main problematic redemptions:
    • Redemptions from related persons (within 2 years before or after issuance).
    • “Basically you take the day that the issuance happens and you check two years before and two years after.” (05:00)
  • De minimis exception:
    • “If the amount paid for in the redemption exceeds $10,000 and more than 2% of the stock held...is acquired.” (06:30)
    • Small redemptions below this threshold are generally allowed.
• Significant Redemption Rule:
  • “Significant means the aggregate value of the redemption...exceeds 5% of the aggregate value of the issuer stock.” (07:00)
  • Tests fair market value at the start of the measurement period; sudden valuation changes can trip up this rule.
• Section 304 Redemptions:
  • “It's sort of hard to explain but if a related corp...basically you’re buying more. Not good.” (09:20)
• Employment-Related Redemptions OK:
  • “A redemption...required due to a fired employee or divorce or retirement, you can ignore that.” (10:20)

C. Status-Preserving Transactions

• Inheritance & Gifts:
  • “For a gift, you just get pure transfer—same basis, same holding period, tax, you're good to go.” (12:15)
• Partnership Distributions:
  • “If partnership distributes the QRSPs to the partner, that’s fine.” (13:15)
  • Additional basis received in a distribution does NOT increase your basis for QSBS exclusion purposes.
• No Go: Partnership Contributions:
  • “Contribution to a partnership? No, no, no. Treasury Reg. 1.10451 F721 will burn you.” (14:00)
• Stock Dividends, E & F Reorgs, Recapitalizations:
  • These typically preserve QSBS status.
  • “Changing classes of stock is fine even if the corporation is no longer a qualified small business.” (15:00)
• Caution on Short Positions:
  • “QSB stock is basically a bet that you're going to make a billion dollars…[don’t] take a short position…shorts can cancel out QSBS status.” (16:00)

D. Qualified Small Business Requirements

• Gross Asset Test (1202(d)(1)):
  • “You need both: [1] aggregate gross assets must not have exceeded $50 million on or after August 10, 1993. And [2] after issuance, aggregate gross assets…cannot be more than $50 million.” (18:10)
• Calculating Gross Assets:
  • “Cash plus the aggregate adjusted basis of the property held by the corp. However, if property was contributed, the fair market value of the property is the basis for aggregate assets purposes.” (20:00)
• Subsidiaries and Consolidation:
  • “If you own 50%, 51%, you bring in a certain amount...own part of a partnership, you bring that part in... LLC in whole—bring the whole thing.” (21:00)
• Agreement Requirement:
  • Both corporation and shareholders must agree to submit reports to IRS—a gray area Matt notes lacks clear guidance. (22:00)

E. Active Business Requirement

• Continuous C Corp Status & Active Conduct:
  • “During substantially all of the period the taxpayer held the stock, the corporation must be a C corp. And...meets an active business requirement.” (24:20)
• Defining “Substantially All”:
  • “I say at least 80%...If you’re 90, you’re great, right?...I’ve seen people say 60% for substantially all. Does 60% sound like substantially all? No.” (24:40)
• Assets Test (by FMV):
  • “At least 80% of the assets by market value…are used in the active conduct of one or more qualified trade or businesses.” (26:00)
• What’s a Qualified Trade or Business? (1202(e)(3)):
  • “Qualified trade or business means any trade or business other than...” (27:00)
  • Excluded Fields:
    • Most services (health, law, architecture, accounting, consulting, etc.)
    • Financial services/banking/insurance
    • Farming/forestry (28:45)
    • Mining/extractive industries
    • Hospitality: “No hotel, no motel, no Holiday Inn. Right. Maybe I should have gone Airbnb.” (29:40)
• Principal Asset is Reputation/Skill:
  • “If you have a person who’s like…that’s why the business exists…No, no, no. We want services.” (27:50)
  • Extremely fact-specific; Matt references tax court’s Owen case.
• Testing Periodicity:
  • “When do you test that 80%?...The answer is probably continuously for most companies…just do it every time you issue [stock], check.” (33:15)
• Startup and R&D Assets:
  • “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.” (36:30)
• Working Capital Allowances:
  • “You can have a reasonable working capital and that's treated as used in the active conduct.” (37:30)
  • <2 years in business: can hold cash for usage over two years.

  • 2 years: no more than 50% of assets as working capital.

• Portfolio and Real Estate Holdings:
  • “More than 10% of FMV of assets [as] portfolio stock/investments or non-active real estate disqualifies.” (40:00)
• Active-Use Real Estate Is Fine:
  • “A building that houses your business, that's okay...that's an active asset.” (41:15)
• Eligible Corporation Definition:
  • Must be a U.S. C corporation; S Corps, REITs, cooperatives, and others excluded (43:00)
  • “B corp’s not a tax status...You can have a B Corp. It’s QSBS. I’ve never seen it, so maybe that’s the unicorn.” (43:20)

Notable Quotes and Memorable Moments

• “I know, I know. How exciting, right?” (03:08) (Matt keeps the tone light and self-deprecating.)
• “I do not doubt that you are smarter than most people in Congress. I do think that Congress has already figured you out, right?” (04:20)
• “Doing one a day won’t really work. This isn’t like eins, you can’t do one a day.” (06:10)
• “Short positions can cancel out QSBS 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.” (16:15)
• “If you have a value spike, you had a value spike, you’re in trouble. You have a value, huge value drop…No value drop, probably not, definitely value spike, right. Could be an issue.” (07:40)
• “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.” (39:30)
• “No hotel, no motel, no Holiday Inn…What did they have out for them?” (29:40)
• “So, you know, knock it off. Hey, don’t do that. Don’t be stupid.” (45:00) (On pushing the envelope on the 80% active asset threshold)

Timestamps for Major Segments

• [03:00] – Exclusion mechanics and big-picture limits
• [04:00 - 10:20] – Original issuance, redemptions, exceptions, and related parties
• [12:00 - 16:15] – Transfers: inheritance, gifts, partnerships, and anti-abuse on shorts
• [18:00 - 22:00] – Gross asset test and consolidated subsidiaries
• [24:00 - 29:45] – Active business requirement and specifics on excluded trades/businesses
• [33:00 - 34:00] – Timing and frequency of asset/activity tests
• [36:30 - 39:45] – Startup, R&D use, working capital, and real estate/portfolio limitations
• [43:00 - 45:00] – Who can be a qualified corporation and final reminders

Conclusion

Matthew Foreman expertly decodes the technical maze of QSBS, clarifying not only what practitioners need to watch out for but also the underlying logic of these rules. His practical humor (“don’t be stupid,” “you want to have a B Corp—it’s a unicorn”) aids listener engagement, while detailed coverage ensures both novices and experts walk away with actionable insights. Stern warnings about redemptions, asset tests, and active business requirements are punctuated by relatable anecdotes and practical “check this before you…” advice. The episode provides a thorough, nuanced guide for anyone serious about leveraging QSBS for tax planning and strategic business decisions.