Interaction Between Sec. 1202 and Other Provisions

Sec. 1202(a) allows taxpayers other than corporations to exclude up to 50% of any gain from the sale or exchange of small business stock held for more than five years. One requirement is that the small business stock must be C corporation stock. This rule raises a potentially difficult entity choice decision for start-up firms.

Since the passage of the current version of Sec. 1202 in 1993, all states have enacted limited liability company (LLC) statutes. Treasury, in an effort to provide certainty as to the tax treatment of LLCs, promulgated the check-the-box rules in Regs. Sec. 301.7701-3. These rules allow a multi-member LLC to either actively elect corporate status (using Form 8832, Entity Classification Election) or to maintain a default tax status as a partnership. Treasury chose the partnership form as the default status under the assumption that a majority of businesses would want the flexibility and flowthrough characteristics of the subchapter K rules. However, the default status precludes the benefit of Sec. 1202.

An LLC cannot merely check the box under Regs. Sec. 301.7701-3(g) and convert to a C corporation prior to a sale of the interest in the entity to obtain gain exclusion under Sec. 1202. Sec. 1202(i)(1)(A) states that, when a taxpayer acquires stock in exchange for property other than money or stock, the IRS treats the stock as acquired on the transfer date. The entity's owners cannot use the substituted holding period provisions of Sec. 1223 to meet the five-year holding period requirement. In addition, Sec. 1202(i)(1)(B) provides that, when a taxpayer transfers property to a corporation in exchange for stock, the stock's basis for Sec. 1202 purposes is no less than the fair market value of the property exchanged. This rule precludes taxpayers from transferring appreciated property to a C corporation (e.g., a successful start-up company's assets) or electing association status for an existing LLC, to exclude 50% of the appreciation that occurred outside of the qualified small business.

As a result of these rules limiting the benefits of Sec. 1202, owners of a start-up LLC may want to immediately check the box if a later sale of the stock is seen as part of a business plan. Checking the box at an early point in an entity's life will both begin the five-year holding period clock and lock in any appreciation within the qualified small business. In addition, Sec. 1244 may provide relief on the ultimate disposition of the stock if the enterprise is not successful. These provisions must be balanced against the owner's desire to currently obtain any flowthrough tax benefits in a partnership structure.

The availability of the benefits of Sec. 1202 may also be limited by the Sec. 341 collapsible corporation rules. Sec. 341 recharacterizes gain on sale of stock in a "collapsible corporation" from capital to ordinary income. Sec. 341(b)(1) defines a "collapsible corporation" as a corporation formed or availed of principally for the manufacture, construction or production of property, or the purchase of certain ordinary income-type assets. The purpose of the rules is to preclude a taxpayer from avoiding ordinary income by incorporating and selling corporate stock. Sec. 341 is a potential concern when a corporation holds certain ordinary-income assets described in Sec. 341(b)(3). A start-up organized as an LLC that contemplates an association election following successful manufacturing activities (for purposes of availing the owners of the Sec. 1202 exclusion) may find the electing association to be a collapsible corporation.

If a corporation falls under the collapsible corporation rules, the impact on the availability of Sec. 1202 is not entirely clear. Sec. 64 states "any gain from the sale or exchange of property which is treated or considered, under other provisions of this subtitle, as 'ordinary income' shall be treated as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b)." "Old" Sec. 1202 (repealed by the Tax Reform Act of 1986) provided for an exclusion of a certain percentage of long-term capital gains that would not be available for collapsible corporation stock. However, "new" Sec. 1202 allows an exclusion for any gain from the "sale or exchange of small business stock," without reference to the character of such gain. It appears that taxpayers may have a reasonable position to exclude 50% of any ordinary gain on the sale or exchange of small business stock treated as stock of a collapsible corporation, effectively lowering the top possible marginal rate from 39.6% to 19.8%.

From Craig G. White, CPA, Ph.D., Assistant Professor of Accounting, Anderson Schools of Management, University of New Mexico, Albuquerque, NM (Not associated with AFAi)