You’re the sole shareholder of an S corporation. You’ve operated as a flow-through business since formation in 2016, and you’ve been perfectly content to do so. What’s not to like about a single-level of taxation? Payroll tax savings? The refreshing simplicity of the rules governing subchapter S?
But after passage of the Tax Cuts and Jobs Act in December 2017, the advice began emanating from all corners. “Switch to a C corporation,” they said. “The 21% rate is too good to pass up, and dealing with the 20% pass-through deduction will speed up your already disconcerting rate of hair loss.”
While these arguments were certainly compelling, they weren’t enough to convince you to change things up.
But then someone whispered four little numbers into your ear that changed everything. “1202” they urged, “check it out.” “You can exclude all gain from the sale of stock held for more than five years, but only stock held in a C corporation.” Well damn…your exit strategy had always been to sell your business after 5-10 years anyway, and the mere possibility of paying no tax upon disposition meant that, just like that, the siren song of subchapter C became too strong to ignore. Now you’re ready to take the plunge and convert to a C corporation effective January 1, 2020.
But before you do, perhaps you should dig a bit deeper into the aforementioned Section 1202, because while it is indeed a provision that promises a huge tax break upon the sale of qualifying stock, it appears there is an inconsistency within the statutory language that will make the manner in which you convert hugely impactful on the eventual payoff.
Let’s take a look…
Section 1202, in its simplest form, allows for a shareholder who acquires “qualified small business stock” (QSBS) after September 2010 and holds it for five years to sell that stock and exclude from income the greater of:
- $10 million, or
- 10 times the shareholder’s basis in the stock.
This simplest form of Section 1202, however, is not its truest form. There are a host of requirements that must be met in order for stock to be meet the definition of QSBS; requirements that often confuse even the most seasoned of tax advisors. If you want a full — and I mean FULL — discussion of those requirements, I’d encourage you to read this article, written by a bright and virile young man.
For our purposes here today, however, we’re going to approach Section 1202 from a high level. We are primarily concerned with the following requirements necessary for stock to meet the definition of QSBS:
- The stock must be issued when the corporation is a C corporation, and the corporation must be a C corporation for “substantially all” of the shareholder’s holding period.
- The stock must have been acquired at original issuance; in other words, the shareholder acquired the stock in exchange for cash, property, or the performance of services.
- From the date of the corporation’s formation up to the moment immediately after the shareholder acquires the stock, the total assets — the sum of the cash plus the adjusted tax basis of all other assets — must be less than $50 million. In cases where the corporation receives assets as a contribution from a shareholder in exchange for stock, however, the contributed assets are counted towards the $50 million test at their fair market value, rather than their adjusted tax basis. In turn, solely for purposes of Section 1202, the shareholder’s basis in the stock is equal to the fair market value of the contributed assets (as opposed to the adjusted basis of the assets, which is the normal rule under Section 358). This ensures that a shareholder can’t convert pre-contribution appreciation into gain eligible to be excluded under Section 1202 upon the disposition of the stock.
- The corporation cannot be a specified service business, including any business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage architecture, engineering, or any other trade or business where the principal asset of the business is the skill or reputation of the owner or employees. This list is nearly identical to those businesses that are generally ineligible for the benefits of the 20% pass-through deduction of Section 199A — in fact, Section 199A cross-references to Section 1202(e) — and as a result, those businesses looking to flip from S to C because they aren’t benefiting from Section 199A will not be eligible to issue QSBS even after conversion to a C corporation.
As you can see, the first requirement is that only stock issued while the corporation is a C corporation can ever qualify as QSBS. This, obviously, has huge implications when a shareholder intends to convert an S corporation into a C corporation by revoking or terminating the S election. Because the existing outstanding stock of the corporation was not issued while a C corporation, the stock will never be eligible for the benefit of Section 1202 upon sale. As a result, after revocation or termination of the S election, the now-C corporation would have to issue NEW shares of stock to the shareholders, who in turn would have to hold that stock for five years — while meeting all of the other requirements for QSBS — before the stock could be sold tax-free. This means that not only will none of the pre-conversion appreciation ever be eligible to be excluded under Section 1202, neither will any of the post-conversion appreciation on the shares that were issued while an S corporation. Only the post-conversion appreciation on the newly issued shares will enjoy the benefits of Section 1202.
Example 1: X Co. was formed in 2016 upon the issuance of 80 shares of stock to A in exchange for $10,000 in cash. A, the sole shareholder, made an S election for X Co. effective upon formation. A revokes X Co,’s S election effective January 1, 2020, when the value of the 80 shares is $800,000 and A’s basis in the shares is zero. X Co. then issues 20 additional shares to A after the revocation in exchange for $200,000. In 2026, A sells all 120 shares for $5 million, at a time when A’s basis in the stock remains a total of $200,000. The $4 million of gain attributable to the first 80 shares issued in 2016 is not eligible to be excluded under Section 1202, because the stock was issued when X Co. was an S corporation and can thus never be QSBS. The remaining $800,000 of gain ($1 million of allocable proceeds less $200,000 basis) attributable to the 20 shares issued while a C corporation, however, may be excluded in full in 2026.
But is there a better way? The value of X Co. increased by $4.2 million AFTER its conversion to a C corporation, but in the example above, only $800,000 of the gain upon disposition can be excluded under Section 1202. What if we could somehow exclude the full $4.2 million of post-conversion appreciation?
Maybe we can.
Section 1202(g) provides that a pass-through entity may also hold QSBS, provided all of the requirements discussed above (and in the article in the hyperlink) are met. In addition, for the owners of the pass-through entity to exclude their share of the pass-through entity’s gain upon the pass-through entity’s disposition of the QSBS, two additional requirements must be met:
- The owners of the pass-through entity must hold an interest in the entity from the time the entity acquires the QSBS through the date of disposition, and
- Each owner may only exclude the gain up to their share of the gain on the date the pass-through entity acquired the stock. Thus, if an owner’s share of the pass-through entity increases during the entity’s holding period of the QSBS, the amount of the exclusion is limited to the owner’s share of the business on the date of acquisition of the QSBS.
Thus, if, for example, an S corporation or partnership invests in a C corporation in exchange for cash, property, or services, provided the S corporation or partnership holds the stock for five years and all other tests are met, when the S corporation or partnership sells the stock, any shareholder or partner who owned an interest in the pass-through entity for the duration of its holding period of the QSBS will be able to exclude the gain on the sale (limited to the ownership percentage on the date of acquisition).
So what if in Example 1 above, instead of simply revoking X Co.’s S status effective January 1, 2020, on that date, X Co. contributed its assets to a newly formed C corporation, Y Co., in exchange for 80 shares of Y Co. stock. At that time, the assets are worth $800,000, so as discussed above, X Co. takes a basis in the Y Co. stock of $800,000 for purposes of Section 1202. The Y Co. stock was acquired by X Co. at original issuance, and the value of Y Co.’s assets are well less than $50 million, so all initial requirements are met for eventually qualifying the 80 shares of Y Co. stock held by X Co. as QSBS.
In 2026, X Co. sells the 80 shares of Y Co. stock for its value of $5 million, when the basis of the shares remain $800,000 for Section 1202 purposes. Thus, X Co. recognizes $4.2 million of gain, which is all passed through to A, and under Section 1202(g), A is entitled to exclude the full amount of the gain.
I know what you’re thinking….that can’t be right. If you simply revoke the S election, you get to exclude $800,000, but by dropping the assets into a newly-formed C corporation, you get to exclude $4.2 million of gain? I’m sure Section 1202 does not allow such a disparate result for what are, effectively, identical transactions.
I see your point, but you need to understand something: While Section 1202 was added to the Code in 1993, it was largely ignored until 2015. Why? Because initially, you could only exclude 50% of eligible gain, and the other 50% was taxed at a 28% rate, meaning the total gain was taxed at 14% during an era when most taxpayers paid a rate of 15% on capital gains. Who was going to go through all the Section 1202 requirements to save 1%?
It wasn’t until 2010, when Congress upped the ante by increasing the exclusion percentage to 100% for stock acquired after September of that year, that Section 1202 became widely utilized. However, those 100%-eligible shares couldn’t be sold until 2015 at the earliest, which means that the first 100% exclusions weren’t reported on tax returns until April 2016. As a result, only now are Section 1202 issues starting to make their way through the audit process and court system. In the absence of any meaningful judicial precedent, we are left to look at regulations and administrative rulings, of which there are….nearly none. As previously mentioned, Section 1202 has been ignored, not just by taxpayers, but also by the IRS. Thus, it is completely possible that there are drafting irregularities like the one discussed in this article that could cause similar transactions to result in dramatically different tax consequences.
So if you’re ready to switch to a C corporation, and reaping the benefits of Section 1202 is one of your primary motivations in doing so, make sure you consider the manner of your conversion. A mistake could cost you millions.