How Can S Corporations qualify for QSBS Exclusion Under Section 1202??

Are you selling your S Corp and wondering if you can use Section 1202 to avoid capital gains?

Section 1202 allows business owners to exclude capital gains from the sale of their business. But, as you already probably know, this section mainly applies to C corporations, not S corporations. So, can S Corp owners still benefit from this tax break?

In this article, we’ll explore a couple of ideas on how S Corp owners can use Section 1202 to avoid capital gains taxes when planning their exit.

What Is Section 1202 in the First Place?

Let's focus on two major rules:

1. Only domestic C corporations can issue Qualified Small Business Stock (QSBS): The company issuing the stock must be a C corporation at the time the stock is issued. If the company is an S corporation, the stock will not qualify for the QSBS exclusion.

   
   

2. The corporation must remain a C corporation for most of the stock’s mandatory five year holding period: The business that issues the QSBS must remain a C corporation for the majority of the time the stock is held by the investor.

   
   

So, the question is: how can an S Corp work around the Section 1202 requirements?

The short answer is that it’s difficult, since only C corporations can issue QSBS. However, there are a couple of workarounds that could allow an S Corp owners to potentially qualify. These strategies involve changes to the corporation’s structure or the timing of certain transactions, and they should only be considered with the help of tax experts due to their complexity.

Here are a couple of ideas for you:

1. Convert from C Corp to S Corp and Back Again.

As we mentioned earlier, when a company gives out QSBS, it needs to be a C corporation for most of the time the investor owns the stock in order to qualify for the 1202 Exclusion. The rule is that the company has to stay a C corporation for “substantially all” of the time the person holds the stock. Now, the phrase “substantially all” isn’t clearly explained in the tax law. Most tax experts agree that 80-95% is a good guideline to follow.

Thus, If a company issues QSBS as a C corporation, but later changes to an S corporation for a short time (for instance, for one year), it could still meet the "substantially all' requirement. As long as the company was a C corporation for the majority (around 80-95%) of the time the stock was held, it might still qualify for the tax benefits of QSBS when the owner sells it.

Why is it important?

Well, a lot of things may happen in the year the business acts as an S Corp. Cash can be distributed, and income or losses will be passed to the shareholders and taxed at their individual level.

However, this is a risky strategy that involves a lot of uncertainties. The IRS hasn’t provided clear guidance on how these temporary conversions from C corporation to S corporation affect QSBS status.

2. Issue New Shares After Converting to C Corp.

Another scenario: if an S Corp converts into a C corporation, it is possible to issue new shares that could qualify as QSBS. However, these new shares must be issued for new consideration, such as cash, property, or services. The new C Corp just can't issue a new stock without receiving something in exchange. And since it is a conversion, you can't really use your own assets to acquire your own stock. So, in essence, you are starting the QSBS journey from the very beginning and you will have unqualified stock that came to you from the time of your company being an S Corp.

The important point here is that shares issued in a stock split or a stock dividend from the original S corporation shares will not qualify as QSBS. The IRS requires that the new shares be issued for new money or property, not just as a continuation of the original S corporation stock.

3. Contribute S Corp's Assets to a Newly Formed C Corporation.

Another strategy is to create a new C Corp and let your existing S corporation contribute its assets to the new C Corp in exchange the it's QSBS. As long as the asset exchange qualifies as a tax-free exchange under Section 351, the S corporation can successfully make this exchange and hold stock on behalf of its shareholders.

In its turn, the C corporation issuing the QSBS must meet all the requirements to be considered a qualified small business under Section 1202.

It’s important to note that the S corporation should not distribute the QSBS to its shareholders immediately, as such a distribution would trigger a deemed sale, which could affect the tax benefits. Instead, the S corporation should hold onto the QSBS until it is sold, and this should happen only after the five-year holding period required for QSBS has been met. The shareholders of the S corporation would benefit from the Section 1202 gain exclusion based on their proportion of ownership in the S corporation.

4. Shut Down an S Corp and Form a New C Corp with the Same Assets.

What if you simply liquidate an S corporation and contribute its assets to a new C corporation for QSBS? Well, this could be costly. If the S corporation has depreciable assets, the tax on the disposition could be high, since gains from the disposition of these assets are taxed at ordinary income rates. This could lead to a large tax bill upfront upon liquidation of the S Corp.

Non-tax issues could also arise, like problems with contracts, licenses, or business liabilities. Alternatives to liquidation include converting the S corporation into an LLC or merging it into one. These methods may avoid some of the issues, but they still require careful planning with tax advisors.

5. Accidental Termination of S Corp (on Purpose).

   
   

We know that if an S Corp violates IRS requirements, it gets converted to a C Corp status. A 2023 IRS Private Letter Ruling implies that if an S corporation inadvertently terminates its status, it can be treated as a C corporation from the date of termination. The PLR suggests that if an S election is revoked, the entity can qualify as a C corporation for QSBS purposes, even retroactively, from the moment the termination act occurred.

Final Thoughts

While Section 1202 primarily benefits C corporations, there are some strategies that could allow S corporations to take advantage of the QSBS exclusion. These strategies involve carefully planning conversions between S and C corporation status, issuing new shares, or contributing assets to a newly formed C corporation, or perhaps simply not complying with IRS S corp requirements! However, each of these strategies comes with risks and complexities, so it’s important for business owners to consult with tax professionals before attempting any of these approaches.

As with all tax planning, professional guidance is essential. And if you ever need help, please reach out. We've helped numerous S Corp owners with their pesky S Corp tax problems.