Originally appeared in the December 2016 issue of Trusts & Estates.
As originally enacted in 1993, Section 1202 of the Internal Revenue Code introduced a 50 percent exclusion from taxable gain (with certain limitations) on the sale of so-called “qualified small business stock” (QSBS) held by an individual for more than five years.1 IRC Section 1202 was subsequently amended to provide an increased exclusion of 75 percent for QSBS acquired after Feb. 17, 2009 and before Sept. 28, 2010 (the 75 percent exclusion period), and a 100 percent exclusion for QSBS acquired after Sept. 27, 2010 (the 100 percent exclusion period, and together with the 75 percent exclusion period, the increased exclusion periods). The increased exclusion periods substantially improved the potential tax benefits of owning QSBS and with it, the importance of understanding the holding period rules that apply in the context of QSBS.
QSBS treatment can be immensely valuable for entrepreneurs and early-stage investors, and the availability of the increased exclusion periods has only raised the stakes. However, the complex financial arrangements sometimes used to capitalize start-ups and compensate their employees can raise difficult questions about a shareholder’s holding period for QSBS purposes, which could affect not only the exclusion period that might apply to a particular shareholder, but also whether the shareholder qualifies for QSBS treatment at all. Additionally, although gain excludable for each taxpayer under Section 1202 is capped at the greater of $10 million or 10 times starting basis, it should be possible to multiply the capped excludable amount through certain structuring (see “Multiplying the Excludable Amount”, p. 40).
Holding Period Rules
In general, the rules for determining when stock is treated as acquired and how long it’s held (that is, the holding period) are controlled by IRC Section 1223, which provides for “tacked” (that is, carried over) holding periods whenever a taxpayer converts or exchanges one capital asset for another in a tax-free transaction. However, Section 1202 provides for a series of specific holding period rules, and in certain cases, these rules appear to modify the general holding period (GHP) rules. The primary QSBS holding period rule that diverges from the GHP rules is included in Section 1202(i)(1)(A), which provides that when a taxpayer transfers property (other than money or stock) to a corporation in exchange for QSBS, the holding period for the acquired stock begins on the date of the exchange (the non-stock, non-cash exchange rule (NSNC exchange rule)).2 Other holding period rules included in Section 1202 (such as rules with respect to convertible stock and stock-for-stock exchanges) simply support the same results that would be reached under the GHP rules.
As a result of the inclusion of special holding period rules that apply only in the context of QSBS interests, there’s some uncertainty as to the extent to which the GHP rules apply when there’s no specific QSBS rule on point. This uncertainty was reduced when Section 1202 was amended in 2012 to provide that the GHP rules should be applied in certain instances when a taxpayer qualifies for one exclusion period under the QSBS holding period rules and a different exclusion period under the GHP rules.
Let’s look at the extent to which the GHP rules and the QSBS holding period rules are consistent or differ with respect to common investment methods for early-age investors, including; (1) an option to acquire stock; (2) debt that’s convertible to stock (3) preferred stock that's convertible to common stock in the same corporation; (4) tax-free exchanges of stock in one corporation For stock in another corporation; and (5) the conversion of a partnership for U.S. tax purposes into a corporation. We’ll also examine the extent to which the GHP rules may be applied in the QSBS context in light of the 2012 amendments and outline the strengths and limitations of two potential readings of such amendments.
Comparison of Rules
Options. The GHP rules treat stock acquired by the exercise of an option to acquire such stock as held from the date of exercise of the option.3 Consistent with the general rule, the legislative history of Section 1202 indicates that stock acquired through the exercise of an option to acquire such stock is treated as acquired for QSBS purposes on the date of exercise of the option.4
Convertible debt. Under the GHP rules, guidance from the Internal Revenue Service confirms that stock received on conversion of a debt instrument should retain the holding period of the debt instrument. In Revenue Ruling 62-140, the taxpayer surrendered convertible debt and paid additional cash in exchange for stock of the debtor. The IRS found that a pro rata portion of the stock received in exchange for the debt instrument retained the holding period of the debt instrument, and the pro rata portion of the stock received in exchange for the cash had a new holding period starting on the date of the conversion.5
In contrast to the general rules, the above-noted NSNC exchange rule should apply to treat stock received in exchange for convertible debt as acquired on the conversion date because the stock is received in exchange for the debt, which is property other than stock or cash. This reading of the NSNC exchange rule is supported by the legislative history to Section 1202, which provides that stock acquired by the taxpayer through the conversion of convertible debt is treated for QSBS purposes as acquired at the date of conversion, and the holding period of the debt doesn’t tack to the stock.6
Convertible stock. Under the GHP rules, similar to the above rule for convertible debt, the IRS found in Rev. Rul. 62-153 that the holding period of convertible preferred stock will tack to the common stock received on conversion. Similar to convertible debt, a pro rata portion of the stock received in exchange for any additional cash paid should have a new holding period starting on the date of the conversion:7
Consistent with the general rules, Section 1202(f) provides that for QSBS purposes, if any stock in a corporation is acquired solely through the conversion of other stock in such corporation that's QSBS in the hands of the taxpayer, the acquired stock is also treated as QSBS and treated as acquired on the same day as the old stock.8 This conclusion is supported try legislative history providing that in the case of convertible preferred stock, the holding period is added to that of the common stock acquired on conversion.9
Tax-free stock reorganizations. The GHP rules provide that stock received in exchange for stock in another corporation in a tax-free exchange (such as under IRC Sections 351 or 368) retains the holding period of the relinquished stock.10 Consistent with the general rule, Section 1202(h)(4)(A) provides that for QSBS purposes, the holding period tacks in the case of QSBS exchanged for stock of another corporation (that isn't QSBS) in a transaction described under Section 351 or 368.11
Partnership entering into corporate form. Rev. Rul. 84-111 prescribes three general forms that a partnership converting to a corporation may adopt for tax purposes: (1) a partnership contributes its assets to a new corporation in exchange for stock and distributes such stock to its partners in liquidation (assets over); (2) a partnership distributes its assets and liabilities to its partners in liquidation, and the partners contribute the liquidated partnership’s assets and liabilities to a new corporation in exchange for its stock (assets up and over); and (3) partners to a partnership contribute their partnership interests to a new corporation in exchange for its stock, and the partnership distributes its assets and liabilities in liquidation to the new corporation (interests over).
In the case of a partnership conversion taking the form of assets over or assets up and over, the partners’ holding period in capital assets and Section 1231 assets (generally depreciable property used in a business and amortizable intangibles) tacks to the new stock received. However, to the extent stock received is attributable to other assets of the partnership (such as account receivables and inventory property), the holding period for stock attributable to such assets will commence on the day following incorporation. Similarly, in the case of a conversion adopting the form of interests over, the partners’ holding period generally tacks except for the portion of partnership interests relating to so-called “IRC Section 751 hot assets” (generally unrealized receivables and inventory property). The holding period for stock attributable to such hot assets will commence on the day following incorporation.12
In contrast to the general rules, the above-noted NSNC exchange rule should apply to a partnership conversion to a corporation because such a conversion is generally viewed as a contribution of property (either partnership assets or partnership interests) to a newly formed corporation in exchange for its stock. As such, all stock received should be treated as acquired on the conversion date, and no tacking of the holding period should occur.
In summary, the GHP rules are consistent with the QSBS holding period rules with respect to options, convertible stock and tax-free reorganizations. However, as a result of the NSNC exchange rule, the QSBS holding period rules conflict with the GHP rules in the case of convertible debt and partnership conversion to a corporation.
Section 1202 was amended in 2012 to require the application of Section 1223 in certain instances. Specifically, Section 1202(a)(3) was amended to provide that Section 1223 should be applied to determine the acquisition date of QSBS when following 2-part test is satisfied: the stock (1) would be considered acquired during the 75 percent exclusion period applying the rules of Section 1202, and (2) wouldn’t be considered acquired during the 75 percent exclusion period applying the GHP rules of Section 1223 (the (a)(3) flush language amendment). An identical provision was added to Section 1202(a)(4) for purposes of determining whether stock is acquired during the 100 percent exclusion period (the (a)(4) flush Language amendment, and together with the (a)(3) flush language amendment, the flush language amendments).
Under a plain reading of the flush language amendments, the GHP rules should apply broadly to measure the holding period of QSBS when the 2-part test is satisfied and would override any special QSBS holding period rule, particularly the NSNC exchange rule. To illustrate the consequences of this reading, if an individual contributed property to a partnership on March 1, 2009, and on Oct. 10, 2010, such partnership converted to a corporation treated as a qualified small business for purposes of Section 1202, the stock received on conversion would be treated as acquired on March 1, 2009 under the GHP rules and acquired on Oct. 10, 2010 under the QSBS holding period rules. If a plain reading is adopted, the acquisition date of the QSBS would be based on the GHP rules, and the taxpayer would qualify for the 75 percent exclusion period instead of the 100 percent exclusion period. Legislative history suggests, as an alternative reading, that the 2012 amendments may have a more limited application.
Section 1045 generally provides that a taxpayer who holds QSBS may sell such stock for cash and avoid current taxation if the sale proceeds are used to purchase alternative QSBS within a certain period of time. Under the GHP rules, Section 1223(13) provides that the holding period for stock acquired in a Section 1045 transaction includes the holding period of the old stock. Prior to the 2012 amendments, there was some uncertainty as to whether the GHP rules applied to determine the acquisition date for QSBS purposes such that the holding period of the relinquished QSBS tacked to the new QSBS in a Section 1045 QSBS rollover to whether special rules in the QSBS context required a different result.
The Senate committee report suggests that the flush language amendments were enacted to clarify that Section 1223(13) should apply in the QSBS context when the 2-part test is satisfied and thus shuts down the opportunity for taxpayers to use a QSBS rollover to achieve a higher exclusion period.” Moreover, the “General Explanation’ published by the Joint Committee on Taxation states that the flush language amendments’ reference to Section 1223 isn’t intended to change the acquisition date of QSBS as determined under the NSNC exchange rule.’”
Based on the legislative history, the Flush language amendments may be read to require the application of the GHP rules “subject to” the QSBS holding period rules (that is, only when Section 1202 doesn’t otherwise provide a special holding period rule). Because Section 1223(13) doesn’t conflict with any of the QSBS holding period rules (that is, replacement QSBS stock is purchased with cash and thus the NSNC exchange rule doesn’t apply), this interpretation would be consistent with the application of the GHP rules “subject to” the QSBS holding period rules. Under this alternative reading, stock received on conversion of the partnership in the preceding example would continue to be treated as acquired on Oct. 10, 2010, and the 100 percent exclusion period would apply, because the NSNC exchange rule conflicts with the GHP rules.
The fact that application of the GHP rules under a plain reading of the 2-part test can lead to results that appear inconsistent with the QSBS rules as a whole lends additional support to the alternative reading. Based on our expertise, this ambiguity is particularly acute in the context of QSBS stock acquired on incorporation of a partnership or other non-corporate entity for the following reasons: (1) the holding period of new stock received may relate not only to the holding period in pre-conversion partnership interests, but also to the holding period in pre-partnership formation assets: (2) the holding period in the partnership interests may only tack to a portion of the stock received (depending on whether the partnership holds account receivables, inventory property or hot assets) and may result in different QSBS exclusion percentages for different blocks of stock received in the same transaction; (3) the fact that QSBS may be treated as held prior in the existence of the corporation to be classified as the qualified small business appears to be counter to the intent identified in the statute to limit application of the statute to business enterprises in corporate form.
In summary, there are two alternative readings of the extent to which Section 1223 may apply in determining the acquisition date of stock for purposes of Section 1202 when the 2-part test is satisfied (1) the entirety of Section 1223 applies and overrides the QSBS holding period rules, or (2) Section 1223 is applied subject to the QSBS holding period rules (and Section 1223(13) applies because it’s consistent with the NSNC exchange rule). Although a plain reading of the flush language amendments suggests a broad application of Section 1223, the legislative history supports the more sensible view that the GHP rules should apply subject to the existing holding period framework of Section 1202.