QUESTION

I am a small business owner and investor who read your informative blog post “Section 1202, Qualified Small Business Stock.”  However, I would like to ask for your clarification of an important requirement for the small business stock capital gain exclusion.

Concerning the “original issuance” requirement, you stated that “QSB stock means any stock acquired on original issuance by the taxpayer from a domestic C corporation…”

My understanding of the meaning of “original issuance,” is that it is stock issued by a corporation at the time of its incorporation, and does not include new stock subsequently authorized and issued by the corporation at a later time.  Practically speaking, this would mean that QSB “original issue” stock could be purchased from a new startup, but not from a corporation that had been in existence for a year, whose directors opted to raise capital by authorizing and offering a new issue.

Alternatively, does “original issue” simply mean stock an investor purchased directly from the issuing C corporation (or through its underwriter), as opposed to acquiring the stock from another investor, or from a broker?  Must an investor desiring the benefit of the gain exclusion provided under Section 1202 purchase only from a startup at its time of incorporation?

SHORT ANSWER

The short answer:  Section 1202 can cover shares issued at any time and from time to time after the incorporation of the Company, provided the various requirements of Section 1202 are met at the time the shares are issued and throughout the time the shares are held.

NOT-SO-SHORT ANSWER

Internal Revenue Code section 1202 defines “qualified small business stock” as any stock in a C corporation which is “originally issued” after the date of the enactment of the Revenue Reconciliation Act of 1993, if:

  1. as of the date of the issuance, the corporation is a “qualified small business,” and
  2. except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its “original issue” (directly or through an underwriter) –
  1. in exchange for money or other property (not including stock), or
  2. as compensation for services provided to such corporation (other than services performed as underwriter of such stock).

The statute does not define “originally issued” or “original issue.”  But a plain English reading of the phrase would mean to me, as a lawyer, that the shares are supposed to come directly from the company – not purchased from another shareholder.  In other words, shares purchased on the secondary market wouldn’t qualify.

Nowhere does the statute say that the stock has to be issued at the time of incorporation.  If Congress had wanted to say that Section 1202 only worked for shares issued as part of the incorporation process, it could have easily done so.

Plus, there is language in the statute which would be completely incongruous with the meaning of “original issue” being  only at the time of incorporation.  For example, the reference to an “underwriter.”  Underwriters aren’t typically present at incorporation.  Similarly, Section 1202 (c)(3) says that stock acquired by the taxpayer will not be treated as qualified small business stock if at any time during the 4-year period beginning on the date 2 years before the issuance of the stock, the corporation issuing the stock purchased any of its stock from the taxpayer or a person related to the taxpayer.  If the statute only covered shares issued at incorporation, the inclusion of the 2year look back language wouldn’t make sense.

There are a number of things that have to happen in order for stock to be “qualified small business stock,” but none of them is that the stock has to be issued on the incorporation or in connection with the incorporation of the company.

In other words, stock issued several years after the incorporation of the company can qualify, if the various requirements are satisfied.

To give you a sense of some of the things that are required:

  1. The aggregate gross assets of the corporation before and after the issuance of the shares cannot exceed $50,000,000;
  2. The corporation must be a domestic C corporation;
  3. The corporation must be engaged in an active trade or business; and
  4. The corporation’s business must be a “qualified trade or business.”

So, to answer your question, there is no requirement in Section 1202 or the regulations under Section 1202 limiting the benefits solely to stock issuance at the time of incorporation.