Is Timing Everything? Only Time Will Tell: Small Business Stock and the Reduced Corporate Tax Rate

May 20, 2019

The Tax Law

In theory, the primary purpose of the income tax, as a body of law, is to raise from the governed the resources that the government requires in order to perform its most basic functions.[i] However, as society has evolved and its needs have changed, and as “the economy” has become more complex, the government has added to the purposes, and expanded the uses, of the income tax law.

Instead of acting only as a revenue generator, the tax law has been adapted to encourage certain behavior among the governed, or segments thereof, that the government has determined will have a beneficial effect upon society as a whole.

The most obvious manifestation of the tax law as a vehicle for behavior modification is found in the tax treatment of various business and investment-related activities. Specifically, by providing favorable tax treatment[ii] to a business and its owners “in exchange” for their making certain investments or engaging in certain activities, the government hopes to create a level of economic prosperity that will benefit not only the business, its owners and employees, but also the persons with which the business transacts, including its customers and its vendors.[iii]

Among the most recent examples of the use of the tax law as an economic incentive is the creation of qualified opportunity zones and the gain deferral and gain “forgiveness” that a taxpayer may enjoy by investing in a qualified opportunity fund.[iv]

Of course, some of these incentives, though well-intentioned, fail to deliver on their promise, in some cases because the provisions under which they are offered are too complicated, in other cases because the drafters miscalculated the causal connection between the proffered incentive and the hoped-for consequences, and in still other cases because other provisions of the tax law negated or outweighed the incentive.

Within this last class of tax incentives – that have failed to attain their potential, in no small part because of other provisions of the tax law – is the exclusion from gross income of the gain from a non-corporate taxpayer’s disposition of certain “small business stock.”[v]

Capital Gain, Section 1202, & C Corps: Parallel Histories

In general, the gain from the sale or exchange of shares of stock in a corporation that have been held for more than one year is treated as long-term capital gain.[vi]

Capital Gain Rate

The net capital gain of a non-corporate taxpayer for a taxable year – i.e., their net long-term capital gain less their net short-term capital loss for the taxable year – has, for many years, been subject to a reduced federal income tax rate, as compared to the rate applicable to ordinary income.[vii]

Indeed, from 1993 into 1998, the capital gain rate was capped at 28-percent; from 1998 into 2003, it was capped at 20-percent; from 2003 through 2012, it was capped at 15-percent; and from 2013 through today, it is capped at 20-percent.[viii]

Section 1202

In 1993,[ix] Congress determined that it could encourage the flow of investment capital to new ventures and small businesses – many of which, Congress believed, had difficulty attracting equity financing – if it provided additional “relief” for non-corporate investors who risked their funds in such businesses.

Under the relief provision enacted by Congress, as Section 1202 of the Code, a non-corporate taxpayer was generally permitted to exclude 50-percent of the gain from their sale or exchange of “qualified small business stock,” subject to certain limitations. The remaining 50-percent of their gain from the sale of such stock was taxable at the applicable capital gain rate. Thus, the aggregate capital gain tax rate applicable to an individual’s sale of qualified small business stock was capped at 14-percent.[x]

However, a portion of the excluded gain was treated as a preference item for purposes of the alternative minimum tax.

In 2009, the portion of the gain excluded from gross income was increased from 50-percent to 75-percent;[xi] in other words, with the then-maximum capital gain rate of 15-percent, a taxpayer who sold qualifying stock at a gain would have been subject to a maximum effective federal rate of 3.75-percent.[xii]

In 2010, the exclusion was increased to 100-percent – which is where it remains today – and the minimum tax preference was eliminated.[xiii]

C Corporation

In order to be eligible for this benefit, the stock, and the corporation from which it was issued, had to satisfy a number of criteria – which will be described below – including the requirement that the stock must have been issued by a “qualified small business,” which was (and continues to be) defined as a C corporation.

Between a Rock and a Hard Place

The decision by a start-up business and its owners to operate through a C corporation, so as to position themselves to take advantage of the exclusion of gain from the sale of stock in a qualified small business corporation, was no small matter when the relief provision was enacted.

In 1993, when Section 1202 was enacted, the maximum federal corporate income tax rate was set at 34-percent; dividends paid to individual shareholders from a C corporation were subject to the same 39.6-percent federal income tax rate applicable to ordinary income. From 1994 through 2017, the corporate tax rate was capped at 35-percent; until 2003, dividends paid to individuals continued to be taxed at the higher rates applicable to ordinary income, though, after 2002, the federal tax rate on such dividends was reduced and tied to the federal long-term capital gain rate.

Unfortunately, beginning with 2013, the dividends paid by a C corporation to a higher-income individual shareholder became subject to the 3.8-percent surtax on net investment income, regardless of the individual’s level of participation in the corporation’s business.[xiv]

It is likely that the combination of (i) a high federal corporate tax rate, (ii) the taxation (initially at ordinary income rates) of any dividends distributed by the corporation to its shareholders – the so-called “double taxation” of C corporation profits – and (iii) the many threshold requirements that had to be satisfied (see below), conspired to prevent Section 1202 from fulfilling its mission.

Thus, the capital gain relief provision was relegated to the shadows, where it remained dormant until . . . . [xv]

Tax Cuts and Jobs Act[xvi]

Effective for taxable years of C corporations beginning after December 31, 2017, the Act reduced the federal corporate tax rate from a maximum of 35-percent to a flat 21-percent.

In addition, the Act eliminated the alternative minimum tax for C corporations.

What’s more, the Act did not change the favorable federal tax rate applicable to long-term capital gain, nor did it cease to conform the rate for dividends to the capital gain rate.

In light of the foregoing, it may be that the gain exclusion rule of Section 1202 will finally have the opportunity to play its intended role.

Although there are still many other factors that may cause the owners of a closely held business to decide against the use of a C corporation, the significant reduction in the corporate tax rate should warrant an examination of the criteria for application of Section 1202.

Qualifying Under Section 1202

This provision generally permits a non-corporate taxpayer who holds “qualified small business stock” for more than five years[xvii] to exclude the gain realized by the taxpayer from their sale or exchange of such stock (“eligible gain”).[xviii]

The excluded gain will not be subject to either the income tax or the surtax on net investment income; nor will the excluded gain be added back as a preference item for purposes of determining the taxpayer’s alternative minimum taxable income.[xix]

Limits on Exclusion

That being said, the amount of gain from the disposition of stock of a qualified corporation that is eligible for this exclusion is actually limited: it cannot exceed the greater of

  1. $10 million,[xx] reduced by the aggregate amount of eligible gain excluded from gross income by the taxpayer in prior taxable years and attributable to the disposition of stock issued by such corporation, or
  2. 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year (with basis being determined by valuing any contributed property at fair market value at the date of contribution).[xxi]

This limitation notwithstanding, where the provision applies, a taxpayer may exclude a significant amount of gain from their gross income. Moreover, any amount of gain in excess of the limitation would still qualify for the favorable capital gain rate, though it will be subject to the surtax.

Qualified Small Business Stock

In order for a taxpayer’s gains from the disposition of their shares in a corporation to qualify for the exclusion, the shares in the corporation had to have been acquired after December 31, 1992.[xxii]

What’s more, with limited exceptions, the shares must have been acquired directly from the corporation – an original issuance, not a cross-purchase – in exchange for money or other property (not including stock), or as compensation for services provided to the corporation.[xxiii]

If property (other than money or stock) is transferred to a corporation in exchange for its stock,[xxiv] the basis of the stock received is treated as not less than the fair market value of the property exchanged. Thus, only gains that accrue after the transfer are eligible for the exclusion.[xxv]

Qualified Corporation

The corporation must be a qualified small business as of the date of issuance of the stock to the taxpayer and during substantially all of the period that the taxpayer holds the stock.[xxvi]

In general, a “qualified small business” is a domestic C corporation[xxvii] that satisfies an “active business” requirement,[xxviii] and that does not own: (i) real property the value of which exceeds 10-percent of the value of its total assets, unless the real property is used in the active conduct of a qualified trade or business,[xxix] or (ii) portfolio stock or securities (i.e., not from subsidiaries[xxx]) the value of which exceeds 10-percent of its total assets in excess of liabilities.

Active Business

At least 80-percent (by value) of the corporation’s assets (including intangible assets) must be used by the corporation in the active conduct of one or more qualified trades or businesses.[xxxi]

If in connection with any future trade or business, a corporation uses assets in certain start-up activities, research and experimental activities, or in-house research activities, the corporation is treated as using such assets in the active conduct of a qualified trade or business.[xxxii]

Assets that are held to meet reasonable working capital needs[xxxiii] of the corporation, or that are held for investment and are reasonably expected to be used within two years to finance future research and experimentation, are treated as used in the active conduct of a trade or business.[xxxiv]

Qualified Trade or Business

A “qualified trade or business” is any trade or business, other than those involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees.[xxxv]

The term also excludes any banking, insurance, leasing, financing, investing, or similar business, any farming business, any business involving the production or extraction of products of a character for which depletion is allowable, or any business of operating a hotel, motel, restaurant or similar business.

Gross Assets

As of the date of issuance of the taxpayer’s stock, the excess of (i) the corporation’s gross assets (i.e., the sum of the cash and the aggregate adjusted bases of other property[xxxvi] held by the corporation), without subtracting the corporation’s short-term indebtedness, over (ii) the aggregate amount of indebtedness of the corporation that does not have an original maturity date of more than one year, cannot exceed $50 million.[xxxvii] For this purpose, amounts received in the issuance of stock are taken into account.

If a corporation satisfies the gross assets test as of the date of issuance, but subsequently exceeds the $50 million threshold, stock that otherwise constitutes qualified small business stock would not lose that characterization solely as a result of that subsequent event, but the corporation can never again issue stock that would qualify for the exclusion.[xxxviii]


In the case of a corporation that owns at least 50-percent of the vote or value of a subsidiary, the parent corporation is deemed to own its ratable share of the subsidiary’s assets – based on the percentage of outstanding stock owned (by value) – and to be liable for its ratable share of the subsidiary’s indebtedness, for purposes of the qualified corporation, active business, and gross assets tests.[xxxix]

Pass-Through Entities as Shareholders

Gain from the disposition of qualified small business stock by a partnership or S corporation that is taken into account by a partner or shareholder of the pass-through entity is eligible for the exclusion, provided that (i) all eligibility requirements with respect to qualified small business stock are met, (ii) the stock was held by the entity for more than five years, and (iii) the partner or shareholder held their interest in the pass-through entity on the date the entity acquired its stock and at all times thereafter and before the disposition of the stock.[xl]

In addition, a partner or shareholder of a pass-through entity cannot exclude gain received from the entity to the extent that the partner’s or shareholder’s share of the entity’s gain exceeds the partner’s or shareholder’s interest in the entity at the time the entity acquired the sock.

Sale or Exchange of Stock

The exclusion rule of Section 1202 applies to the taxpayer’s sale or exchange of stock in a qualified small business.

Obviously, this covers a sale by the shareholders of all of the issued and outstanding shares of the corporation, subject to the limitations described above.

It should also cover the liquidation of a C corporation and its stock following the sale of its assets to a third party.[xli] In that case, the double taxation that normally accompanies the sale of assets by a C corporation may be substantially reduced.

The Future?

Assuming a non-corporate shareholder can satisfy the foregoing criteria, they will be permitted to exclude a substantial part of the gain from their sale of stock in a qualifying C corporation.

When individual entrepreneurs and investors start to understand the potential benefit of this exclusion, and as they become acclimated to the new C corporation income tax regime, with its greatly reduced tax rate and the elimination of the alternative minimum tax, they may decide that their new business venture should be formed as a C corporation, assuming it is a qualified trade or business for purposes of Section 1202.

In making this determination, however, these non-corporate taxpayers will have to consider a number of factors, among which are the following: Is the five-year minimum holding period acceptable? Will the corporation be reinvesting its profits, without regular dividend distributions?[xlii] Is it reasonable to expect that the corporation will appreciate significantly in value?

If each of these questions can be answered in the affirmative, then the taxpayer-shareholders should strongly consider whether they can structure and capitalize their business as a C corporation, and whether the corporation’s business can satisfy the requirements described above, in order that the taxpayers may take advantage of the gain exclusion rule.

[i] Stated differently, the income tax is the means by which each member of the public contributes their pre-determined share of the costs to be incurred by the government they have chosen to serve them.

[ii] I.e., a reduced tax liability.

[iii] For example, bonus depreciation under IRC Sec. 168(k).

[iv] IRC Sec. 1400Z-1 and 1400Z-2, added by P.L. 115-97 in 2017.

[v]IRC Sec. 1202.

[vi] IRC Sec. 1222.

[vii] IRC Sec. 1(h).

[viii] Beginning with 2013, a capital gain may also be subject to the 3.8-percent surtax on net investment income. IRC Sec. 1411.

[ix] P.L. 103-66; the Omnibus Budget Reconciliation Act of 1993.

[x] 50-percent of the gain taxed at 28-percent, and 50-percent taxed at 0-percent.

[xi] P.L. 111-5; the American Recovery and Reinvestment Act.

[xii] 25-percent of the gain multiplied by 15-percent.

[xiii] P.L. 111-240; the Small Business Jobs Act of 2010.

[xiv] IRC Sec. 1411.

[xv] It was rediscovered by Smeagol, who lost it to a Hobbit, who then became a star of literature and cinema.

[xvi] P.L. 115-97; the “Act.”

[xvii] This holding period begins with the day the taxpayer acquired the stock. If the taxpayer contributed property other than cash to the corporation in exchange for stock, the taxpayer’s holding period for the property is disregarded for purposes of the 5-year holding requirement.

[xviii] IRC Sec. 1202(a).

[xix] IRC Sec. 1202(a)(4).

[xx] In the case of a married individual filing a separate return, $5 million is substituted for $10 million.

[xxi] Note that the first of these limits operates on a cumulative basis, beginning with the taxpayer’s acquisition of the stock and ending with the taxable year at issue; the second operates on an annual basis, and depends upon how much stock was disposed of during the taxable year at issue.

[xxii] Seems like yesterday. In 1993, I prepared an “Alert” for Matthew Bender (the publisher) that summarized many of the changes enacted by the Omnibus Budget Reconciliation Act of 1993.

[xxiii] IRC Sec. 1202(c).

In the case of certain transfers, including, for example, a transfer by gift or at death, the transferee is treated as having acquired the stock in the same manner as the transferor, and as having held the stock during any continuous period immediately preceding the transfer during which it was held by the transferor.

Two more special rules should be noted: (i) stock acquired by the taxpayer is not 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 such stock, the issuing corporation purchased any of its stock from the taxpayer or from a person “related” to the taxpayer; and (ii) stock issued by a corporation is not treated as qualified business stock if, during the 2-year period beginning on the date 1 year before the issuance of such stock, the corporation made 1 or more purchases of its stock with an aggregate value (as of the time of the respective purchases) exceeding 5-percent of the aggregate value of all of its stock as of the beginning of such 2-year period. IRC Sec. 1202(c)(3).

[xxiv] It is assumed for our purposes that any in-kind contribution to a corporation in exchange for stock qualifies under IRC Sec. 351; in other words, the contributor, or the contributing “group” of which they are a part, will be in control of the corporation immediately after the exchange; otherwise, the contribution itself would be a taxable event.

[xxv] IRC Sec. 1202(i)(1)(B). Compare this to Sec. 351 and Sec. 358, which provide that stock received in a Sec. 351 exchange has the same basis as that of the property exchanged.

[xxvi] IRC Sec. 1202(c)(2)(A).

[xxvii] Because the corporation must be a C corporation at the issuance of its stock, an S corporation issuer can never qualify for the benefits under Section 1202 by converting to a C corporation.

[xxviii] IRC Sec.1202(e)(4).

[xxix] IRC Sec. 1202(e)(7). The ownership of, dealing in, or renting of real property is not treated as the active conduct of a qualified trade or business for purposes of this rule.

[xxx] A corporation is considered a subsidiary if the parent owns more than 50-percent of the combined voting power of all classes of stock entitled to vote, or more than 50-percent in value of all outstanding stock, of such corporation.

[xxxi] IRC Sec. 1202(e)(1).

[xxxii] IRC Sec. 1202(e)(2).

[xxxiii] IRC Sec. 1202(e)(6). Sounds familiar? See the proposed regulations for under IRC Sec. 1.1400Z-2 and the definition of a qualified opportunity zone business.

The term “working capital” has not been defined for this purpose.

[xxxiv] For periods after the corporation has been in existence for at least 2 years, no more than 50-percent of the corporation’s assets may qualify as used in the active conduct of a qualified trade or business by reason of this rule. In other words, the corporation may have to be careful about raising “too much” capital.

[xxxv] IRC Sec. 1202(e)(6). Déjà vu, for the most part? See the exclusion of a “specified service trade or business” under IRC Sec. 199A’s qualified business income deduction rule.

[xxxvi] For purposes of this rule, the adjusted basis of property contributed to the corporation is determined as if the basis of the property immediately after the contribution were equal to its fair market value. IRC Sec. 1202(i).

This should be compared to the general rule under IRC Sec. 351 and Sec. 362, under which the corporation takes the contributed property with the same adjusted basis that it had in the hands of the contributing shareholder.

Property created or purchased by the corporation is not subject to this rule.

Both the corporation and the contributing taxpayer will have to be very careful to determine the fair market value of any in-kind contribution of property to the corporation lest they cause the corporation to exceed the $50 million threshold, and thereby disqualify the contributing taxpayer and any future contributors from taking advantage of Sec. 1202’s gain exclusion rule.

[xxxvii] IRC Sec. 1202(d). What’s more, the gross assets of the corporation must not have exceeded $50 million at any time after the 1993 legislation and before the issuance.

[xxxviii] Query what effect this would have on raising additional capital.

[xxxix] IRC Sec. 1202(e)(5). The subsidiary stock itself is disregarded.

[xl] IRC Sec. 1202(g).

[xli] IRC Sec. 331 treats the amount received by a shareholder in a distribution in complete liquidation of the corporation as full payment in exchange for the stock.

[xlii] In other words, will the corporation’s earnings be subject to one or two levels of tax?