As widely discussed, the Treasury Department released "General Explanations of the Administration's Fiscal Year 2022 Revenue Proposals," which includes a potential increase in the long-term capital gains rates for taxpayers meeting certain annual income thresholds. Although the outcome of this tax proposal is unclear, taxpayers should consider taking advantage of the favorable tax treatment of qualified business stock (QSBS) under Section 1202. [1] Section 1202 provides a framework for preexisting and newly-formed corporations to attract capital investment because of its attractive federal income tax benefits. Generally, a noncorporate shareholder can exclude up to 100% of the gain recognized on the sale of QSBS held more than five years, capped at the greater of $10 million or 10 times the tax basis of its initial investment. [2] Noteworthy, this limitation is on a per corporation and per shareholder basis.

Stock of a corporation may qualify as QSBS if the following requirements are met:

• the stock is issued to a noncorporate stockholder (individuals, trusts, estates, and in certain circumstances, persons owning QSBS through a partnerships, LLCs taxed as partnerships, or S-corporations);

• the issuer is a C-corporation;

• the stock is acquired directly from the corporation at its original issuance in exchange for money or other property (not including stock) or as compensation for services;

• the small business' aggregate gross assets from inception to the date the stock is issued (including proceeds received in exchange for the stock) is $50,000,000 or less. Aggregate gross assets generally are equal to the amount of cash and aggregate adjusted basis of the property held by the corporation; [3] and

• during substantially all of the time the stockholder holds the stock, the small business is engaged in a qualified trade or business and uses 80% (by value) of its assets in the active conduct of one or more qualified trades or businesses.

The use of Section 1202 stock is a relatively new phenomenon in the world of tax planning. As such, the IRS has issued little guidance to address the uncertainty for some of the QSBS requirements. For example, the IRS Tax Code defines a "qualified trade or business" as any trade or business other than: (i) any trade or business involving the performance of services in certain fields, includes but not limited to accounting, engineering, consulting, financial services, brokerage services, law, health, or any other trade or business, where the principal asset is the reputation or skill of one or more of its employees; (ii) any banking, insurance, financing, leasing, investing, or similar business; (iii) any farming business; (iv) any mining, oil, or gas business; and (v) any business operating a hotel, motel, restaurant, or similar business. Although the definition of services may seem straightforward, the activities of many business organizations may be uncertain when applying this rule. The IRS has issued a handful of private letter rulings on the matter. For example, the IRS ruled that a corporation that provided research to pharmaceutical companies was not considered a service business because it was not offering services in the form of individual expertise. [4] The IRS recently issued a private letter ruling, addressing what constitutes brokerage services since it is not defined in Section 1202. [5] After noting the definition of broker in the Merriam Webster dictionary, the IRS ruled a broker was a business that acts merely as an intermediary. Open issues in this area are significant. If taxpayers are concerned about meeting the trade or business exclusions in Section 1202, they may choose to review the Section 199A Regulations to consider how the IRS may interpret their respective trade or business for purposes of Section 1202.

Notably, special rules concerning redemptions related to the issuance of QSBS and tax-free transactions may apply. One other useful feature of QSBS stock is that an electing shareholder can sell original QSBS in an otherwise taxable transaction and purchase new QSBS within 60 days of the sale without triggering gain if the QSBS stock was held for at least six months to the extent that the proceeds from the sale does not exceed the amount invested in the replacement QSBS. [6]

Under the right set of facts, QSBS stock can have significant tax benefits to investors to eliminate 100% capital gains. Future federal legislation increasing the capital gains rates may make this even more attractive in the future.

[1] Unless otherwise stated, all references to "Section" are to the Internal Revenue Code of 1986, as amended, and all references to "Regulation" or "Treas. Reg." are to the Treasury Regulations promulgated thereunder. This article does not address the state and local income tax treatment of Section 1202 stock, which may vary.

[2] QSBS stock issued from August 11, 1993 to February 17, 2009 is eligible for a 50% federal income exclusion. QSBS stock issued from February 18, 2009 to September 27, 2010 is eligible for a 75% federal income exclusion. QSBS stock issued after September 27, 2010 is eligible for a 100% exclusion, Current QSBS gain is also 100% excluded from the alternative minimum tax and the 3.8% net investment income tax.

[3] See Section 1202(d)(2)(B), which provides that the adjusted basis is equal to its fair market value at the time of contribution. The fair market value is measured for the purpose of the $50,000,000 threshold regardless if the property was contributed in a Section 351 transaction that currently requires a carryover of asset basis for the property contributed for other tax purposes. There is also no tacking of the holding period of the contributed assets to the QSBS for measuring the five-year holding period requirement.

[4] PLR 201436001 (September 5, 2014). See also PLR 201717010 (April 28, 2017) (corporation that provided medical testing results without diagnosis or treatment was not a service provider).

[5] PLR 202114002 (January 13, 2021).

[6] See Section 1045.