August 26, 2019
The Tax Cuts and Jobs Act (TCJA) changed the corporate tax rate to 21% and included a 20% pass-through deduction. Although some businesses decided it was worthwhile to change from a S corporation to a C corporation, others did not.
Nitti points out the Section 1202 allows you to exclude all gains from the sale of stock held for more than five years, if the stock is held in a C corporation. Section 1202, in its simplest form, allows for a shareholder who acquires qualified small business stock (QSBS) after September 2010 and holds it for five years to sell that stock and exclude from income the greater of:
- $10 million, or
- 10 times the shareholder's basis in the stock
Even though this sounds too good to be true, Nitti addresses inconsistencies within the Section 1202 statutory language that makes the way you convert hugely impactful on the eventual payoff. Nitti points out that Section 1202 requires that:
- The stock must be issued when the corporation is a C corporation, and the corporation must be a C corporation for “substantially all” of the shareholders holding period.
- The stock must have been acquired at the original issuance. The shareholder acquired the stock in exchange for cash property, or the performance of services.
- From the date of the corporation’s formation to the time the shareholder acquires the stock, the total assets – the sum of the cash plus the adjusted tax basis of all other assets – must be less than $50 million. In cases where the corporation receives assets as a contribution from a shareholder in exchange for stock, the contributed assets are counted towards the $50 million test at the fair market value, rather than the adjusted tax basis. For the purposes of Section 1202, the shareholder’s basis in the stock is equal to the fair market value of the contributed assets as opposed to the basis of the assets (under Section 358). This ensures that a shareholder cannot convert pre-contribution appreciation into gain eligible to be excluded under Section 1202 upon the disposition of the stock.
- The corporation cannot be a specified service business, including any business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage architecture, engineering, or any other trade or business where the principal asset of the business is the skill or reputation of the owner or employees. This list is nearly identical to those businesses that are generally ineligible for the benefits of the 20% pass-through deduction of Section 199A -- in fact, Section 199A cross-references to Section 1202(e) -- and as a result, those businesses looking to flip from S to C because they aren't benefiting from Section 199A will not be eligible to issue QSBS even after conversion to a C corporation.
There are other rules and limitations that apply. Feel free to call any member of our team at 610-828-1900 (PA) or 732-341-3893 (NJ) with questions. You can also contact Jackie Himes, CPA, director – tax services at
or me at
. We are always happy to help.
Martin C. McCarthy, CPA, CCIFP
McCarthy & Company, PC
Disclaimer: This alert is for informational purposes only and does not constitute professional advice. Information contained in this communication is not intended or written to be used as tax advice, and cannot be used by the recipient to avoid penalties that may be imposed under the Internal Revenue Code. We strongly advise you to seek professional assistance with respect to your specific issue(s).