Qualified Small Business Stock Rules Deserve Big IRS Attention

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Section 1202 It’s a well-known secret that the tax code provides significant benefits for investments in small businesses, including tax-free gains on the sale of qualified small business shares, or QSBS, up to $10 million or 10 times the investment basis. .

But to get these rewards, taxpayers must navigate complex and unclear rules. There are ambiguities and potential pitfalls in Section 1202(c)(3)(B) of the Significant Redemption Act that may inadvertently penalize early-stage entrepreneurs.

The IRS shall interpret the regulations in this subsection to conform its application to Congress’ intent.

Variations in redemption rules

Stock does not qualify for QSBS under section 1202(c)(3)(B) during the two-year period beginning one year before the stock is issued.

A significant redemption during this period will disqualify all shares issued during the two-year period from QSBS status if the amount paid exceeds the statutory significant redemption test under section 1202(c)(3)(B), or if the amount redeemed exceeds the amount redeemed. The de minimis threshold.

In order for the redemption to be considered significant, the corporation must have redeemed shares at a total value of more than 5% of the total value of the shares at the beginning of the two-year period in question.

However, Reg. Room 1.1202-2(b)(2). If the total amount paid for shares exceeds $10,000 and more than 2% of the shares are purchased, the redemption will only exceed the de minimis threshold.

It is important to know the difference between the two tests. The significant redemption test assesses the stock’s value at the beginning of the two-year valuation window, while the de minimis test considers the stock’s value at vesting.

A key difference in these tests is that the redemption rules are particularly problematic for shares issued in the corporation’s first year.

There are also a few situations in which a corporation can redeem shares without triggering the redemption rules. In Reg. Section 1.1202-2(d)(1)-(4), redemptions are “discharged” if related to termination of services, death, disability or mental incapacity, or divorce.

Legislative intent

The redemption rules are structured to preserve the validity of the original withdrawal requirement of section 1202(c)(1), which protects the taxpayer from abuse by ensuring that the shares issued reflect the fresh capital invested in the small business.

The legislative history of omnibus budget reconciliation 1993 He described the significant redemption rules as an “anti-avoidance” measure aimed at “evading the requirement that the shares be newly issued”. The rules are designed to remove the original withdrawal requirement.

Similarly, IRS, Reg. Section 1.1202-2, cited in the Internal Revenue Bulletin as a concern No. 1996-30 (IA-26-94) “In many circumstances, redemptions that have neither the purpose nor the effect of evading the substantive issue requirement may be disallowed under these regulations. Section 1202(k) allows the Treasury to prescribe such regulations as may be appropriate to carry out the purposes of section 1202.”

Congress, recognizing that something like this could happen, allowed the IRS to order regulations so as not to undermine the policy behind section 1202.

Similar redemption issues are resolved with additional guidance. The IRS has made exceptions for redemptions after death, disability or mental incapacity, and divorce.

Enter in Treasury Resolution 8749 These new exceptions were added because “eligible small business shares may not lead to the removal of the requirement to purchase first issue shares.”

Based on the existing legislative history, the redemption statutes’ sole purpose is to prevent evasion of the original withdrawal requirement.

Founders dilemma

Significant redemption rules require a retrospective review of the share price. This is especially problematic for founders who receive stock in the first year of a company’s creation.

Under a literal reading of section 1202(c)(3)(B), the statute may assign zero value to a stock at the beginning of a two-year assessment period because the company did not exist during that period.

This definition jeopardizes the QSBS exclusion for early adopters, as any de minimis or excluded redemptions within this timeframe are considered significant.

That was not the purpose of the critical redemption laws, which were enacted only to end the original withdrawal requirement. Based on a literal reading, any non-de minimis or excluded redemption could trigger significant redemption rules and invalidate all QSBS issued within that two-year window, which is clearly not the intent of the rules.

The proposed solution

To solve this glaring problem, in Reg. section 1.1202-2(b), or a private letter ruling or similar guidance clarifying section 1202(c)(3)(b)—in a private letter such that the IRS explains what section 1202(e)(3)(a) means with compliance. A trade or business that involves the performance of services in the field of health in law 202125004.

Ideally, the explanation should specify that the significant redemption period must begin at the beginning of the two-year period or earlier than the date of establishment.

This change prevents early-stage entrepreneurs from being unduly penalized and, similar to the above exclusions, cannot lead to the elimination of the initial consumption requirement.

This article does not necessarily reflect the views of Bloomberg Industry Group, publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author information

Zachary M. Nolan Greenberg is a tax consultant at Glucker Fields Claman & Machtinger in Los Angeles.

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