Qualified Small Business Stock (IRC 1202): Part I – How Tax Works

Jan 21, 2025

 

In Episode 17 of How Tax Works, Matt Foreman talks about Qualified Small Business Stock (QSBS), which is section 1202 of the Internal Revenue Code.  In this episode, he discusses how (and whether) income is excluded, the holding requirement, basis rules and the per-issuer requirement, and certain transactions that allow for continued deferral of tax. 

Please also see Matt Foreman’s upcoming webinars! Details below:

Listen to the episode here:

  

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

Whether you’re a seasoned entrepreneur, accountant, lawyer, or financial advisor, “How Tax Works” offers a wealth of knowledge to empower you in making sound business decisions. Tune in and embark on a journey to unravel the complexities of tax law, one episode at a time.

This podcast may be considered attorney advertising. This podcast is not presented for purposes of legal advice or for providing a legal opinion. Before any of the presenting attorneys can provide legal advice to any person or entity, and before an attorney-client relationship is formed, that attorney must have a signed fee agreement with a client setting forth the firm’s scope of representation and the fees that will be charged.

Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matt Foreman [00:00:00]:
Welcome to the 17th episode of How Tax Works. I’m Matt Foreman. In this episode and the next probably two episodes, if I’ve timed this out right, I am going to talk about the exclusion of gain from the sale of qualified small business Stock under section 1202 of, of the internal Revenue Code. I’m going to apologize for my voice. I am. I’m no longer sick, but my voice is still not what it could be. But I’m still doing this because I apparently I love tax so much.

Matt Foreman [00:00:36]:
So let’s, let’s make it happen. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please, please, please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law and guidance to demystify how taxes shape the financial and business decisions that we all make. Before we get started, a few administrative things. New episode, two weeks. Every two weeks.

Matt Foreman [00:01:06]:
Although a bunch of them are getting shifted days due to holidays. Next episode. Obviously QRSPs from doing a couple of them. We’re rolling with it. If you have any questions, comments, constructive criticism, email me at my FRB email address. Use your favorite search engine for that. Got a couple of webinars coming up. This one Tomorrow, tomorrow, tomorrow, January 22nd, 2 to 3pm Eastern Standard Time.

Matt Foreman [00:01:28]:
It’s on domicile and tax residency considerations for business owners alicle. There’s CLE and cpe. There’s a link on the website for this for this on the How Tax Works website on the FRB website where you can sign up for it. And February 17th, 1 to 3pm Eastern Standard Time. I’m going to talk about revenue ruling 99.5 and 99.66. We’re going to go into a lot more details. It’s two hours. My podcast was like 20 minutes.

Matt Foreman [00:01:53]:
So going to be a lot more detailed and we’ll probably have some really cool deck co presenting it. One of the co presenters is Michelle Cable. She’s an associate at the firm in our tax group. She’s going to be even better than I am. If you think I’m good boy, let me tell you something. You have low standards. She’s going to be great. So definitely, definitely something you should check out.

Matt Foreman [00:02:09]:
It’s Stratford. So CLE and I believe CPE as well. There’s also a link on the Outs Experts website. So let’s get going. This is, this is a long one. I tried to fit this into one episode And I’m going to be really honest. I probably could have done two full hours on this. Qualified small business stock is super nuanced and it exists, right? The reason that it’s so nuanced is because it’s an exclusion and they want to make it very narrow and very hard to get.

Matt Foreman [00:02:36]:
They want to say this is all we’re doing, right? This was passed in I believe, 2009. And. And that’s a lie. This was passed many, many years ago. I’d have to think through the date. I have it in here somewhere. But basically it’s been changed a couple of times. Change 2009, changed 2010, et cetera, et cetera.

Matt Foreman [00:02:55]:
And people ask, you know, the really important thing is like, why is this so hard to get? You know, what’s so what? Why is this so important that this is so crazy? 1993. 1993 is when they did my research, right? Stern click during a recession. And basically what they were concerned about was people had stopped investing. You know, like you think about this kind of crazy, right? Venture capital and angel investors were like, well, we’re not investing in long shop companies anymore. It’s just not worth it. The ecosystem that exists now, this is just not even a possibility. But I guess it was a concern then. I don’t really remember 1993 all that well.

Matt Foreman [00:03:28]:
You know, I was still in elementary school, right? So it’s been a few minutes, as they say. But let’s talk about it, right? What is qsps? What is qualified small business stock and why it is so valuable? There are a lot of things I’m going to go through. I’m going to go slightly out of order repeatedly because you kind of, kind of drill into one thing, get into some details, move on to the next. But I think I’ll get into everything by the time we’re done, right? So the first thing, there’s a per issuer limitation, per company. Limitation also ends up being a limitation per owner, per shareholder that sort of functions in a way. It’s really not as much of a limitation. Not a strict dollar amount, could theoretically be a trillion dollars. Lot of facts have to happen, hit that, that probably don’t exist, but theoretically could happen, right? It’s for taxpayers other than corporations.

Matt Foreman [00:04:13]:
That’s C Corporations S. Corporations as they pass through same with partnerships, goes to the owners and you exclude the income. You don’t exempt the income, you don’t deduct the income. So it’s just never, never, never, never income. One point I’m going to make on this. There are a number of states that decoupled that do not follow. 1202. New Jersey and California are two examples.

Matt Foreman [00:04:34]:
Make sure some states we only do 50%. New York, greatest state in America, it follows it 100%. So that’s why you should move to New York. Reason number 4870. Right. So excluded income. So the stock has to be acquired on or before February 17, 2009, but after. Right after 1993.

Matt Foreman [00:04:53]:
There’s a date in 1993. My reserves are right, it’s April 10, but I didn’t actually write it down. 1993, that you get a exclusion. Right. So what happens is if you. Okay, let’s back this up. I’m gonna say this again. Cause I’ll get it right.

Matt Foreman [00:05:06]:
Cause it’s a little confusing. You have to acquire the stock after August 10, 1993. If you acquired it on or before February 17, 2009 is a 50% exclusion. If you acquired it after February 17, 2009. So February 18 or later, but before February 28, so February 27 or earlier of 2010, then you get a 75% exclusion. Then. Then if you acquired it on or after September 28, 2010, 100% exclusion. I promise you, I promise you there’s a reason I’ll get to in a moment why those dates matter.

Matt Foreman [00:05:43]:
Okay. There’s also empowerment zone interactions. I’m not even going to talk about it. That’s, that’s 20 minutes for me to get into. Maybe 10 at the early. At the least. I’m not doing it. This is already three parts.

Matt Foreman [00:05:53]:
We’re moving on. There’s a per issuer limitation. So each company, there’s a limit how much they gave to each company. We’re not getting there. I’m going to get that later. Let’s talk about tax rates. So effective tax rates are really important. Okay.

Matt Foreman [00:06:05]:
People always say, okay, capital gains is 20%. Right. Let’s save $1 billion of income. That’d be a good problem to have. I will pay that tax. Right? Billion bucks, worst case scenario, end up with 500 million. We’re going to have a fun party with that. So basically what you get is the exclusion multiplied by the rate.

Matt Foreman [00:06:21]:
I talked about if you acquired a certain time, 50% exclusion. However, the non excluded amount is not tax. Normal tax rates, zero. Normal tax rates, better capital gains, zero, 15 or 20. It’s actually a flat 28% tax. Okay. So what happens is you have it. People say, oh, it’s 14%.

Matt Foreman [00:06:40]:
I say, well, back it up. Back it up. There’s also net investment income tax. Is always going to have net investment income tax on it, right? Well, I guess unless they’re under $250,000. But we’re assuming max rate, you know, that’s the assumption. So the rates are going to be 14, seven and zero. Right. Because they are 50% of excluded on 28%.

Matt Foreman [00:07:02]:
That’s 14%, 25%, 75% excluded. So 25% of 28% is seven and a full exclusion, a hundred percent is zero. But with the net investment income tax you have to do 3.8%. But then you’re only going to take 50 or 25% of that. So the rates are effectively 15.9%. This is federal only, right. 12.7 to 7.9. So you know, it’s really important.

Matt Foreman [00:07:25]:
Right. If you exceed the exclusion amount, you know, let’s say exclusion amounts. $10 million. I’ll get into that in a second. We have $20 million a game. First 10 million. Let’s say it’s fully excluded, no tax above that. 20% plus net investment income tax plus state.

Matt Foreman [00:07:41]:
States do kick back in, they’re not forever. So it could be 23.8 plus whatever the state rate is. I’m not doing the math. Doesn’t matter. The most important requirement that I always talk about going to requirements slightly out of order, but it’s fine, you know, we’ll walk through it, we’ll get the whole way is the. What’s called the five year holding requirement. Okay. The holding period starts on the date of exchange.

Matt Foreman [00:08:02]:
So the date basically you acquire the stock if you buy it. Right? You bought the stock. That’s it. If you exchange. So if there’s you know, a transaction that happens, 351 contribution, you contribute, you know, a patent in exchange for stock, something like that. That’s going to work. The exchange could also be 368. I’ll get into those.

Matt Foreman [00:08:21]:
Those are tax free reorgs. I’ll get into that in a moment. Not right now. Right. You could also acquire it by gift death or a distribution under section 731. So a partnership distribution, you get a tact holding period. I will talk about the gift and the death a lot. Not really going to talk about the 731 distribution.

Matt Foreman [00:08:40]:
But. But we’ll get into it in a bit. You can acquire it due to conversion of stock in a different corporation. Right. I’m sorry. In the same corp. Different stock and same corp. You get a tackling period.

Matt Foreman [00:08:50]:
Let’s say you have Class C. Class C has no voting. Like all right, whatever. We’re going to convert into class A. You have voting or voting to non voting or everyone’s getting done in. There’s going to be a recap. You still have stock, the same economic rights. That’s cool, that’s fine.

Matt Foreman [00:09:05]:
You still have QSBs, you still have a tackle holding period, no recognition, which is cool. What if you buy into a partnership that holds QSBs? No, no. 1202 G. You do not get QSBs if you buy into a partnership that holds it not how it works. All right, so let’s talk about the basis rules and the per issuer limitation. This is probably the most technically complex part. I would love to say that there’s other parts that are similarly technically complex. This one’s really hard.

Matt Foreman [00:09:35]:
It’s really fact specific. And I promise you, even if you listen to me perfectly and I explained perfectly, you’re going to misunderstand it. And the reason is because it’s quirky as heck. So like what I’m going to say here, and this is really important is if you have questions about this, talk to your tax professional, talk to a lawyer, talk to accountant, talk to enrolled agent, talk to whomever you get your tax advice from. Right. Shaman, whomever it may be, just roll with it, that’s fine. So the basis matters a lot. A lot.

Matt Foreman [00:09:59]:
A lot, a lot. Right. You buy stock with cash. That that’s your basis, that’s your cash amount. Stock is granted for services. Right. Section 83. I already talked about this a couple ago.

Matt Foreman [00:10:08]:
Right. The basis is equal to the fair market value at the time of vest generally grant. Right. If you make an 83B election, you get stocked the vest over a couple of years and you make an 83B election on that day. It’s as if for 1202 purposes that you in fact everything vested on that day, even if it didn’t so can accelerate it, get that five year holding period earlier, et cetera, et cetera. Really, really important. What if you contribute property, right? Well, what’s really interesting is you contribute it basis for basis purposes, general income gain, things like that. Under, under 1001.

Matt Foreman [00:10:42]:
The basis is your actual basis, right? Contribute it. C Corp. You have 8080 control 351 no gain tax free contribution. Conversely for 1201 purposes, if you actually do it, say you contribute a piece of property worth 100 with a basis of 20, congratulations, your basis for QSBS purposes is actually 100. It’s the fair market value. It is no lower than the fair value of what you contribute. I’ve had a lot of questions dealing with it with some clients where there’s debt involved. I don’t know the answer.

Matt Foreman [00:11:11]:
I’ve researched it. I have some thoughts. Not putting that on a podcast if you want that. That’s something you have to hire me to talk about. But I’ll walk you through it. Got some ideas. The excluded gain, right? The excluded gain. How much is the actual exclusion under 1202? Really important question because at the end of the day, the exclusion doesn’t matter if you don’t have taxable income.

Matt Foreman [00:11:32]:
So it’s basically the amount received minus your basis for 1202 purposes, right? However, what it’s done, that’s the amount. That’s the amount of your gain, right? So, you know, say you sell it. Your basis is 100, you sell it for 1,000, and your basis and the property you contribute is 20. But it’s what I said earlier, right? Fair market value is 100. So 1202 purposes, it’s. It’s 100. Your gain for 1202 purposes is 900,000 minus 100. But here’s the thing.

Matt Foreman [00:11:58]:
The 1202 exclusion amount, which is per issuer, which means per company, per corporation, right? Is the greater of $10 million. So you’re getting at least 10 million free. That’s cool. Or 10 times your 1202 basis. So if your basis, let’s say you contributed $2 million for the stock and you sell that sucker, you know, six years later for 18 million bucks, right? Let’s make it $22 million, right? What’s your gain for 1202 purposes? 22 million amount received minus your basis, 2 million. That’s $20 million of gain. What’s your 1202 exclusion? $2 million basis multiplied by 10, 20 million bucks. Boom.

Matt Foreman [00:12:35]:
Excluded. That’s great. But here’s an important point, right? Let’s say that a bunch of people put money into a partnership and I’ll get into why this matters in a moment. They use that money to buy QSPS stock, right? One of them later dies, right? Get a 754 step up in basis. No, no, no. That does not add basis. For 1202 purposes. You cannot increase your exclusion that way.

Matt Foreman [00:12:55]:
It functionally increases your exclusion because it increases your basis. So there’s less taxable income. So you’re still kind of stacking, but it doesn’t like double and triple. Really. The worry is not so much that it’s increasing in a dollar for dollar but think about it. If you were to do this and you were to receive it by inheritance, which you can, you still still tax, still still works on, and you have good 1202 stock in that situation, and your basis goes from basically zero to like let’s say 5 million bucks. Suddenly you have $50 million of exclusion. No, no, no.

Matt Foreman [00:13:25]:
Congress did not want that. They were able to actually figure that one out in time. So no. 754, elections to step up basis, no. 10, 14, step up in basis, et cetera, et cetera. There’s a whole host of things that you can do that would do it. But basically you can’t add basis later. The basis sticks.

Matt Foreman [00:13:43]:
That’s key. If you do an installment sale under section 453, you actually prorate the 1202 exclusion. It just kind of kicks in there. Kind of neat how that’s done. They actually thought through that. Again, exclusion is per issuer. So multiple tranches of a stock of the same corporation are subject to a single limitation. What if you do a de reorg, right? Let’s say you have two corporations, they do one corporation, just two things, split it off tax free, D reorg.

Matt Foreman [00:14:08]:
You wait a couple years, you sell them. You still only have one limitation for both corps, right? It’s still the max of one because it’s still one corporation at the time that you made the contribution. You can do it. You can de re org and you can sell. You’re going to get 10 million bucks on whatever you sell first. Or, you know, if the amount’s higher. I generally just sort of said 10 million. But that’s not always what happens.

Matt Foreman [00:14:30]:
Actually can be quite different. I’ll give you some examples, right? So you contribute $5,000 of cash, buy a bunch of stock, you eventually sell for $12 million. That’s cool. Your gain is eleven and a half million dollars. Twelve or two exclusion is either the larger of ten times $500,000, $5 million or ten million boom exclusions. Ten million. So what you’re going to do is you’re going to pay no tax on that. You see of 12, 12 million dollars.

Matt Foreman [00:14:52]:
No tax in the first half million because that’s basis recovery. No tax on the next 10 million because that’s 12 or 2 exclusion. And then you’re going to pay 20% multiplied by 3.8%. So you have a total of 23.8% on the $1.5 million. So 23.8 times 1.5 million. I’m not going to do the math on the Fly, because it doesn’t matter because they’re going to be state tax too. So no matter what number that I use, that’s wrong. Okay, second example, let’s say you buy for $2 million of cash and you sell that sucker for $20 million.

Matt Foreman [00:15:23]:
You’re like, well, Matt kind of already did this, right? Gain is 18 million, 1200 2. Exclusion is 20. 20 million. There’s no tax, no tax whatsoever. I should note, I’m assuming that you purchased it in the third period, right? You purchased it on or after September 28, 2010. And the reason that I’m assuming that is because it makes my math easier, right? If it’s only 50% exclusion and if your exclusion amounts $20 million, congratulations, you’re only going to exclude half of that 18 million bucks. So you get, you get 9 million tax free. 9 million at the full board tax rate.

Matt Foreman [00:15:57]:
Still not bad. Still lowers your tax rate a lot. It’s a good thing. Third one, right? Cash of a million bucks. This one’s an interesting one because you’re splitting it into two different sales, right? Cash, a million bucks to buy stock. You know, you’re serving me $5 million meets all the requirements, yada yada yada. You sell half for 8 million bucks. Gain is seven and a half million.

Matt Foreman [00:16:17]:
Your 1202 exclusion, right, is seven and a half million dollars because it’s 10 times easy enough, no tax. But let’s say two years later, you sell the remaining half for 9 million more dollars, right? Your gain is eight and a half million dollars. How do I get that? You remember your initial basis was a million. Sold half. Use half the basis, you sold the other half. Use the other half the basis. So you have eight and a half million dollars, right? So what’s happening is the exclusion is two and a half million, which is 10 million minus the draft remaining, or 10 times the half a million dollars of basis left, which is $5 million. You’re going to exclude 5 million because 5 million is larger than 2 1/2 million dollars.

Matt Foreman [00:16:55]:
So actually end up with a total of 12 and a half million dollars of exclusion right over it. One thing I say, people say, oh, then I’ll just wait a week and sell it. First off, most buyers just want to buy it. Secondly, don’t, don’t mess around with the economic substance. Step transaction with this because you don’t want the audit. You don’t want that smoke not worth, right? Let’s go into one more example. All right? Buy for a million again, you sell 10% for 10 million, right? Your gain that’s excluded is 9.9 million. How do I get to that? Easy.

Matt Foreman [00:17:26]:
You’re going to do 1 million sold 10%. 10% of your basis. A hundred thousand dollars, 9.9 million is used of your exclusion because you have 10 million. That’s the max you can use. Then you sell the remaining for $10 million. Right? So obviously the price of the value went down. A lot sold 10% for 10 million. You sold 90% for 10 million.

Matt Foreman [00:17:45]:
That’s not great. I should have sold the whole thing. But you’re still doing all right. Invested $1 million and you ended up with 20. It’s not bad, right? Under 1001, your gain is $9.1 million or 10 million $900,000 a basis, right? Or 1202. You have $900,000 basis. You have $9 million of exclusion to use. So you successfully used $18.9 million of exclusion.

Matt Foreman [00:18:08]:
It’s a little quirky. Let’s work through the math. Make sure it’s right. Get your basis right, make it make sense. Sense. So I think that that’s really important. Okay, so you know, think about this, right? But think about it with gifting. I’ll get to this later.

Matt Foreman [00:18:21]:
This is like two episodes from now if I planned it out, right? But basically gifting gets, you know, it gets a transfer basis, gets a transfer of tax, holding, period, et cetera, et cetera. You have $19,000 of gifting per year plus the annual exclusion, which if my memory serves it right, is $13.99 million. Couldn’t quite get to 14. Right. And your exclusion for 20, 25, right, I. $19,000 or $76,000 if you do it four ways. If you don’t understand what that means. Basically, if you have two married couples and one, one person from a married couple gives to the other, you can pretend, you know, spouse A gives a spouse one, spouse A gives a spouse two, spouse B gives a spouse one, spouse B gives a spouse two.

Matt Foreman [00:19:02]:
Even if A goes straight to one, you pretend all four of those gifts 19 times 4, $76,000. Huge, huge, huge, separate exclusion. And that’s pretty cool. All right, we’re going to take a quick break. We’re going to run, run, run a little more and we’re going to talk a little more about per issuer limitations and status preserving transactions. All right, we’re back. Hope you enjoyed the music. Really, really wonderful.

Matt Foreman [00:19:31]:
Calms the nerves, you know, the purge issuer limitation and status preserving transactions. So remember, look, we’re assuming that you already have QSB stock, qualified small business stock. So you’re qualifying. So you’re going to exchange it for another stock. Let’s pretend the other stock is not QSB stock right in the transaction. So let’s give a hypothetical, right? Let’s save a company a C corp, you qualify and everything like that. Google comes you, hey cool. We want to give you $30 million worth of QSB stock worth of our stock in exchange for your stock.

Matt Foreman [00:20:01]:
That sounds pretty good, right? Super liquid. Google’s probably a good investment. It’s not financial advice, but I think we all agree, you know, Google might have a future, may be able to make some money in the future. So this transaction is going to be governed either by 351, you’re contributing for stock, probably not with Google because it’s you know, you know where you’re getting the 8080. So it’s probably going to be like a type A reward, right? Where you merge the two companies there survives or you triangular keep yours but it’s underneath whatever and you get stock and it quite. I use Google because I use Google. No reason, right? That’s 368 A1A. So you maintain the exclusion.

Matt Foreman [00:20:35]:
This is quote, I’m quoting here, right? 1202 H4 Cap B. You maintain the exclusion amount only to the extent of the gain which would have been recognized at the time of the transfer had 351 or 368not applied. So basically how much is your gain at that moment, right when you eventually sell the new company stock? Your gain that’s excluded under 1202 is limited to amount it would have been had you received cash at that time. That’s really important, right? Doesn’t keep going up. Google doubles in value, does increase your QSBs. You are getting that amount no matter what. Run the calc, keep it in Excel, put it in your return, talk to your preparer. That’ll be exciting.

Matt Foreman [00:21:16]:
Right? So that’s it. So it’s really as if you sold it, but it’s deferring the gain. So but what if the buyer, the acquirer is a qualified small business? Oh heck yeah. Right. This is great. It can still grow. It’s as if the initial formation was it. So, so you know, look, there’s no guidance on it.

Matt Foreman [00:21:35]:
This is a position I take. Is that the new company, you boom, you have qsb. That’s it. This sort of runs into the situation that I’ve run into a few times with 10:45. I’m going to get to it later. But you can roll over QSB stock. This would be consistent with that because you’re basically as if you sold it, but. And you rolled the gain into a new qsb.

Matt Foreman [00:21:53]:
Why do you need to do that? Right. Doesn’t really matter. So if the buyer is qsb, probably still. All right, so let’s talk about it. Right. Per issuer limitation and married individuals. I’m going to get this into this later. I want to talk about it for a second.

Matt Foreman [00:22:07]:
Because it’s a question of what. What you have to do. So it’s unclear. All right. There’s language on it. I think you have at least a reasonable basis. But that’s something we should talk about. Right.

Matt Foreman [00:22:16]:
The question is whether it’s $10 million for a married couple or. Or you double it to 20. I always think about it. Right. Hypo A. Right. A has $10 million. You give 10 million to the spouse.

Matt Foreman [00:22:26]:
Right. Or the different situation where A and B are not married. There are two investors and they meet at an investor meeting. Oh, what a wonderful story. Put that the Times right. Be front page and wedding announcements. Think that’s on Sunday. Get a picture, you know, make sure your eyes are lined up.

Matt Foreman [00:22:40]:
If you ever applied to that and know about it, you have to line your eyes up to get your picture. And the Times kind of crazy, right? And they get married later. Like, why should those be later? Why should those be different? Should people get divorced in order to get QSPs? Kind of a bonkers thing to do. But people do all kinds of crazy stuff for tax purposes, right? So there you go. So you know, there’s other places that change if you’re married. It says married fund jointly or married separately is different. This one only really deals with, you know, it talks about married funds separately. And it really depends on the definition of taxpayer.

Matt Foreman [00:23:10]:
But I want to get into that later. I want to mention it here. A little preview of Flava, but that’s it. All right, let’s get a little more music here. We’re going to. We’re going to do basically two little parts and then we’re going to end this episode three. Really? Gosh, I guess it is four. Yeah.

Matt Foreman [00:23:27]:
Three parts. And then we’re going to. We’re going to end this episode. So I’ll be back in a moment. All right, I’m back. Let’s talk about pass through entities. Partnership or an S Corp. Right.

Matt Foreman [00:23:44]:
They invest in QSB stock. First off, if you do this with an S corp, like I’m gonna be really, really annoying. Right, because you can get us. You don’t get a step basis. Be like, oh, you don’t get a step up in basis for 1202 purposes. Yeah, but you do for regular purposes. You still do. If the basis steps up and there’s no gain anyway, then you probably don’t need QSB at all.

Matt Foreman [00:24:04]:
So don’t do this in S Corp. Don’t use S Corps generally to hold stock. It’s not a great idea, right? People do it. But these roles generally qualify work for partnerships and S Corps. Right? So partnership invests in USB stock and then it sells. Right. The gain is basically passive to the partners or the S Corp shareholders. The C Corp partner.

Matt Foreman [00:24:23]:
So if there’s a C Corp that’s a partner of a partnership, right. Obviously a C Corp can’t be a partner of an S Corp. You know what happens if a C Corp is a partner of an S Corp. C Corp is now a shareholder. Or I should say a C Corp is a shareholder in S Corp. You have a C Corp that’s a shareholder and a C Corp. Right? So the C Corp partners don’t get QSP stock exclusion. It’s in the code.

Matt Foreman [00:24:41]:
Don’t even try. Let’s think about something else, right? A partner must have owned the partnership or S Corp. Right. When they acquire the QSP stock. Can’t buy into it later. If you do, you just don’t get qsp. You might get the gain allocated to you, but you don’t get qsb. Solution.

Matt Foreman [00:24:56]:
Haha. Right. The next one. The limitation is per partner, per S corporation shareholder, not per partnership, not per S corporation. There’s more stuff. There’s a lot more stuff. Notice 9764 deals with registered investment companies Ricks that hold QSPs. It’s like I would have to do 10 minutes on it.

Matt Foreman [00:25:13]:
I’m not doing it. Already running up against long episodes. So we’re not doing it extraneous. The other one is if you buy QSPs and contributed to a partnership. No, don’t do it. Q triggering section 721 blows QSPs. They are a really inventive way to blow QSPs, as anyone knows. I find these fascinating.

Matt Foreman [00:25:29]:
Sorry. I guess let’s say you have a single member LLC that owns QSPS stock. Why are you doing this? I don’t know. Don’t do it. Then you gift part of that partner that LLC to someone or you die and it becomes a partnership. Congratulations, you don’t have QSPS stock anymore. Not the best idea. Right.

Matt Foreman [00:25:48]:
All right, let’s. Let’s move on a bit. Opportunity zones. Look. Yes, you can do both. Yes, I have seen it. I have seen it done. It is in the wild.

Matt Foreman [00:25:56]:
It exists. It’s not a unicorn. Okay, so it really does exist. But it’s like a seven footer who can shoot threes. So we got what? Wemby, kd, bodegacat, few others. Shaq wants himself on that list. He’s not on that list. All right, what’s the guy used to play for Gonzaga? Can’t think of his name.

Matt Foreman [00:26:13]:
And he’s now with the funder. You know another one? There’s a couple of them. Right. Someone will probably email me. Oh, how’d you forget his name? Right. I can picture him. Don’t remember who his name is. But look, they exist.

Matt Foreman [00:26:23]:
You can do it. I’m not going into it because basically you just have to make sure you meet the requirements and you’re doing QSPs. But the whole idea of stacking opportunities on the QSPs, kind of wild, right? Never pay tax, increase your basis. But the increased basis under opportunity zone hold, increase your basis for USPS purposes. So remember that. That’s really important. All right, I kind of skipped ahead a bit and I’m going to bounce around a lot. This is not a linear topic, but we’re going to go to the last part for this episode and then we’re going to come back.

Matt Foreman [00:26:52]:
Talk original issuance requirement. But that’s in two weeks. Right now we’re going to talk about how does a stock qualify as qualified small business stock 1202, C1 and C2. Talk about the original issuance requirement. Right. So I talked about it. I already fumbled over it once. Not going to fumble it again.

Matt Foreman [00:27:13]:
Issued after August 10, 1993. That’s when you acquired it. That’s really important. That’s when you acquired the stock. The corp must be a C Corp. The corp satisfies the qualified small business requirement. I. E.

Matt Foreman [00:27:27]:
The corporation is a qualified small business. Get into that later. That’s next week, I believe. Also, the corporation satisfies the active small business requirement. Doesn’t just have to be a small business, it has to be an active business. So small business that buys real estate sits on it, you can’t put in anywhere, won’t work for two reasons. One, can’t put that much real estate in these businesses and two, has to be active. Most real estate like this probably wouldn’t qualify as active.

Matt Foreman [00:27:52]:
And finally, stock options is a really important one. Stock options are not qualified small business stock. I know, I know. There’s. There’s a case on it. Nat Kuhn, I believe is how you pronounce it. I apologize if I mispronounce. Mispronounce it.

Matt Foreman [00:28:08]:
N A T K U. N A, N A T H A NTC Memo 201015 is affirmed by the Ninth Circuit. All right, Gotta be stock. Someone’s like, what about safes? I say, probably not. I don’t think any safes are. What about convertible debt? I already talked about this, right? I talked about this in my safe. Convertible debt. 1.

Matt Foreman [00:28:26]:
I think probably not for convertible debt. But here’s the thing, and here’s going to be my final thought on this episode. Okay? Really, really important. If you have a stock option that has rights to dividends and it has rights to vote, you don’t have a stock option. You have stock. If you have a safe that has that. If you’ve convertible debt that doesn’t have that, section 385, the internal revenue Code is going to tell you that you probably actually have stock. So people say, oh, I have a safe, but qualifying for QSPs.

Matt Foreman [00:28:55]:
And I tell them, congratulations on your stock. You don’t have a safe new stock. That’s it. I have convertible debt. That has it. Do you? You know, that’s the question. Not trying to be sarcastic, but it’s a real viable question. Do you actually have it? Right.

Matt Foreman [00:29:09]:
On that lovely note, thank you. Right. That was the 17th episode of How Tax Works. I hope you learned something. Hope you enjoyed. I mean, back in two weeks, minus one day, you know, because there was a holiday yesterday, right, for the 18th about. I’m going to be talking about QSBS again. And now.

Matt Foreman [00:29:26]:
And now. And now for the best song of all time. Thanks for listening.