April 2022 Q&A

April Q&A

QSBS Expert Q&A: Section 1202 Original Issuance Qualification and Secondary Transactions

The startup ecosystem and investment landscape are constantly evolving. As new questions arise, answers and solutions are not far behind. In our monthly series, the QSBS Expert team provides insights into these pressing questions in the highly nuanced world of QSBS.

Section 1202 (QSBS) is a highly nuanced portion of the tax code. Many of the questions that we receive deal with the expansion and delineation of these tax code details. 

Part of the conditions found within Section 1202 revolve around Section 1202’s nuanced criteria of “original issuance.” 

Recently, our team received a question about QSBS qualifications as it relates to the conversion of securities and the tie-in with “original issuance.”  

Q: “I recently purchased LLC member interests (LLC taxed as a partnership) from a previous holder of those securities (i.e. a secondary transaction). The Company subsequently converted to a C-Corporation, and my LLC units were converted to common equity in the C-Corp. 

Would my common shares be considered obtained at “original issuance” for Section 1202 purposes?”  

Companies often convert from an LLC to a C-corporation as they look to bring on new investors. Such conversions can be effectuated in several ways.

To address this question we look to two provisions within Section 1202 that may provide guidance:

  1. As per I.R.C § 1202(c)(1)(B), QSBS stock must be “acquired by the taxpayer at its original issue”, in exchange for “money or other property (not including stock), or as compensation for services…”.  

But what if the original issuance of the C-corporation does not yet exist?  

While the taxpayer acquired the LLC units in a “secondary” transaction, the company at the time was not a Qualified Small Business because it was not a C-corporation. If the company in effect terminated (“dissolved”) the LLC and started a new C-corporation, issuing equity shares, the newly issued stock would appear to be obtained at “original issuance” for those shareholders. The QSBS 5-year required holding period will generally start when the stock is issued from the C-corporation.   

  1. As per I.R.C § 1202(h)(4), “In the case of a transaction…if QSBS is exchanged for other stock with would not qualify as QSBS…such other stock shall be treated as qualified small business stock acquired on the date on which the exchanged stock was acquired.”

Further, as per Rev. Rul. 84-111; 1984-2 C.B. 88, 1202(h)(4) would apply in situations where a conversion of an LLC, taxed a partnership, to a C-corp would fall under a transaction that occurs under Section 351. See Section 1202(h)(4)(A). Within Rev, Rul. 84-111, a partnerships transfer of assets for a C-corporations stock was considered a transaction under Section 351, “…each partnership is considered to have transferred its assets and liabilities to a corporation in exchange for its stock under section 351 of the Internal Revenue Code, followed by a distribution of the stock to the partners in liquidation of the partnership.” Rev. Rul. 84-111; 1984-2 C.B. 88

The facts set forth under the Revenue Ruling was as follows: “The partners of Z transferred their partnership interests in Z to newly-formed corporation T in exchange for all the outstanding stock of T. This exchange terminated Z and all of its assets and liabilities became assets and liabilities of T.” Rev. Rul. 84-111; 1984-2 C.B. 88

This section would seem to indicate that the QSBS stock can be received by the taxpayer through certain transactions, such as the case of an LLC converting to a C-corporation.

A: Yes, based on the above factors, we believe stock obtained upon conversion from an LLC to a C-corporation could be considered obtained at original issuance in the hands of the holder, and provided the other QSBS eligibility requirements are met could be eligible for QSBS tax treatment.

Please contact us if you or your company have specific questions, like the one above, about QSBS investments, qualifications, or eligibility. Our team here at CapGains tackles pressing questions pertaining to the highly nuanced nature of the QSBS regulations and how they may affect corporations and their shareholders. 

Reach out to our team today and let us know the questions you are encountering, and look for our thoughts in our next monthly edition of QSBS Expert Q&A. 

In case you missed the previous QSBS Expert Q&A, find them here

Capgains specializes in aiding investors and corporations as they navigate QSBS tax exemption qualifications. Our experienced team is ready to guide and support you throughout the life of your stock.

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This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.

About QSBS Expert

QSBS Expert was founded by a group of entrepreneurs, investors, accountants and lawyers who came together when trying to navigate a QSBS situation of their own. We quickly realized that the regulations left a lot of open questions and the publicly available information was confusing to sift through…so we thought that others may also benefit from having a “go to” resource for all things QSBS.