Is QSBS litigation “about to get big”?

In a TaxNotes article from April 10, 2023, Nathaniel S. Pollock of SouthBank Legal examines recent litigation involving QSBS and notes that the case may be the “tip of the QSBS litigation iceberg”. 

To date, QSBS litigation and other rulings have been limited to few cases, a handful of Private Letter Rulings and one Chief Counsel Memo.  Pollock argues that the rapid increase in QSBS / 1202 claims by taxpayers will lead to many more QSBS matters being heard before the tax courts.  While additional clarity around the many “gray areas” of the QSBS regulations may be welcome, taxpayers looking to benefit from QSBS should consider if such rulings may have implications for their own securities.

Pollock’s article examines a recent decision in Leto v. United States1.  In short, the taxpayer, Leto, claimed a QSBS exclusion which the IRS rejected upon a deeper review.  The key elements relate to whether the stock held by Leto, the Company’s CEO, was issued by a C-corporation. 

The company, GlobalTranz Enterprises Inc., was originally founded as an LLC, GlobalTranz Enterprises LLC and had elected to be treated as an S-corporation for federal tax purposes.  As per IRC Section 1202(c), QSBS stock means “stock in a C-corporation…acquired by the taxpayer at its original issue”.  While Leto’s original stock was issued by the S-corporation, in 2011 the company converted to a C-corporation and the members of the LLC received C-corporation stock as compensation for their interests in the LLC, and it was from that point in time when Leto believed his shares would be eligible QSBS stock. 

As noted by Pollock however, “because the LLC membership interests were “stock” for federal tax purposes, the conversion of the LLC to a C corporation was – according to the Justice Department- a stock-for-stock exchange.”

QSBS stock must be acquired in exchange for money or other property (not including stock) or as compensation for services provided to the corporation (IRC Section 1202(c)(1)(B).  In this situation, the fact that the QSBS stock was acquired for other stock prevented the C-corp stock from qualifying as QSBS in Leto’s hands. 

Many companies begin as LLCs or make elections to be taxed as an S-corporation early on, and later decide to convert to a C-corporation.  As demonstrated in this case, from a QSBS perspective such elections complicate QSBS eligibility, but don’t necessarily disqualify all taxpayers from benefitting, so it is important to consider the facts and circumstances of each particular situation carefully and determine what may be the best course of action to take to help ensure the benefits of QSBS are maintained.

1 Leto v. United States, No. CV-20-02180-PHX-DWL (D. Ariz. 2022).

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

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