Section 1202 of the tax code is a little-known secret that offers substantial benefits for investments in small businesses, including tax-free gains on the sale of qualified small business stock, or QSBS, up to the greater of $10 million or 10 times the investment basis.

But to reap these rewards, taxpayers must navigate a complex and vague set of rules. There are ambiguities and potential pitfalls in the significant redemption rule of Section 1202(c)(3)(B) that could inadvertently penalize early-stage entrepreneurs.

The IRS should clarify the rules in this subsection to align its application with the purpose that Congress intended for it.

Redemption Rule Differences

Stock doesn't qualify as QSBS under Section 1202(c)(3)(B) if the corporation makes a significant redemption within a two-year period that starts one year before the stock is issued.

A significant redemption within this period disqualifies all stock issued in that two-year period from QSBS status if the redeemed amount exceeds the statutorily defined test of significant redemption under Section 1202(c)(3)(B), or if the purchased amount exceeds the de minimis threshold.

For a redemption to be considered significant, the corporation must redeem stock with a total value at the time of the purchases exceeding 5% of the total value of all its stock at the beginning of the two-year period in question.

However, Reg. Section 1.1202-2(b)(2) holds that a redemption only surpasses the de minimis threshold if the aggregate amount paid for the stock exceeds $10,000, and more than 2% of all outstanding stock is purchased.

Recognizing the distinctions between the two tests is crucial. The significant redemption test evaluates the stock's value at the beginning of the two-year assessment window, whereas the de minimis test considers the stock's value when it's redeemed.

The key difference in these tests is what makes the significant redemption rules particularly problematic for those issued stock in the corporation's first year.

There are also a few scenarios where the corporation can redeem stock without triggering the redemption rules. Under Reg. Section 1.1202-2(d)(1)-(4), redemptions will be "ignored" if connected to termination of services, death, disability or mental incompetency, or divorce.

Legislative Purpose

The redemption rules were structured to maintain the integrity of the original issuance requirement of Section 1202(c)(1), which safeguards against taxpayer abuse by ensuring that issued shares reflect fresh capital infused into a small business.

The legislative history in the Omnibus Budget Reconciliation Act of 1993 describes the significant redemption rules as an "anti-evasion" measure whose goal is to "prevent evasion of the requirement that the stock be newly issued." The rules were designed to prevent avoidance of the original issuance requirement.

Similarly, the IRS, when issuing Reg. Section 1.1202-2, noted concern in Internal Revenue Bulletin No. 1996-30 (IA-26-94) that "in many cases, redemptions that have neither the purpose nor the effect of evading the original issue requirement may result in disqualification under these rules. Section 1202(k) authorizes Treasury to prescribe such regulations as may be appropriate to carry out the purposes of Section 1202."

Congress, aware something like this could arise, allowed the IRS to prescribe regulations to prevent the potential overreach of the significant redemption rules from frustrating the policy behind Section 1202.

Similar redemption issues have been resolved with additional guidance. The IRS created an exception for redemptions following death, disability or mental incompetency, and divorce.

It reasoned in Treasury Decision 8749 that these new exceptions were added because they're "unlikely to lead to avoidance of the requirement that qualified small business stock be purchased at original issue."

Based on the available legislative history, it appears the sole purpose of the redemption rules is to prevent evasion of the original issuance requirement.

Founders Dilemma

Significant redemption rules require a retrospective evaluation of stock value. This is particularly problematic for founders who receive stock in the first year of a company's existence.

Based on a literal reading of Section 1202(c)(3)(B), the statute could assign zero value to a stock at the start of the two-year assessment period, because the company didn't exist at such time.

This interpretation could jeopardize the QSBS exclusion for the initial founders, as almost any non-de minimis or excluded redemption within this time frame would be deemed significant.

That wasn't the intention of the significant redemption rules, which were only enacted to backstop the original issuance requirement. Based on a literal reading, any non-de minimis or excluded redemption could trigger the significant redemption rules and taint all QSBS issued within that two-year window, which clearly isn't the rules' intent.

Proposed Solution

To fix this glaring issue, there should be either an update to the language of the significant redemption rules in Reg. Section 1.1202-2(b), or a private letter ruling or similar guidance clarifying Section 1202(c)(3)(B)—similar to how the IRS clarified what Section 1202(e)(3)(A) means with respect to a trade or business involving the performance of services in the field of health in Private Letter Ruling 202125004.

Ideally, the clarification should state that the testing period for significant redemptions should start at the earlier of the start of the two-year period, or the date of formation.

This change would prevent early-stage entrepreneurs from being unintentionally penalized and, similar to the exclusions above, is unlikely to lead to avoidance of the original issuance requirement.

Originally published by Bloomberg Tax.

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