Highlights
- Carried interest earned by fund managers on qualified small business stock dispositions may be excludable from income, although the issue is not free from doubt.
- Careful planning is required to ensure investors are eligible to receive pass-through gain exclusions, especially in regard to warehoused pre-fund investments.
- As highlighted in this Holland & Knight alert, gain exclusion benefits can easily be lost without careful planning.
The capital gains exclusion under Internal Revenue Code (Code) Section 12021 with respect to gain from the sale or exchange of qualified small business stock (QSBS) is available to any taxpayer other than a corporation.2 Structuring investments in qualified small businesses to qualify for this exclusion under Section 1202, where possible, is an attractive proposition for investment funds organized as partnerships. However, funds must be careful in structuring their investments to consider the special rules applicable to pass-through entities to plan for optimization of the Section 1202 exclusion and not fall into traps for the unwary. This Holland & Knight alert addresses several issues that pooled investment fund partnerships may encounter in this quest.
Application of Section 1202 to Carried Interests
Of great interest to sponsors of pooled investment fund partnerships is whether their carried interest can qualify for the Section 1202 capital gains exclusion. Generally, a partner's distributive share with respect to a partnership interest the partner held on the date a partnership acquires QSBS, which is attributable to gain on the sale or exchange by the partnership of such QSBS (Pass Through Section 1202 Gain) and meets the holding period requirements of Section 1202, will qualify the partner for the capital gain exclusion under Section 1202(a).3 If the partnership interest of the partner increases following the date the partnership acquired the QSBS, the partner's eligibility for the capital gain exclusion with respect to such partner's Pass Through Section 1202 Gain is limited to the amount that would have applied if the partner's distributive share of the gain were determined by reference to the partnership interest held by the taxpayer on the date the QSBS was acquired.4
Based on the plain language of the statute, it seems fairly clear that any Pass Through Section 1202 Gain attributable to a partner's carried interest held in the partnership on the date the partnership acquired the QSBS giving rise to the Section 1202 gain would qualify for exclusion by the holder of the carried interest under Section 1202(a). The statute does not define the term "interest" in the pass-through entity. Under long-standing law acknowledged by the IRS,5 a carried interest (more formally known as a "profits interest") is a partnership interest. Though the Code often distinguishes between an interest in partnership capital and an interest in partnership profits, Section 1202(g) merely refers to the partner's interest, potentially leaving open the question of how to measure the partner's interest in the partnership. However, it seems obvious that the statute is speaking to the partner's interest in partnership profits as that is the only measure relevant to determining the partner's distributive share of Pass Through Section 1202 Gain.
Unfortunately, the IRS and U.S. Department of the Treasury have cast some doubt on the above conclusion. Under Section 1045, if a holder of QSBS disposes of the QSBS prior to the expiration of the holding period necessary to qualify for the exclusion under Section 1202(a), the taxpayer may avoid gain by investing an amount equal to the gain from the sale into new QSBS.6 The statute provides that for purposes of applying Section 1045 to partnerships, rules similar to Section 1202(g) shall apply.7 The IRS and Treasury Department have issued regulations under Section 1045(b)(5) providing that the amount of a partner's distributive share of Pass Through Section 1202 Gain eligible for Section 1045 rollover deferral is limited to the partnership's realized gain multiplied by the partner's smallest percentage in partnership capital.8 Thus, under the interpretation of the regulations, a carried interest holder is ineligible to roll over Pass Through Section 1202 Gain attributable to its carried interest held on the date the partnership acquired the QSBS under Section 1045 because its smallest interest in partnership capital is, by definition, zero.
One might surmise that the drafters of the regulations under Section 1045 might believe that the "interest" of a partner in a partnership for purposes of Section 1202 is its capital interest. However, no such regulations have been issued under Section 1202, and such interpretation would seem contradictory to the plain language of the statute. As things stand, there is a good position that carried interest can qualify for the Section 1202(a) capital gains exclusion.
Subsequent Closing Following Acquisition of QSBS
Frequently, pooled investment fund partnerships permit new partners to acquire partnership interests over a period of time, including after the fund has acquired assets. If a new partner acquires an interest in the fund after the fund has acquired QSBS, that partner will not be able to qualify for a future exclusion of Pass Through Section 1202 Gain because the partner did not have an interest in the partnership when the partnership acquired the QSBS.9
Warehousing
Sometimes, an opportunity to acquire an investment needs to close before a contemplated fund has been formed. In these situations, it is common for the sponsor or its affiliates to acquire the investment and "warehouse" it until such time as the fund has been formed. After the fund is formed, the holder of the warehoused investment will sell or contribute the property to the fund. If the warehoused property is stock in a qualified small business, an acquisition of the stock by the partnership or a noncorporate subsidiary would not qualify as QSBS because the stock was not acquired by purchase in an original issuance by the corporation.10
If the warehoused stock in a qualified small business constitutes stock possessing more than 50 percent of the total combined voting power of all classes of stock of the corporation and 50 percent of the total value of shares of all classes of stock, an alternative structure might allow the purchase of a warehoused investment. The fund could form a new corporation and acquire 100 percent of the new corporation's stock at original issue and that corporation could acquire the stock of the qualified small business. See the discussion of acquisitions of existing small businesses below.
In-Kind Distributions
On occasion, a fund needs to, or it is tax-advantageous to, distribute properties of the fund to one or more of its partners in kind. If a partnership distributes QSBS to a partner, the partner generally will step into the partnership's shoes with respect to the QSBS (i.e., will be treated as having acquired the stock in the same manner as the partnership and having held the stock for the period held by the partnership prior to the distribution).11 Requirements similar to those in Section 1202(g) must also be satisfied.12 Presumably, this limitation restricts the ability of the partner to step into the shoes of the partnership only with respect to QSBS held indirectly by that partner on the date the partnership acquired the QSBS (i.e., if the partner could not have received an allocation of gain from the partnership in respect of such QSBS that would be excludable, taxpayers cannot make an end run around that limitation by distributing the stock to the partner prior to a sale).
Application of Section 1202 to Controlling Acquisitions
The legislative intent behind Section 1202 is to encourage venture capital investments in small businesses to provide those businesses with capital for growth. In furtherance of that intent, QSBS can be acquired only from the issuing corporation at its original issuance. Stock in a qualified small business acquired by cross purchase from an existing holder of that stock cannot qualify as QSBS.
Despite the possible contradiction with the legislative intent of the statute, Section 1202 appears to provide a mechanism of achieving QSBS benefits when acquiring all of the assets of an existing business as a going concern or acquiring a controlling interest in a corporation. A fund can achieve this by first acquiring, at original issue, all of the stock of a newly formed corporation that the fund capitalizes with cash, followed by the wholly owned corporation acquiring the existing business assets13 or controlling interest in its stock. In order for the stock in the fund's newly created corporate subsidiary to be QSBS, the subsidiary must be actively engaged in a qualified trade or business for substantially all of the corporation's holding period.14 All corporations in the same parent-subsidiary control group, which for this purpose generally requires that the parent own greater than 50 percent of the subsidiary's stock by vote and value, are treated as a single corporation for this purpose and the activities of each subsidiary attributed to the common parent.15 Thus, if the target qualified small business is conducting an active business, the newly formed corporation in which the fund acquires stock at original issue will be conducting an active business. With respect to any gap between the purchase of the stock of the newly formed corporation by the fund and the corporation's purchase of the target stock or business, the newly formed corporation should be deemed to be conducting an active business under a special rule related to startup activities, including investigating the acquisition of a business.16
The statute does not provide any rule for a look-through for partnerships. Perhaps that is because Congress believed such a rule was unnecessary under a view of partnerships being just an aggregate of the partners, which would mean the activity of a partnership would be attributed to a partner no matter how small the interest. Under Section 355, involving spinoffs of corporations where there is an active business requirement, the IRS will not attribute the activities of a partnership to a corporation unless either the corporation owns at least one-third of the partnership interests17 or 20 percent of the partnership interests and actively participates in management.18 A taxpayer could point to these IRS rulings as being a similar situation, but the rulings are clearly not authority for a position under Section 1202. If the corporation has ownership of a partnership that meets the standard for a parent-control group of corporations, it is difficult to rationalize why the activities of such a partnership would not be attributed to the corporation when the activities of a corporation are, but there is no authority for this.
Issues with Add-On Acquisitions
What if, after structuring an acquisition of a portfolio company that is a qualified small business, the fund determines to have the target acquire a related business in an add-on acquisition that requires additional capital from the fund? If the contribution will not cause the parent-subsidiary group to have aggregate tax basis exceeding $75 million, the fund should be able to acquire additional QSBS from the parent. This new stock would have a holding period starting on the issuance date, and the additional purchase price would increase the per issuer limitation by 10 times the purchase price for the new stock. But if the aggregate tax basis exceeds $75 million at the time of the add-on (after taking into account the new contribution), new stock would not qualify as QSBS.
Alternatively, the fund could make an additional capital contribution with respect to the existing QSBS. The statute implies that this can be done and that it does not taint the character of the stock in respect of which such a contribution is made to cause it to fail to qualify as QSBS.19 Accordingly, even if the $75 million aggregate basis limitation would be exceeded at the time of the additional capital contribution, the additional capital contribution of cash would not appear to cause a portion of the gain on sale after the holding periods are satisfied to not qualify for the capital gains exclusion under Section 1202(a). However, the IRS has made clear that it believes that basis and holding periods should be split under general tax principles when there are additional capital contributions without a corresponding issuance of new shares.20 If true, a single share of stock, even if treated in whole as QSBS, could result in gain that is in part excludable and in part not excludable on the basis that the latter portion has not satisfied the minimum holding period requirements of Section 1202. The resolution of this issue remains to be determined. Note also that contributing capital in respect of existing shares, instead of issuing new shares, generally will leave the economic arrangement of the shareholders untouched (i.e., if the percentage of shares owned by one shareholder does not change vis-à-vis the other shareholders, liquidation and sale proceeds would not shift in any meaningful way to the contributing partner as consideration for the capital contribution). Accordingly, this alternative approach is available only where the fund owns 100 percent of the company.21
Footnotes
1 All references to the "Code" are with respect to the Internal Revenue Code of 1986 (IRC), as amended and, except as indicated otherwise herein, all Section references are references to sections of the Code.
2 IRC § 1202(a)(1).
3 IRC § 1202(g)(1).
4 IRC § 1202(g)(3).
5 See Rev. Proc. 93-27.
6 IRC § 1045.
7 IRC § 1045(b)(5).
8 Treas. Reg. § 1.1045-1(d).
9 IRC § 1202(g)(2).
10 IRC § 1202(c)(1).
11 IRC § 1202(h)(1).
12 IRC § 1202(h)(2)(C).
13 For this purpose, acquiring all of a business's assets would include acquiring all of the interests of a limited liability company (LLC) that has not elected to be classified as a corporation.
14 IRC § 1202(c)(2)(A).
15 IRC §§ 1202(e)(5)(A)and 1202(d)(3).
16 IRC § 1202(e)(2).
17 Rev. Rul. 2007-42.
18 Rev. Rul. 2002-49.
19 IRC § 1202(b)(1) (providing that additional contributions with respect to existing QSBS are ignored for purposes of the 10 times basis per issuer limitation); IRC § 1202(i)(2) (providing that for purposes of Section 1202, additional capital contributions of property with respect to QSBS will adjust basis at the fair market value of that property rather than its tax basis, which rule is intended to merely disallow gain from contributed built-in gain property from exclusion under Section 1202 by excluding such amounts from the definition of "eligible gain" under Section 1202(b)(2), as opposed to bifurcating a share of stock such that it is treated in part as QSBS and in part as nonqualifying stock).
20 See GLAM 2020-005.
21 Courts have long recognized that the issuance of stock by a wholly owned corporation in exchange for a contribution is unnecessary for the transaction to qualify for tax deferral under Section 351 because the issuance of additional shares has no effect on the proportionate ownership of the corporation and would be a "meaningless gesture." See, e.g., Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
