Highlights
- For stock to qualify for the exclusion of taxable gain under Internal Revenue Code Section 1202, the issuing corporation must satisfy the Gross Assets Test, which generally requires that the corporation have no more than $75 million of gross assets.
- Upon a disposition of qualified small business stock, the selling shareholder will be able to exclude all or a portion of its gain up to $15 million or 10 times the shareholder's aggregate basis in the stock that was sold.
- This Holland & Knight alert discusses how special Section 1202 basis calculations impact the Gross Assets Test and the limitations on exclusion from gross income.
In order for stock to be qualified for an exclusion on gain under Internal Revenue Code (Code) Section 1202, the issuing corporation must, among other requirements, have aggregate gross assets of no more than $75 million at the time of the stock issuance (and no more than $50 million for stock issued on or before July 4, 2025).1 But the calculation of aggregate gross assets, referred to here as the Gross Assets Test, isn't as intuitive as it may appear.
Aggregate gross assets means the amount of cash plus the "aggregate adjusted basis" of other property held by the corporation.2 But buyer beware. "Adjusted basis" in this context doesn't always mean what you might think it means for any other provision of the Code. For property contributed to the corporation (or acquired by the corporation with a carryover basis from the transferor of the property), the adjusted basis of such property – for purposes of the Gross Assets Test – is equal to its fair market value (FMV) at the time of the contribution.3 Accordingly, it is the FMV of such contributed property that should be counted to determine whether the corporation has gross assets in excess of the limit.
Property within a corporation should fall into three broad categories: 1) cash (from any source, including borrowed cash), 2) assets purchased by the corporation (whether purchased with cash or debt) or 3) property received in exchange for stock of the company or by merger that has a carryover basis. It is only property in this third category that is treated as though it has a basis equal to its FMV, and it is treated as such solely for purposes of Section 1202 (i.e., it does not impact the shareholder's overall gain calculation upon disposition of the qualified small business stock (QSBS)). Cash always has a basis equal to its value, and assets acquired by the corporation that do not have a carryover basis should use the adjusted basis number calculated for other purposes of the Code (e.g., historical cost minus accumulated depreciation, etc.).
The assets of any subsidiaries of the corporation also should be counted on a consolidated basis if the corporation owns more than 50 percent of the voting shares of the subsidiary or 50 percent of the value of all shares of the subsidiary.4 Ownership through a chain of subsidiaries is determined using the attribution rules of Section 1563(e).
Notably, because cash contributed to a corporation often will be used to acquire depreciable assets or fund deductible expenses, it is possible that a corporation might maintain a relatively low adjusted tax basis over a period of time. In such case, it would be possible for a corporation to raise capital in excess of $75 million, and continue to be eligible to issue QSBS as long as the adjusted tax basis of its assets never exceeds $75 million at any point in time.
The 10X Basis Exclusion Calculation
Upon a disposition of QSBS, the selling shareholder will be able to exclude all or a portion of its gain up to 1) $15 million,5 or 2) 10 times (10X) the shareholder's aggregate basis in the stock that was sold.6 Similar to the rule for calculating the Gross Assets Test, the shareholder's basis in the stock – for purposes of calculating the shareholder's 10X basis exclusion – is equal to the FMV of the money and other contributed property exchanged for the QSBS (i.e., not the shareholder's carryover basis in the stock used for calculating overall gain upon a disposition of the QSBS).7
Incongruous Basis Treatment for Subsequent Contributions
Section 1202 uses aggregate basis in three distinct ways. First, the inside basis is used to calculate the Gross Assets Test to be sure the corporation has gross assets under $75 million (or $50 million for stock issuances on or before July 4, 2025). Second, the outside stock basis is used to calculate the 10X basis exclusion on gain from the sale of QSBS. Third, the outside stock basis is used to calculate the eligible gain (see the next section for a discussion of eligible gain).
For purposes of the first and second issues, contributions to the corporation in respect of QSBS after its original issuance (a subsequent contribution) are treated differently. For inside basis, and for purposes of calculating the gross assets of the corporation, any subsequent contributions in respect of QSBS made after the original issuance of such QSBS are counted toward the total gross assets.8 Section 1202(d)(2)(B) provides that the basis of any contributed property shall be no less than its FMV for this purpose. Accordingly, if a holder of QSBS contributes built-in gain property to a corporation in respect of previously issued QSBS, for purposes of calculating the gross assets of the corporation, the FMV of such assets is used in such a calculation instead of its carryover tax basis.
The contributing shareholder in a subsequent contribution, however, gets zero credit for any additional basis created in the stock because, for purposes of the 10X basis exclusion calculation, stock basis is determined without regard to any additions to stock basis after the original issuance of the stock.9 This means that if a QSBS shareholder contributes property or money to the corporation, the FMV of such contributions will be counted for purposes of the Gross Assets Test, but it will not be counted for determining the 10X basis exclusion for the shareholder. Accordingly, shareholders should always make contributions in exchange for newly issued stock and not merely in respect of shares they already hold.10
Eligible Gain
One final use of the special basis rules in Section 1202 is the amount of overall gain on the disposition of QSBS that can be excluded, subject to the $15 million exclusion or the 10X basis exclusion. Though Section 1202(a) and Section 1202(b)(2), which defines eligible gain, provide that "any gain" can be excluded up to the limitation amounts, the U.S. House of Representatives committee report from 1993 when Section 1202 was first enacted provides that:
If property (other than money or stock) is transferred to a corporation in exchange for its stock, the basis of the stock received is treated as not less than the FMV of the property exchanged. Thus, only gains that accrue after the transfer are eligible for the exclusion.11
This implies that we should read Section 1202(i)(1)(B) to mean that the actual gain from the disposition of stock should be recalculated as if the adjusted basis utilized the FMV basis rule. And only that portion of the overall gain would be eligible for exclusion. This sets up an implied rule that is not clearly articulated in the statute, which is that the excluded gain will be the lesser of the limitation amount under Section 1202(b)(1) or the eligible gain, as recalculated using the special FMV basis rule.
This conclusion is supported by Section 1202(i)(1)(B) and Section 1202(i)(2), which provide that for purposes "of this section" (i.e., Section 1202), regardless of whether a contribution is made at original issuance or in a subsequent contribution, the basis of the QSBS includes the FMV of any property contributed in exchange for or in respect of such stock.12 Though this appears at first glance to apply to the entirety of Section 1202, it does not.
As noted in the previous section of this article, there are only three applications of basis within Section 1202. The rule in Section 1202(i) relating to stock basis is consistent with the rule for the calculation of gross assets in Section 1202(d)(2)(B), which also uses the FMV of contributed assets instead of the carryover basis. But solely for purposes of calculating the 10X basis exclusion limit, the flush language in Section 1202(b)(1) explicitly provides that additions to stock basis after the original issuance are ignored, overriding the general rule provided in Section 1202(i). This leaves only the calculation of eligible gain as a functional purpose for Section 1202(i). Reading the statute in this way achieves the intended outcome described in the legislative history: that pre-contribution built-in gains are not eligible for exclusion.13
For example, assume a taxpayer contributed an existing business operated as a sole proprietorship to a corporation after July 4, 2025, when that business had a FMV of $5 million and an adjusted basis of $1 million. More than five years later, the taxpayer sold all of its QSBS for $30 million. Under Section 1001, the taxpayer would have an overall realized gain of $29 million ($30 million of sales proceeds minus $1 million of carryover basis in the stock). But the eligible gain would be only $25 million ($30 million of sale proceeds minus $5 million, which was the FMV of the business at the time of contribution). Though the taxpayer would have a 10X basis exclusion limit of $50 million, more than enough to cover the entire gain, only $25 million would be excludable. The $4 million of additional gain, which represents the accrued built-in gain at the time of contribution, would still be taxable at capital gains rates and not excluded under Section 1202.
To illustrate the impact of subsequent contributions, assume the same facts above except that the taxpayer contributed additional assets after the original issuance of the QSBS with a FMV of $4 million and an adjusted basis of $2 million. For purposes other than Section 1202, the taxpayer's basis in its stock would be $3 million ($1 million from the original contribution plus $2 million from the subsequent contribution). Also assume the sale price upon disposition is $53 million. Such a transaction would result in $50 million of realized gain ($53 million minus $3 million of basis). The 10X basis exclusion amount would also be $50 million because the subsequent contribution would not change the 10X basis exclusion amount established at the original issuance ($5 million of FMV times 10).14 The recalculated "eligible gain," however, would be only $44 million ($53 million minus $5 million of FMV basis for the original contribution minus $4 million of FMV basis for the subsequent contribution). The taxpayer would exclude the lesser of the recalculated gain of $44 million or the total realized gain of $50 million, leaving $6 million of the gain to be taxable at capital gains rates, which represents the built-in gains of the original contribution ($4 million) and the subsequent contribution ($2 million).
Footnotes
1 IRC § 1202(d)(1).
2 IRC § 1202(d)(2)(A).
3 IRC § 1202(d)(2)(B).
4 IRC § 1202(d)(3).
5 For QSBS issued on or before July 4, 2025, the limit is $10 million instead of $15 million.
6 IRC § 1202(b)(1).
7 IRC § 1202(i)(1)(B).
8 IRC § 1202(d)(2)(B).
9 See the flush language at the bottom of Section 1202(b)(1).
10 It is often advisable to issue new shares for additional capital contributions for other reasons as well. For example, holding separate blocks of stock may provide flexibility on a sale, allowing a shareholder to choose to sell shares that meet the required QSBS holding period, while continuing to hold shares that do not yet meet the required holding period.
11 H. Rept. No. 103-111 (PL 103-66) p. 603.
12 Section 1202(i)(1)(B) applies generally to any contribution in exchange for stock (other than money or other stock) and Section 1202(i)(2) applies to contributions in respect of QSBS made after the original issuance.
13 H. Rept. No. 103-111 (PL 103-66) p. 603.
14 See the flush language at the bottom of Section 1202(b)(1).
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.
