Unlocking Tax-Free Gains: The Power of QSBS in Mergers & Acquisitions

Internal Revenue Code (IRC) Section 1202 offers a significant tax incentive for investors in qualified small business stock (QSBS). This provision allows eligible shareholders to exclude up to 100% of capital gains realized from the sale of QSBS, subject to certain limitations. This exclusion can result in substantial tax savings, making it highly attractive to founders, investors, and employees who hold equity in eligible companies. Sellers benefit by potentially eliminating federal capital gains taxes on stock sales, enhancing their after-tax returns, while buyers should care because QSBS status can increase a company’s appeal to investors, improve valuation, and create incentives for long-term investment. Given the potential tax benefits, understanding how QSBS can be utilized in the mergers and acquisitions (M&A) context is crucial for both buyers and sellers.

Overview of IRC Section 1202

IRC Section 1202 aims to encourage investment in small businesses by offering a substantial capital gains exclusion. Under this provision, a taxpayer can exclude a percentage of gain from the sale or exchange of QSBS, provided the following key conditions are met:

• The stock must be issued by a domestic C corporation.
• The corporation must have gross assets of $50 million or less at the time of stock issuance.
• The stock must be acquired at original issuance (not from another shareholder), typically in exchange for cash, property, or services.
• The corporation must actively engage in a qualified trade or business (excluding service-oriented businesses like law, accounting, consulting, and finance).
• The taxpayer must hold the stock for at least five years before selling it.

Tax Considerations

For shareholders of a company undergoing an acquisition, the QSBS exclusion can result in substantial tax savings. If the stock qualifies for Section 1202 treatment, shareholders can exclude up to 100% of eligible gains from federal income tax, subject to a per-issuer cap of $10 million or 10 times the adjusted basis of the stock. It is important to note that QSBS exclusions may be stacked through utilizing estate planning vehicles. Specifically, stacking QSBS exclusions may be accomplished by gifting QSBS to one or more family members either directly or indirectly via irrevocable trusts treated as non-grantor trusts (i.e. a trust for which the Settlor of the trust is not the taxpayer and, therefore, the trust must apply for its own EIN), each of which is eligible for a QSBS exclusion from gain on a sale of the stock.

These tax benefits can be particularly valuable in the following M&A scenarios:

1. Stock-for-Stock Transactions

When a target company with QSBS is acquired via a stock-for-stock exchange, shareholders may face challenges in maintaining QSBS eligibility. If the acquiring company is not a qualified small business, the exchanged stock may no longer qualify under Section 1202. However, careful structuring may preserve some tax benefits, such as through a Section 368 tax-free reorganization where QSBS holders receive acquiring company stock with similar attributes.

2. Cash Sales and Partial Rollovers

If shareholders sell their QSBS for cash, they can realize the full benefits of the Section 1202 exclusion, assuming all eligibility criteria are met. However, if part of the consideration includes stock in the acquiring company, the treatment of that portion depends on the structure of the transaction. A properly structured exchange may allow for deferral under Section 1045 (QSBS rollover), enabling investors to reinvest proceeds into new QSBS and maintain eligibility for future tax benefits.

3. Earnouts and Contingent Consideration

In some M&A deals, sellers receive earnouts or deferred payments. If the consideration involves QSBS treatment, structuring the transaction appropriately is critical to ensuring that subsequent payments maintain eligibility under Section 1202.

IRC Section 351 and IRC Section 1202

Section 351 allows a taxpayer to transfer property to a corporation in exchange for stock without recognizing gain or loss, provided that the transferor (or group of transferors) controls at least 80% of the corporation immediately after the transfer and the transferor does not receive boot (i.e., cash or property other than stock). If stock is received in a § 351 exchange, it may qualify as QSBS under § 1202 if the corporation otherwise meets the requirements. The key concern is ensuring that the transferor receives stock directly from the corporation and that the corporation meets the gross asset and active business tests.

If nonqualified property (e.g., stock in another corporation) is contributed in the § 351 transaction, however, the resulting stock might not be QSBS. If a partnership contributes property in a § 351 exchange, the partners might not receive QSBS treatment since they are not acquiring stock directly from the corporation. Under § 1202, the five-year holding period typically starts when the stock is issued. However, if stock is received in a § 351 exchange for QSBS, the holding period may carry over from the original stock.

When structuring, the following considerations should remain at the forefront of planning.

• Ensure the entity remains a C corporation and does not exceed the $50 million asset limit.
• Structure contributions to ensure that stock is acquired directly from the corporation.
• Avoid transfers that could disqualify the stock from QSBS treatment, such as contributions of ineligible property.

Conclusion

IRC Section 1202 presents a powerful tax incentive for investors in qualified small businesses and plays a significant role in M&A transactions. Sellers can benefit from substantial tax savings if their stock qualifies, while buyers may be able to negotiate a lower purchase price due to the increase in after tax proceeds to the seller due to the exclusion. Buyers must also carefully structure transactions to ensure continued eligibility where possible. Given the complexity of QSBS rules, expert legal and tax guidance is essential to fully leverage the benefits of Section 1202 in the M&A landscape.

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