Accidental Termination on Purpose? S Corp Ruling Could Be Huge For QSBS Owners

Qualified Small Business Stock (“QSBS”) is arguably one of the largest “gifts” Congress has given taxpayers by excluding from a shareholder’s gross income the greater of $10 million or 10 times the shareholder’s basis in the QSBS that was sold. With the recent IRS Private Letter Ruling (“PLR”), that exemption has perhaps become easier to obtain for taxpayers who initially thought they have missed the boat, and it is perhaps even possible to retroactively qualify to satisfy the 5-year holding period requirement. 

Sec. 1202(a) of the Internal Revenue Code (Code) provides that a noncorporate shareholder may exclude from the shareholder’s gross income 100% of the gain from the sale of QSBS that has been held for 5 years. QSBS must be stock in a C corporation, and, thus, Sec. 1202 is generally not available to exclude gain on the sale of S corporation stock or partnership interests.  

The first requirement that the business be formed as a C corporation, although seemingly straightforward, has been the subject of some uncertainty. Although Sec. 1202 was enacted many years ago, it has relatively few regulations and rulings, which created some uncertainty in cases where an entity was initially formed as an S corporation under Sec. 1362, but later revoked its S corporation status.     

The PLR issued in October of 2023, however, has shed light on that uncertainty and suggested that if a corporation taxed as an S corporation terminates its tax election on or before the date the stock is issued, it would be considered as if a C corporation issued the stock. Consequently, the entity could potentially qualify for the QSBS exclusion, provided all other criteria under Sec 1202 are met. S corporations that want to issue QSBS mid-year by ending an S election can now, based on this PLR, potentially make this QSBS exclusion available.   

In the PLR, the corporation made an S election to be treated as an S corporation, but it invalidated its S election by issuing a second class of stock, in violation of Reg. 1.1361-1(l)(1).  Despite the original S election and subsequent revocation, the IRS nevertheless concluded the corporation had a qualified trade or business under Sec. 1202.  

While the PLR did not actually discuss the legal basis for the IRS’s position, the legal framework for its conclusion would appear to be found in Reg. 1.1362-2(b)(2), which states that when an S corporation no longer meets the criteria for a small business corporation, its S election is terminated as of the date of the disqualifying event and the entity converts automatically to a C corporation for federal income tax purposes as of such date.  

As a result, a corporation’s S corporation status should terminate on the day any one of the following requirements is violated: (i) exceeding the limit of 100 shareholders; (ii) including shareholders who are neither individuals nor certain specified trusts; (iii) having a nonresident alien as a shareholder; (iv) issuing more than one class of stock (as in the case of the PLR); (v) not filing the S election in a timely manner; and (vi) not securing S election signatures from spouses in community property states. 

Once a corporation terminates its S election, it can’t regain that status for four taxable years after the taxable year of termination unless the IRS permits it under Sec. 1362(g). Although the corporation in the PLR made an S election on Day 1, it immediately violated its election and was treated as a C corporation at the time it issued the stock, and therefore was eligible for QSBS treatment.  

Though it has not been legally established yet, it may be the case that the same result would apply when a limited liability company that is initially taxed as a partnership or single-member disregarded entity makes an election to be taxed as a C corporation. Following this logic, one could extrapolate the analysis further: where an entity requests late election relief under Rev. Proc. 2009-41, making the election to be taxed as a C corporation up to 3 years and 75 days after the requested effective date, the entity could be permitted to meet the C corporation requirement as well as the 5-year holding period dating back to the effective date of the election, similar to the conclusion the IRS made in the PLR that the S corporation termination would retroactively meet the C corporation requirement from its inception. These scenarios are hypothetical but, until there is more clarity regarding how to interpret the interplay between established law and new guidance, tax strategies must scrutinize more closely the risks and rewards of tax elections.   

In any case, Sec. 1202 and the QSBS continue to play a vital role in the exemption of capital gains tax for startups and small businesses, and tax strategies should be carefully analyzed by one’s tax professional to structure one’s business to take advantage of the IRS’s gift where possible.    

——————————————————————–

This DarrowEverett Insight should not be construed as legal advice or a legal opinion on any specific facts or circumstances. This Insight is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The contents are intended for general informational purposes only, and you are urged to consult your attorney concerning any particular situation and any specific legal question you may have. We are working diligently to remain well informed and up to date on information and advisements as they become available. As such, please reach out to us if you need help addressing any of the issues discussed in this Insight, or any other issues or concerns you may have relating to your business. We are ready to help guide you through these challenging times.

Unless expressly provided, this Insight does not constitute written tax advice as described in 31 C.F.R. §10, et seq. and is not intended or written by us to be used and/or relied on as written tax advice for any purpose including, without limitation, the marketing of any transaction addressed herein. Any U.S. federal tax advice rendered by DarrowEverett LLP shall be conspicuously labeled as such, shall include a discussion of all relevant facts and circumstances, as well as of any representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) upon which we rely, applicable to transactions discussed therein in compliance with 31 C.F.R. §10.37, shall relate the applicable law and authorities to the facts, and shall set forth any applicable limits on the use of such advice.