What should you do if you receive a Schedule K-1 reporting Section 1202 gain?
Treatment of Section 1202 gain reported by a pass-through entity
To qualify for a Sec. 1202 gain exclusion, once the gain has tiered through any partnerships or S corporations, pass-through entity owners must meet the same general requirements that would apply to direct QSBS owners, but with slight twists:
- The owner must be an individual, estate, or trust.
- The owner must have owned their interest in the PTE at the time the entity acquired the QSBS.
- The owner must have held their interest in the PTE during the entire time the entity held the QSBS.
- The excludible gain is capped based on the owner’s interest in the PTE at the time the entity acquired the QSBS.
These requirements generally mean an owner can’t qualify for gain exclusion under Sec. 1202 by acquiring or increasing an interest in a PTE subsequent to the entity’s acquisition of qualified stock. As a result, owners are effectively prevented from buying or selling the underlying Sec. 1202 benefits.
When a PTE sells QSBS, it’s required to report the gain on a dedicated line of its tax return and the Schedule K-1 provided to its owners. It’s also required to provide on the Schedule K-1 all additional information necessary for the owners to determine their Sec. 1202 exclusion, including the acquisition date of the QSBS and the owner’s share of the basis in the QSBS.
What should owners consider if they receive a Schedule K-1 with Section 1202 gain?
Upon receiving a Schedule K-1 reporting Sec. 1202 gain, the owner should take four steps to determine whether they can take advantage of the Sec. 1202 gain exclusion:
1. Confirm ownership at acquisition
The owner should verify that they owned their interest in the PTE at the time the entity acquired the QSBS. The entity isn’t required to perform this analysis and will report the gain on the Schedule K-1 as Sec. 1202 gain regardless of when the owner acquired their interest. If the date the PTE invested in the corporation isn’t disclosed on the Schedule K-1, the partner may need to request this information.
2. Verify pass-through conclusions
In order to properly report the gain on Schedule K-1, the PTE should have determined that the corporation and PTE’s investment in that corporation meet the requirements for Sec. 1202. However, the ultimate owner will generally be responsible for paying any resulting tax, penalties, and interest if that position turns out to be incorrect.
It’s also not uncommon for owners to receive a Schedule K-1 reporting long-term capital gain related to the sale of stock, which also includes a footnote indicating that the gain is eligible for Sec. 1202. Alternatively, some Schedule K-1s merely indicate that long-term capital gain might be eligible for Sec. 1202 benefits without overtly concluding or may directly indicate that the entity hasn’t otherwise validated the position.
As such, owners should always exercise some caution when relying on the PTE’s determination. Consideration should be given to obtaining a copy of the underlying Sec. 1202 analysis performed by the entity. If the owner isn’t comfortable with the analysis performed, they should consider independently evaluating whether the stock qualifies as QSBS, particularly when the exclusion is substantial.
3. Apply the pass-through limitation
Even if all Sec. 1202 requirements are met, the owner may not necessarily be able to exclude the entire gain reported on the Schedule K-1.
Sec. 1202 gain can be excluded only to the extent of the owner’s original interest in the PTE. If the owner’s interest in the entity increases after the entity acquired the QSBS, the owner will likely be allocated gain in proportion to their current ownership interest. The entity isn’t required to perform this analysis and will report the entire gain on the Schedule K-1 as Sec. 1202 gain regardless of how the owner’s interest may have changed over time.
Example: Keith is an individual investor who acquires a 25% interest in ABC Partnership, and ABC Partnership subsequently acquires QSBS. Keith later buys Sam’s 25% interest in ABC Partnership to increase his total ownership to 50%. At the time of that purchase, the value of the QSBS had not changed. After holding the QSBS for six years, ABC Partnership sells the stock, resulting in a $100,000 gain. Keith is allocated $50,000 of gain in accordance with his 50% interest in the partnership ($100,000 x 50% = $50,000), but only $25,000 is eligible for exclusion under Sec. 1202 because Keith’s interest in ABC Partnership was 25% at the time the partnership acquired the QSBS ($100,000 x 25% = $25,000). However, ABC Partnership isn’t required to perform this analysis on Keith’s behalf, so it will report the entire $50,000 as Sec. 1202 gain on Keith’s Schedule K-1.
4. Apply the $10 million or 10X basis limitation
The total gain exclusion for each owner is limited to the greater of $10 million or 10x the owner’s basis. The limitation is calculated as if the owner was the direct holder of the QSBS and the owners will take into account their proportionate share of the PTE’s adjusted basis in the QSBS. This also means that if the owner holds other interests in the corporation, directly or indirectly, they must combine the total gain to calculate their exclusion.
The benefit each pass-through owner receives can vary substantially from one person to the next. Therefore, owners must carefully consider their eligibility to take a Sec. 1202 gain exclusion and whether their circumstances comply with the rules under Sec. 1202.
How we can help
Our experts can assist taxpayers with navigating the Sec. 1202 rules to ensure they are properly reporting gain from the sale of QSBS on their tax return, even if they hold the QSBS indirectly through PTEs. Since the best offense is a good defense, our experts can also help to ensure that a taxpayer’s investment in a PTE or a corporation is structured to maximize Sec, 1202 benefits and to help ensure that subsequent actions don’t put those potential benefits in jeopardy.