Section 1202: Proactively protect your QSBS exemption
Section 1202 documentation challenges
In order to claim the Sec. 1202 exemption, the shareholder needs to understand numerous facts regarding the corporation’s business activity, assets, and transactions with other investors that may not be readily available to an investor in a private company. However, a corporation isn’t currently required to remit any documentation to its shareholders informing them that their stock may qualify as QSBS. In some instances, corporations may choose to voluntarily provide information to their shareholders indicating that the corporation has met the entity-level QSBS exemption requirements. This could take the form of a simple yes-or-no-style checklist or an informal email indicating the entity-level requirements have been met. Shareholders receiving this information may not have insight into the scope of procedures performed by the corporation, if any, to draw those conclusions. Additionally, once shareholders have sold their shares, they may not have the ability or the legal right to gather the necessary information from the corporation.
This raises a concern. The shareholder is taking on all of the risk because the Sec. 1202 gain exclusion is a tax position taken on the shareholder’s tax return. If the IRS determines that a shareholder’s Sec. 1202 position isn’t appropriately substantiated, the shareholder — not the corporation — would be at risk for additional tax, penalties, and interest. Given how quickly Sec. 1202 tax benefits can add up in even small transactions, shareholders should be proactive in compiling adequate support for their Sec. 1202 eligibility.
The shareholder is taking on all of the risk because the Sec. 1202 gain exclusion is a tax position taken on the shareholder’s tax return.
How much Section 1202 documentation do you need for the QSBS exemption?
To date, the IRS has performed a limited number of audits involving Sec. 1202 positions, and there is minimal other guidance. Because of this, there is uncertainty as to the level of documentation the IRS will expect shareholders to maintain to substantiate their Sec. 1202 positions. While a yes-or-no-style checklist or a confirmatory email from the corporation may suffice, it seems likely the IRS will be looking for more, particularly when the QSBS gain exclusion is substantial.
For example, one test requires that the corporation use at least 80% of the fair market value of its assets in a qualified trade or business. While a checklist provided by the corporation might indicate that it has met this test, the IRS will likely expect to see details showing what assets were held by the corporation at various points throughout the shareholder’s holding period, how those assets were connected to the business, and why the corporation’s business was a qualified one. Even if these answers seem obvious to the shareholder, the IRS isn’t likely to take their word on the reasonableness of the conclusions. Ultimately, the shareholder has the burden of proof to support its gain exclusion.
As such, taxpayers should consider engaging a tax advisor to perform a Sec. 1202 analysis as opposed to relying on informal documentation in the event of an IRS exam. These analyses will typically address each Sec. 1202 requirement in detail, document all relevant corporate and shareholder information, and provide detailed calculations and supporting documentation. This type of analysis minimizes the chance that a shareholder will ever need to gather additional information after the fact even if the IRS examines the Sec. 1202 position.
In many cases, the amount of gain exclusion can reach into the millions or even tens of millions, in which case the benefit of a formal analysis far outweighs the cost. In addition, over time, the shareholders may have less access to information as a result of the sale, so gathering the information while it’s most accessible may be important — even if it’s long before an IRS audit may occur.
Gathering the information while it’s most accessible may be important — even if it’s long before an IRS audit may occur.
We can help with protecting your Sec. 1202 benefit
If you believe your stock may be eligible for the QSBS exemption, our advisors can help you understand whether you qualify and what documentation you should gather to best support your position. If you’ve recently been informed that your stock may be eligible for Sec. 1202, we can review the information provided and help you to ask appropriate follow-up questions. In either scenario, this proactive work will help you to gain further comfort with your Sec. 1202 position and secure your substantial tax savings.