Qualified Small Business Stock Rules Deserve Big IRS Attention – Tax Authorities

Section 1202 of the tax code is a little-known
secret that offers substantial benefits for investments in small
businesses, including tax-free gains on the sale of qualified small
business stock, or QSBS, up to the greater of $10 million or 10
times the investment basis.

But to reap these rewards, taxpayers must navigate a complex and
vague set of rules. There are ambiguities and potential pitfalls in
the significant redemption rule of Section 1202(c)(3)(B) that could
inadvertently penalize early-stage entrepreneurs.

The IRS should clarify the rules in this subsection to align its
application with the purpose that Congress intended for it.

Redemption Rule Differences

Stock doesn’t qualify as QSBS under Section 1202(c)(3)(B) if
the corporation makes a significant redemption within a two-year
period that starts one year before the stock is issued.

A significant redemption within this period disqualifies all
stock issued in that two-year period from QSBS status if the
redeemed amount exceeds the statutorily defined test of significant
redemption under Section 1202(c)(3)(B), or if the purchased amount
exceeds the de minimis threshold.

For a redemption to be considered significant, the corporation
must redeem stock with a total value at the time of the purchases
exceeding 5% of the total value of all its stock at the beginning
of the two-year period in question.

However, Reg. Section 1.1202-2(b)(2) holds that a redemption only
surpasses the de minimis threshold if the aggregate amount paid for
the stock exceeds $10,000, and more than 2% of all outstanding
stock is purchased.

Recognizing the distinctions between the two tests is crucial.
The significant redemption test evaluates the stock’s value at
the beginning of the two-year assessment window, whereas the de
minimis test considers the stock’s value when it’s

The key difference in these tests is what makes the significant
redemption rules particularly problematic for those issued stock in
the corporation’s first year.

There are also a few scenarios where the corporation can redeem
stock without triggering the redemption rules. Under Reg. Section
1.1202-2(d)(1)-(4), redemptions will be “ignored” if
connected to termination of services, death, disability or mental
incompetency, or divorce.

Legislative Purpose

The redemption rules were structured to maintain the integrity
of the original issuance requirement of Section 1202(c)(1), which
safeguards against taxpayer abuse by ensuring that issued shares
reflect fresh capital infused into a small business.

The legislative history in the Omnibus Budget Reconciliation Act of 1993 describes the significant
redemption rules as an “anti-evasion” measure whose goal
is to “prevent evasion of the requirement that the stock be
newly issued.” The rules were designed to prevent avoidance of
the original issuance requirement.

Similarly, the IRS, when issuing Reg. Section 1.1202-2, noted
concern in Internal Revenue Bulletin No. 1996-30 (IA-26-94) that “in many
cases, redemptions that have neither the purpose nor the effect of
evading the original issue requirement may result in
disqualification under these rules. Section 1202(k) authorizes
Treasury to prescribe such regulations as may be appropriate to
carry out the purposes of Section 1202.”

Congress, aware something like this could arise, allowed the IRS
to prescribe regulations to prevent the potential overreach of the
significant redemption rules from frustrating the policy behind
Section 1202.

Similar redemption issues have been resolved with additional
guidance. The IRS created an exception for redemptions following
death, disability or mental incompetency, and divorce.

It reasoned in Treasury Decision 8749 that these new
exceptions were added because they’re “unlikely to lead to
avoidance of the requirement that qualified small business stock be
purchased at original issue.”

Based on the available legislative history, it appears the sole
purpose of the redemption rules is to prevent evasion of the
original issuance requirement.

Founders Dilemma

Significant redemption rules require a retrospective evaluation
of stock value. This is particularly problematic for founders who
receive stock in the first year of a company’s existence.

Based on a literal reading of Section 1202(c)(3)(B), the statute
could assign zero value to a stock at the start of the two-year
assessment period, because the company didn’t exist at such

This interpretation could jeopardize the QSBS exclusion for the
initial founders, as almost any non-de minimis or excluded
redemption within this time frame would be deemed significant.

That wasn’t the intention of the significant redemption
rules, which were only enacted to backstop the original issuance
requirement. Based on a literal reading, any non-de minimis or
excluded redemption could trigger the significant redemption rules
and taint all QSBS issued within that two-year window, which
clearly isn’t the rules’ intent.

Proposed Solution

To fix this glaring issue, there should be either an update to
the language of the significant redemption rules in Reg. Section
1.1202-2(b), or a private letter ruling or similar guidance
clarifying Section 1202(c)(3)(B)—similar to how the IRS
clarified what Section 1202(e)(3)(A) means with respect to a trade
or business involving the performance of services in the field of
health in Private Letter Ruling 202125004.

Ideally, the clarification should state that the testing period
for significant redemptions should start at the earlier of the
start of the two-year period, or the date of formation.

This change would prevent early-stage entrepreneurs from being
unintentionally penalized and, similar to the exclusions above, is
unlikely to lead to avoidance of the original issuance

Originally published by Bloomberg Tax.

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.

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