IRC §1202 Exclusion May Affect Decision to Convert S Corporation to C Corporation

Shareholders who are considering converting their S corporation to a C corporation might think IRC §1202 seals the deal. While the 1202 exclusion of gain on qualified small business stock is very generous,  its various restrictions and requirements could make it irrelevant to a conversion decision.

S Corp Conversions More Attractive Now

The flat 21% tax rate on C corps enacted by the 2017 Tax Cuts and Jobs Act is causing many S corp owners to take a fresh look at the conversion option. That’s because income from an S corporation is not taxed at the corporate level, so it doesn’t qualify for the 21% rate.

Instead, S corp income passes through to the shareholder’s personal return, where it can be taxed at rates as high as 37%. And some types of pass-through income might also be subject to the 3.9% net investment income tax, resulting in an effective tax rate of almost 41%.

But What About the §199A Deduction?

The 199A deduction for up to 20% of a taxpayer’s qualified business income was intended to give pass-through income a tax benefit that is competitive with the 21% corporate rate. However, it doesn’t always work that way, for several reasons:

  • Not all pass-through income qualifies for the 199A deduction.
  • The deduction is so complicated some taxpayers would rather avoid it entirely.
  • The 199A deduction is temporary, while the 21% corporate tax rate is permanent.

How the IRC §1202 Exclusion Works

IRC §1202 can allow shareholders to exclude as much as 100% of their gain on the sale of qualified small business stock that they hold for at least five years. So if this were all there is to it, the S corp conversion decision would be easy:

  1. Terminate the S corp election.
  2. Make sure the resulting C corp is a qualified small business.
  3. Enjoy the 21% corporate tax rate for five years.
  4. Then sell the C corp stock and exclude the gain.

§1202 Requirements and S Corp Conversions

Unfortunately, it isn’t that simple, because §1202 is a very complicated provision. In particular, the definition of a “qualified small business” (QSB) includes several requirements that might make §1202 irrelevant to an S corp conversion.

S Corp Can’t Be a QSB

For example, a QSB must be a C corporation at the time it issues the qualified stock, and for substantially all of the shareholder’s holding period. So stock that was issued by an S corp can never be QSB stock.

Of course, the C corp that replaces the S corporation can issue QSB stock, if the corporation satisfies the many requirements for a QSB. But that won’t affect the S corp stock. So appreciation in the S corp stock both before and after the conversion can never qualify for the §1202 exclusion.

Service Business Can’t Be a QSB

Shareholders of an S corp service business might be especially tempted to convert to a C corp because a specified service trade or business (SSTB) cannot qualify for the §199A deduction. However, a service business also cannot be a QSB.

The definitions of a “service business” for 199A purposes and for 1202 purposes are not identical, but they are very similar; in fact, §199A defines an SSTB in large part by reference to §1202. Thus, service businesses that are shut out of the 199A deduction are also likely to be shut out of the 1202 exclusion.

Other §1202 Options for S Corps

Despite these complications, bolder S corp shareholders might still be able to take advantage of the §1202 exclusion. This is because IRC §1202(g) allows an S corp to buy QSSB stock directly. The S corp can then exclude its own gain on the sale of the QSB stock, and pass that exclusion through to the shareholders.

Not surprisingly, §1202(g) has its own set of requirements and restrictions, on top of all of the rules that apply to §1202 in general. For instance, to use the S corp’s exclusion, the shareholder must hold an interest in the S corp for the entire time it holds the QSB stock. A shareholder’s exclusion is also limited by the shareholder’s ownership interest in the S corp on the date the S corp acquires the QSB stock.

QSB Rules Just One Consideration

The 1202 exclusion is only one of many factors in an S corp conversion decision, and it won’t be relevant to everyone. However, if the shareholders hope to use the exclusion after the conversion, they should be aware of the many technical requirements their new C corp will have to satisfy. They should also remember that the QSB requirements are just one of the complexities of the 1202 exclusion.

By Kelley Wolf, JD, LLM

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CCHTaxGroup

All stories by: CCHTaxGroup