One recurring issue involves working with the owners of S corporations who are considering converting their companies to C corporations, usually with an eye towards eventually taking advantage of Section 1202’s gain exclusion. The challenge is that only stock issued by a C corporation can qualify as QSBS, which means that merely converting to a C corporation won’t turn the founders’ outstanding S corporation stock into QSBS. A fair question is whether the outstanding S corporation stock problem can be cured by exchanging stock that was historically S corporation stock for new C corporation stock. Unfortunately, this plan doesn’t work because under Section 1202(h)(4) stock received in the recapitalization is not QSBS unless it is issued in exchange for QSBS. Even if the position was taken that the recapitalization was governed by Section 1202(h)(3), this wouldn’t change the result because Treasury Regulation Section 1.1244(c)(3), Example (1) confirms that the original stock (i.e., the non-QSBS S corporation founder stock) must meet the requirements of Section 1244 stock (here substitute Section 1202 for Section 1244), in order for favorable treatment under Section 1244(d)(2) to apply.

One workaround addressing this problem involves a contribution by the S corporation of assets or a single-member LLC interest to a newly-formed C corporation in exchange for stock. The C corporation should be eligible to issue QSBS to the S corporation, additional investors and employees (if an equity plan is adopted), so long as there exists bona-fide business reasons for adopting this plan.

A second possible workaround would be to terminate the S election and recapitalize the now-C corporation by exchanging the outstanding common stock for a class of preferred stock and issuing additional shares of common stock to investors, employees and to existing stockholders for new consideration. The rules of Section 306 governing the issuance of preferred stock in Type E recapitalizations would need to be contended with and the initial preferred stock would not qualify for Section 1202’s gain exclusion. This workaround might also be a useful tool where an S corporation has already converted to a C corporation before there is an opportunity to consider the first planning method addressed in the preceding sentence.

F. What are the consequences of exchanging QSBS in a Type F reorganization (mere change of form, identity or place of organization) for other equity of the corporation?
QSBS held by stockholders participating in a Type F reorganization is subject to the same treatment applicable to QSBS in a Type E reorganization discussed in Section D above. A typical Type F reorganization includes redomiciling a corporation from Colorado to Delaware or converting an Delaware LLC taxed as a corporation (i.e., an LLC that has filed a “check-the-box election”) to a Delaware state-law corporation.

G. What are the consequences of a “stock split” (e.g., where one share splits into 100 shares) involving QSBS?
In a forward stock split, a share is split into multiple shares of the same corporation. A stock split can be accomplished by actually “splitting” a share of stock into multiple shares (e.g., the corporation’s articles/certificate of incorporation is amended to provide that each share of stock splits into multiple shares of stock) or by means of a stock distribution with respect to an outstanding share (e.g., 99 shares are distributed with respect to each outstanding share). The effect of a forward stock split on the QSBS status of outstanding stock is addressed below:

• A stock split accomplished through an amendment to the certificate/articles should be treated as falling within the scope of Section 1202(h)(4) because that transaction qualifies as a Type E reorganization (Section 368(a)(1)(E)), and the articles/certificate can reference the exchange of the one share for multiple shares (meeting Section 1202(h)(4)’s literal requirement for an “exchange.”[10] There are no tax authorities addressing the issue of whether the corporation must be treated as “issuing” replacement stock for purposes of Section 1202, triggering application of the $50 Million Test at the time of the stock split, but Section 1202(h)(4) does not distinguish between participation in a single-corporation transaction versus rolling QSBS up into a larger corporation in an acquisitive transaction under Sections 368 or 351.

• A second method for accomplishing a stock-split is a stock dividend, where the corporation distributes additional shares with respect to each outstanding share of QSBS. Section 1202(h)(3) provides that rules similar to those in Section 1244(d)(2) apply for purposes of defining the scope of QSBS transfers and issuances of stock with respect to QSBS that do not adversely affect QSBS status. Treasury Regulation Section 1.1244(d)-3(b) provides the following in respect to excluded stock distributions, “[i]f common stock is received by an individual or partnership in a nontaxable distribution under section 305(a) made solely with respect to stock owned by such individual or partnership which meets the requirements of section 1244 stock determinable at the time of the distribution, then the common stock so received will also be treated as meeting such requirements.” The regulation also notably provides that Section 1244’s “gross receipts test” is not includable among the requirements of Section 1244 “determinable at the time of the distribution or exchange.” The language of this regulation supports an argument that for purposes of Section 1202, a stock dividend falls favorably within the scope of Section 1202(h)(3) (i.e., if the stockholder holds QSBS, then the additional shares distributed pursuant to the stock dividend would also qualify as QSBS) and as a result, the corporation would not be subject to $50 Million Test retesting when the dividend occurs.

With certain modifications, Section 1202 follows the general holding period rules of Section 1223. With respect to a Type E reorganization (a reorganization governed by Section 368), Section 1202(h)(4) provides that with respect to stock received in an exchange governed by Section 368, the “stock shall be treated as qualified small business stock acquired on the date on which the exchanged stock was acquired.” With respect to a stock dividend, Section 1223(4)(A) provides that, “[i]n determining the period for which the taxpayer has held stock or rights to acquire stock received on a distribution, if the basis of such stock or rights is determined under Section 307, there shall (under regulations prescribed by the Secretary) be included the period for which he held the stock in the distributing corporation before the receipt of such stock or rights upon such distribution.” Section 307 controls the allocation of basis for any tax-free stock distribution under Section 305(a). Based on this authority, the holding period for the QSBS issued in the stock distribution should include the holding period for QSBS held by the stockholder.