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What are the consequences of converting convertible preferred QSBS?

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Scott Dolson, JD
The conversion of preferred stock into common stock is treated as a recapitalization for federal income tax purposes.[3] A single corporation recapitalization generally qualifies as a tax-free Type E reorganization (Section 368(a)(1)(E)). Section 1202(f) provides that if stock is acquired solely through the conversion of QSBS, then the stock so acquired is treated as QSBS, and the holding period for the original QSBS carries over to the holding period for the QSBS issued in the conversion.
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Scott Dolson, JD
Section 368 includes Type A (merger), Type B (stock for stock) and Type C (stock for assets) reorganizations, and certain triangular mergers. These are reorganization provisions used to structure tax-free stock for stock and stock for assets acquisitions.

If target stockholders exchange QSBS for buyer stock in a tax-free reorganization, then the stock issued to the target stockholders will qualify as QSBS, subject to the possible application of Section 1202(h)(4)(B)’s limitation on claiming Section 1202’s gain exclusion.[4] Under Section 1202(h)(4)(B), if the acquiring corporation in a tax-free reorganization does not meet all of Section 1202’s eligibility requirements for issuing QSBS at the time of exchange, the amount of gain exclusion available to the target stockholders when they sell their buyer stock received in the reorganization will be limited to the amount of gain deferred at the time of the reorganization.[5] An eligibility requirement that buyer corporations will often fail to meet is the requirement that the buyer’s aggregate gross assets do not exceed $50 million immediately after the exchange (the “$50 Million Test”).[6] For example, if stockholders holding QSBS exchange their stock for stock of a public company in a Type B (stock for stock) reorganization, and the amount of gain deferred at the time of the exchange is $100 per share, when the public company stock is sold for $200 per share, the amount of a stockholder’s Section 1202 gain exclusion would be limited to the $100 per share, with the excess gain taxed at capital gains rates.[7]

If QSBS is exchanged for stock in a tax-free reorganization, a target stockholder’s holding period for buyer stock will include the holding period for the target corporation QSBS. This rule is helpful for stockholders looking to achieve the necessary five-year holding period for claiming Section 1202’s gain exclusion.

Section 1202(h)(4)(C) provides rules applicable to situations where there are multiple recapitalizations or reorganizations during a stockholder’s QSBS holding period. In general, if QSBS is exchanged for other QSBS in a Section 368 reorganization, that stock can later be exchanged again for other QSBS in further tax-free reorganizations. In connection with each subsequent reorganization, the issue of whether the $50 Million Test was satisfied would need to be addressed if the stockholder was holding QSBS at the time of the reorganization.

Presumably, if QSBS is exchanged for non-QSBS in a tax-free reorganization subject to Section 1202(h)(4), and the stockholder is holding non-QSBS (e.g., the exchange for QSBS for public company stock), none of Section 1202’s ongoing eligibility requirements should apply to the public company, other than the requirement that the company remain a C corporation through the date of sale of the stockholder’s non-QSBS. The various stockholder level eligibility requirements such as the five year holding period requirement and the limitations on a stockholder’s ability to transfer the stock other than by gift or at death would continue to apply. Finally, there are no tax authorities addressing how Section 1202’s gain exclusion cap would apply in this situation, but the most reasonable approach might be to aggregate sales of the original corporation’s QSBS with sales of the non-QSBS received in the reorganization to apply Section 1202’s gain exclusion cap.

If QSBS is exchanged for QSBS, a reasonable conclusion is that all of Section 1202’s eligibility requirements at both the corporate and stockholder level would continue to apply through the sale of the replacement QSBS. With respect to calculating Section 1202’s gain exclusion cap, if the replacement QSBS is treated as having been issued by a new issuer for purposes of the $50 Million Test, then it seems reasonable to conclude that the corporation issuing the replacement QSBS would be treated as a separate corporation for purposes of Section 1202’s gain exclusion cap (i.e., there would be no aggregating of gain exclusion of the corporations issuing the original and replacement QSBS).
Leave a Comment 6 weeks ago


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