Advanced Section 1202 (QSBS) Planning For S Corporations

Section 1202 provides for a substantial exclusion of gain from federal income taxes when stockholders sell qualified small business stock (QSBS).[1] A number of requirements must be satisfied before a stockholder is eligible to claim Section 1202’s gain exclusion. Those requirements have been addressed in a series of articles on Frost Brown Todd’s website. This article focuses on the planning challenges posed by S corporations for business owners interested in pursuing the benefits of Section 1202’s gain exclusion.

This article is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045. The C corporation has gained favor in recent years as the entity of choice because of the 21% corporate tax rate and the potential for benefiting from Section 1202’s gain exclusion. Additional information regarding the eligibility requirements for Sections 1202 and 1045 can be found in our QSBS library.

The following Section 1202 eligibility requirements show why S corporations and QSBS are incompatible:
Only C corporations can issue QSBS (stock issued by an S corporation can never qualify as QSBS) — Section 1202(d)(1).[2]
A corporation issuing QSBS must remain a C corporation during “substantially all” of a stockholder’s holding period for the QSBS (i.e., after QSBS is issued, conversion by the issuing corporation to an S corporation will usually terminate QSBS status) — Section 1202(c)(2)(A)
A corporation issuing QSBS must remain a C corporation when the QSBS is sold — Section 1202(c)(1).

S corporations are corporations for federal income tax purposes that have made an election to be taxed under the S corporation regime. S corporation stockholders share in the corporation’s income and loss which is passed through on Schedule K-1s. There is nothing inherently wrong with operating a business through an S corporation, but business owners who seek Section 1202’s gain exclusion should avoid S corporations. This article suggests several approaches for addressing the situation where a business has strayed into the grasp of the S corporation.
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