Section 1202 provides for a substantial exclusion of gain from federal income taxes when stockholders sell qualified small business stock (QSBS). But a number of requirements, including avoidance of Section 1202(c)(3)’s anti-churning rules, must be satisfied in order to be eligible to claim Section 1202’s gain exclusion. This article focuses on the potential forfeiture of QSBS status that can be triggered by poorly-timed issuances and redemptions of stock.
If Section 1202’s anti-churning rules are triggered, the affected stock will forfeit its QSBS status. Presumably, Section 1202(c)(3) was enacted as an effort to block the strategy of exchanging non-QSBS for QSBS. The potential application of these rules should be considered before stock is redeemed or QSBS issued. Also, understanding how these rules work is important when vetting whether stock is QSBS.
Stock redemptions are not common occurrences for early-stage companies. But companies do occasionally redeem stock from exiting founders and early-stage employees. Later-stage companies also occasionally rely on stock redemptions as a source of liquidity for founders or investors. Understanding whether the anti-churning rules would be triggered by a redemption is a necessary part of the planning process.
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. During the past five years, the C corporation has gained favor as the entity of choice for many start-ups. Much of this interest can be attributed to the reduction in the federal corporate income tax rate from 35% to 21%, but savvy founders and venture capitalists have also focused on qualifying for Section 1202’s gain exclusion. Efforts by Congress to reduce Section 1202’s benefits over the past several years have failed. Additional information regarding the eligibility requirements for Sections 1202 and 1045 can be found in our QSBS library.
What qualifies as a stock redemption?