Cross-Border Tax Planning with §1202

Section 1202 provides an exclusion from gross income of capital gain derived from the sale of qualified small business stock (QSBS).^[1] The QSBS rules were enacted in 1993 to encourage equity investments in small businesses. While many tax practitioners are familiar with the benefits of using §1202 in the purely domestic setting, they may not be as familiar with planning opportunities in the cross-border arena. This article begins with an overview of §1202 and then discusses how §1202 can apply in both outbound and inbound tax contexts.

Overview of §1202

Section 1202 provides a 100% exclusion from gross income of capital gain derived from the sale of QSBS held for more than five years.^[2] When first enacted, it provided a 50% exclusion, but it has been amended a few times since then and currently allows for a 100% exclusion up to the per-issuer limitation.^[3]

Under the per-issuer limitation, a taxpayer that sells QSBS can exclude the greater of: 1) $15 million (reduced by prior exclusions relating to the same company);^[4] or 2) 10 times the taxpayer’s initial, aggregate adjusted basis of QSBS sold during the taxable year.^[5] It is called the per-issuer limitation because it applies to stock held by a taxpayer in each issuing company, meaning that a taxpayer can receive the benefit of a full exclusion under §1202 in multiple companies. Importantly, the two limitations can be used in tandem with each other; for example, a taxpayer can use the $15 million limitation in one year and the 10 times basis limitation in a later year.

Qualification for QSBS treatment is complex, and there are many layers of definitions in the statute, but they can be distilled into two groups of requirements. There are requirements that apply to the issuer of the stock and there are requirements that apply to the shareholder seeking an exclusion from gross income by selling QSBS. Some of the requirements must be met as of a specific point in time, and others must be met for substantially all the taxpayer’s holding period in the shares. This means that a taxpayer’s eligibility for QSBS treatment is fluid and must be tested over time; just because a taxpayer qualifies today does not mean he or she will qualify tomorrow. This can give rise to planning opportunities, but it can also be a trap for the unwary.

In general, the company-specific requirements are as follows:

1) The company must be a domestic C corporation:^[6] a) when it issued the stock;^[7] b) during substantially all the taxpayer’s holding period in the stock; and c) when the shareholder sells the stock.^[8]

2) The company’s “aggregate gross assets” when it issues the stock, and immediately after the issuance, cannot exceed $75 million.^[9] This includes the amount of cash held by the company plus the aggregate adjusted bases of all other property held by the corporation. But in the case of property contributed to the company, the company’s basis in the property cannot be less than the fair market value of the property at the time of contribution.^[10]

3) The company must meet the “active business requirement,” meaning that it must be engaged in one or more qualified trades or businesses (QTBs)^[11] and use at least 80% of the value of its assets in the active conduct of one or more QTBs during substantially all the taxpayer’s holding period in the stock:^[12]

a) Section 1202(e)(3) carves out certain industries from the definition of a QTB, but there is no requirement that a QTB operate in the U.S.;

b) Ownership of real estate is limited. First, operating a hotel, motel, restaurant, or similar business is excluded from being a QTB.^[13] Second, if more than 10% of the value of a company’s assets consist of real property that is not used in the active conduct of a QTB, then the active business requirement is not met.^[14] For this purpose, the ownership of, dealing in, or renting of real property is not treated as the active conduct of a QTB;^[15]

c) There is a look-through rule for stock in subsidiaries.^[16] Section 1202(e)(5) provides that if a parent company owns more than 50% of voting power or value of stock in a subsidiary, then the stock and debt in the subsidiary is disregarded and the parent company is deemed to own its ratable share of the subsidiary’s assets, and to conduct its ratable share of the subsidiary’s activities.^[17] This rule allows for stock in holding companies to qualify for QSBS treatment on the basis of the activities of its subsidiaries;^[18]

d) Despite the look-through rule, a company will not be considered to meet the active business requirement during any period in which more than 10% of the value of its assets (in excess of liabilities) consists of stock or securities in other corporations when it owns 50% or less of the vote or value of the stock, other than stock or securities held as working capital;^[19]

e) The company must be an eligible corporation, meaning it cannot be a domestic international sales corporation (DISC), former DISC, a regulated investment company (RIC), real estate investment trust (REIT), real estate mortgage investment conduit (REMIC), or a cooperative.^[20]

4) The company must not have engaged in certain redemption transactions.^[21] There are two separate redemption rules; one that affects the shareholder (and certain related persons) redeemed,^[22] and one that affects all shareholders if the redemption is considered significant.^[23]

5) The company agrees to submit such reports to the IRS and to shareholders to carry out the purposes of §1202.

The shareholder-specific requirements are as follows:

1) The shareholder must be an individual, trust, estate, partnership, S corporation, regulated investment company, or common trust fund.^[24]

2) The shareholder must have acquired the stock directly from the company in an “original issuance,” meaning from the company itself in exchange for money, property (other than stock), or services (other than as an underwriter of the stock), but not from another shareholder in a cross-purchase.^[25]

3) Before the sale, the shareholder must have held the stock continuously for more than five years without engaging in certain transactions that hedge or minimize the risk of owning the stock.^[26]

Outbound Planning With §1202

There are at least two tax planning opportunities in the outbound context that can be coupled with the benefits of §1202. The first one applies to businesses that take advantage of the deduction under §250 for foreign-derived deduction eligible income (FDDEI). Under §250, a U.S. C corporation generally receives a 33.34% deduction (and, therefore, a 14% effective U.S. federal income tax rate)^[27] on income attributable to sales of personal property, the provision of services, and the license of intellectual property to non-U.S. persons.^[28] Assuming such income also is attributable to a QTB under §1202 — for example, a business that licenses computer software to non-U.S. persons — and the other requirements of §1202 are met, then a qualifying shareholder can sell the stock of the U.S. company, or liquidate it, after the requisite holding period is met and receive an exclusion under §1202. The combination of these two provisions gives rise to a 14% effective tax rate as a result of §250, and potentially no shareholder-level tax under §1202 (compared to the 23.8% tax rate that applies to long-term capital gain that is subject to the net investment income tax).

The second opportunity involves a taxpayer owning a controlled foreign corporation (CFC) through a U.S. holding company to take advantage of §1202 on a sale or liquidation of the holding company. This strategy relies on the look-through rule under §1202(e)(5), which treats a corporation owning more than 50% of the voting power or value of a subsidiary corporation as owning its ratable share of the subsidiary’s assets, and as conducting its ratable shares of the subsidiary’s activities. The look-through rule is not limited to the ownership of domestic subsidiaries, so a U.S. holding company is treated as owning its ratable shares of its CFC’s assets, and as conducting its ratable shares of the CFC’s activities. Assuming the CFC is engaged in one or more QTBs, and the other requirements of §1202 are met, then the stock of the U.S. holding company can qualify as QSBS.

For example, a U.S. parent corporation can form a Cayman Islands CFC that is engaged in the business of manufacturing rum cakes in the Cayman Islands. Under §1202(e)(5), the active business of the CFC is attributed ratably to its U.S. parent. Therefore, the stock in U.S. parent can qualify as QSBS if it otherwise meets the requirements of §1202. Assuming the income of the CFC is characterized as “net CFC tested income” under §951A, the U.S. parent would pay an effective corporate income tax rate of 12.6% each year on its allocable share of the net CFC tested income.^[29] The profits of the CFC can later be repatriated to the U.S. parent tax-free under §959 as previously taxed earnings and profits. Finally, the U.S. individual shareholders of the parent corporation can receive an exclusion under §1202 if they sell their stock in U.S. parent or receive a liquidating distribution from it. If the entire shareholder-level gain is excluded from gross income under §1202, then the effective U.S. tax rate in this structure would be 12.6%.^[30]

A similar result can be achieved if the income of a CFC is not taxable to its U.S. parent on an annual basis, either because: 1) the U.S. parent elects the high-tax exception from subpart F income or net CFC tested income;^[31] or 2) the U.S. parent owns shares of a CFC that have limited dividend rights.^[32] For example, assume a U.S. parent owns more than 50% of the value of a CFC but 50% or less of its non-participating, voting preferred shares. Under Reg. §1.951-1(e), even though the U.S. parent owns more than 50% of the value of the CFC, it will have a limited subpart F or net CFC tested income inclusion because of its limited dividend rights.^[33] Therefore, the U.S. parent obtains deferral on its remaining allocable share of the CFC’s earnings and profits. After five years, the U.S. parent can liquidate the CFC and get a §245A dividends-received deduction on its share of the liquidation proceeds.^[34] The individual shareholders of the U.S. parent can then either sell their shares or liquidate U.S. parent and receive an exclusion under §1202, assuming the requirements are met.

• Can the IRS Successfully Challenge U.S. Holding Company Structures? — There is no requirement in §1202 that a QTB be conducted in the U.S., and §1202(e)(5) does not limit the application of the look-through rule to domestic corporations. Despite this, the IRS could attempt to limit the application of §1202 in a case in which a U.S. parent company has no direct U.S. trade or business and its only asset is a non-U.S. entity that’s engaged in a non-U.S. trade or business. One assumes Congress did not intend §1202 to operate in this manner, but it never limited the language of §1202.

In addition to economic substance and similar common law doctrines, there are two specific provisions that could apply here — §1248(e) and §269(a). In general, §1248(a) provides that gain recognized by a U.S. shareholder that owned 10% or more of the voting power of all classes of stock of a CFC at any time during the prior five-year period is recharacterized as a dividend to the extent of the shareholder’s allocable share of the CFC’s untaxed earnings and profits. Under §1248(e), if a U.S. person sells or exchanges stock of a domestic corporation, and such domestic corporation was “formed or availed of principally for the holding, directly or indirectly, of stock of one or more foreign corporations,” then the sale or exchange of such domestic stock is treated as a sale or exchange of the stock of the foreign corporation held by the domestic corporation. Whether a domestic corporation is “formed or availed of principally” for the holding of stock of one or more foreign corporations is based on all the facts and circumstances of each case.^[35]

Although there is very little guidance on the applicability of §1248(e), it should not apply in the case in which a U.S. parent corporation is taxed on an annual basis on the CFC’s earnings and profits as either subpart F income or net CFC tested income. This is because there would be no untaxed earnings and profits to be recharacterized under §1248(a). Similarly, §1248(e) should not apply if a U.S. corporate parent owns a CFC that is organized in a jurisdiction that has a comprehensive income tax treaty with the U.S. because the tax rate that would apply to a deemed sale of the CFC stock under §1248(e) would be the same as the tax rate that would apply to a sale of the domestic corporation’s stock (i.e., 23.8%).^[36]

Therefore, it seems that §1248(e) could potentially apply only when the earnings and profits of a CFC are not taxed on an annual basis (e.g., as net CFC tested income) and the CFC is organized in a jurisdiction that does not have a comprehensive income tax treaty with the U.S.^[37] Even in such a situation, however, the IRS may have a difficult time using §1248(e) to challenge the use of a U.S. holding company in this context because of the obvious non-tax benefits of the structure and the fact that the holding company would need to be in existence for at least three to five years, which is not an insignificant amount of time. Moreover, Congress essentially has encouraged the use of U.S. C corporation holding companies in closely held outbound structures after the 2017 Tax Cuts and Jobs Act by providing a 33.34% deduction for FDDEI and a 40% deduction for net CFC tested income under §250, neither of which is available to individual shareholders of CFCs. In addition, U.S. corporate shareholders of CFCs are also able to claim an indirect foreign tax credit under §960 for any corporate-level taxes paid by the CFCs, whereas individual shareholders of CFCs do not receive the same benefit. Finally, individual U.S. shareholders can obtain qualified dividend income treatment on dividends received from a U.S. C corporation, whereas only dividends received from CFCs organized in jurisdictions that have comprehensive income tax treaties with the U.S. provide such a benefit.^[38] Therefore, despite the seemingly broad scope of §1248(e), it is not certain to apply.

Another anti-abuse rule that may be relevant to the CFC examples above is §269(a). That section provides that if any person acquires control of a corporation, and the principal purpose of such acquisition is the avoidance of federal income tax by securing the benefit of an allowance that such person would not otherwise enjoy, the IRS may disallow such benefit. Control for this purpose means the ownership of stock representing at least 50% of the vote or value.^[39] The issue is whether the formation of a U.S. C corporation holding company to own shares of a CFC and potentially obtain an exclusion under §1202 at the individual shareholder level could be subject to challenge under §269(a). Although this issue is not entirely free from doubt, it does not appear as though the IRS would be successful in such a challenge. Individual U.S. shareholders can obtain the same benefits under §1202 without having to acquire control of a U.S. C corporation holding company. In other words, a U.S. individual shareholder that owns, for example, 10% of the stock of a U.S. corporate holding company would still be eligible for the exclusion under §1202. It is not necessary for the individual shareholders to obtain control of a U.S. C corporation for §1202 to apply. The Tax Court has held that the predecessor to §269(a) will not apply if obtaining control of a corporation is not required to obtain the tax benefit.^[40] Therefore, it does not seem as though challenging the use of a U.S. holding company under §269(a) to obtain a tax benefit under §1202 would be a viable argument for the IRS to make in this situation.

Inbound Planning with §1202

Non-U.S. shareholders can also benefit from §1202 in the inbound context in appropriate circumstances. Specifically, non-U.S. individuals that invest in domestic C corporations that are characterized as U.S. real property holding companies for purposes of the Foreign Investment in U.S. Real Property Tax Act (FIRPTA) rules can potentially take advantage of §1202 to override §897.

In general, foreign persons are subject to U.S. federal income tax in the U.S. on two types of income: 1) U.S.-source passive income (e.g., interest, dividends, rents, and royalties) that is not connected to a U.S. trade or business — this is subject to the 30% gross-basis withholding tax; and 2) any income that effectively connected to a U.S. trade or business (ECI) — this is subject to tax at graduated U.S. income tax rates.^[41] Under §897, when a non-U.S. person disposes of a U.S. real property interest (USRPI) at a gain, such gain is treated as ECI, even if the non-U.S. person is not otherwise engaged in a U.S. trade or business.^[42] USRPIs are interests in real property located in the U.S. and/or stock in a U.S. corporation that is a U.S. real property holding corporation (USRPHC).^[43] A USRPHC is a corporation that holds USRPIs that equal at least 50% of the sum of the fair market value of all of the corporation’s U.S. and non-U.S. real estate as well as other trade or business assets.^[44]

Section 1202(e)(7) contains a limitation on the amount of real property a company can hold to meet the active business requirement, but it applies only to real property that is not used in the active conduct of a QTB. If real property is used in the active conduct of a QTB, then taxpayers otherwise subject to tax under §897 can escape taxation under §1202. This is because §897(a)(1) treats gain from the sale of a USRPI as ECI, but it does not otherwise alter the nature or character of the gain. Section 1202(a)(1) then applies an exclusion to such gain and there is no conflict between the operation of these two sections. They seem to operate in tandem and the application of §897 does not foreclose or limit the application of §1202, assuming the requirements of §1202 are met.

Also, §1202(a) applies to any “taxpayer” other than a corporation, and “taxpayer” is defined to mean any “person” subject to any internal revenue tax.^[45] The term “person” means any individual, trust, estate, partnership, association, company, or corporation,^[46] which is broader than the definition of a U.S. person.^[47] Thus, §1202 is not limited to U.S. persons.

For example, assume a domestic company that manufactures widgets owns a warehouse (i.e., a USPRI) that amounts to 60% of the value of its assets. The company would be a USRPHC. If the warehouse is used in the active conduct of the manufacturing business, then the limitation under §1202(e)(7) would not apply and the company would be a QSB (assuming the other requirements of §1202 are met) and a USRPHC. If a non-U.S. individual sells stock in the company, he or she would be entitled to an exclusion under §1202 because the stock is QSBS. In other words, nothing in the FIRPTA rules limits the application of §1202, and these rules can operate together because they do not conflict with each other. The practical consequences of these two sets of rules would be that §1202 overrides §897. It does appear that FIRPTA withholding would still apply, however, forcing the non-U.S. taxpayer to file a claim for refund or file for a FIRPTA withholding certificate prior to the sale or exchange.^[48]

Conclusion

While many tax practitioners think of §1202 strictly in the domestic tax context, the statute contains no such limitations. There is no requirement that a U.S. corporation directly conduct a QTB in the U.S. and there is similarly no requirement that the individual shareholders of the U.S. C corporation be U.S. taxpayers. As illustrated in this article, these factors produce interesting tax planning opportunities in the cross-border setting that may not have been contemplated.

This column is submitted on behalf of the Tax Section, Michael J. Wilson chair, and Charlotte A. Erdmann, editor. Special thanks to Abrahm Smith and Adam Smith for their peer review of this article.