Navigating the Latest QSBS 1202 Updates | Key Changes in One Big Beautiful Bill

Ben Aspir: Thank you, Kayla, and welcome to everyone that has joined us for today's webcast. Before we dive into today's material, let's start with a bit of background. 1202 refers to the tax code section. It was enacted in the early nineties to spur investment in small business corporations. 1202 is a powerful and still a somewhat underutilized benefit. In the task code and recent enhancements that Kayla alluded to, we're going to talk about today and planning opportunities that can be done have made 1202 even more accessible and more valuable shareholders and investors if they meet the qualifications, which we'll discuss today, can potentially exclude millions of dollars in capital gains taxes. So let's get started with what are the benefits of 12 0 2, 12 0 2. Up until the changes of the one big beautiful app act, which we'll refer to as the OBBA prior to that enactment, the exclusion is the greater of $10 million.

The federal tax occlusion, the greater of $10 million with 10 times the shareholder's basis In the corporation, it is limited to corporations with gross assets of $50 million. The exclusion, the amount of exclusion is dictated by when the stock is purchased, not when it's sold. So if stock purchase from August of 93 from the enactment through February 17th of oh nine, you can exclude, if held for five years, you can exclude up to 50% of the gain on sale. This illustrates why it was largely ignored for the first 16 years, almost 16 years since enactment told to the exclusion was 50%. The other half the taxable gain is taxed at 28%. That's a quirk of the tax code. Nowadays with the 3.8 net investment income tax, you're at 31.8%. So the effective rate comes to 15.9%. Stock acquired from February oh nine to September 10 is a 75% exclusion rate, and after September 27th, 2010, which was the biggest change, stock acquired after that date, you can exclude up to a hundred percent of the gain at the greater of $10 million, which is a lifetime limit or 10 times the aggregate adjusted basis of the QS BS or qualify as small business stock.

The additional thing happened along the way. In 2017, the TCJA, the tax cut and Jobs Act made the corporate tax rate a flat 21%, which made corporations a more attractive way of doing business for tax purposes.

So as Kayla alluded to, the enhancement and the expansion of 1202 is the biggest changes to this coast action. Since the PATH Act in 2015 made the a hundred percent exclusion permanent, and what the OBVA enhancement did was three things. It increased the gross asset test. Now, corporations that have up to 75 million in gross assets can potentially benefit from 1202. It increased the annual exclusion to $15 million. I'm sorry, the lifetime exclusion from 10 to $15 million. So it increased it by 50% and the holding period, like I mentioned previously, it has to be held for five years. Now if it's held, stock acquired after the enactment, so from July 5th and on of 20 25 3, if you hold it for three years, the exclusion is 50%. If you hold it for four years, the exclusion is 75%, and if you hold it for five years and beyond, it's a hundred percent gain of solution up to the gain limitations I mentioned. This slide really does a good job of summarizing all the changes. As you can see, up until July 4th, 2025, it has to be held more than five years, and the changes posten enactment of OBVA, it could be held for exactly five years. OBVA, it has to be more than five years. The A MT adjustment, there's a 7% adjustment on the amount that's not excluded pre OBVA that was removed for any pre post OBVA shares that were issued.

Jeff Kelson: Ben, can you go back to that slide for a second?

Ben Aspir: Sure.

Jeff Kelson: There's a lot to unpack here because I think what we've done is really give the effective rates of what the benefits are, and you'll see that, as Ben said, the first 16 years of nobody really cared about this section. It didn't really have much of a benefit because the capital gain rate 20 15%. But you'll see in the last three after the date of enactment we took into account the 50% exclusion isn't really a 50% tax savings. That's if you hold it three years or more because the taxable portion, in that case, the 50% is taxed at the 28% collectibles rate, and I think it's important. So it's not a 50% tax savings comes out more like a 33% tax savings, and if you hold the four years, it's not a 75% tax savings, more like a 65, 60 6% tax savings. So it's very important to mention, but go ahead. But this is a great slide that shows if you owned it prior to the date of enactment or if you invested asset date of enactment, what the different, there's a lot to unpack in next slide.

Ben Aspir: And it's important to note that the enhanced or either the $10 million lifetime exclusion or the $15 million lifetime exclusion is per qualify small business. You can invest in multiple qualifiable business and benefit from each one up to $15 million depending on when the shares were acquired. There are multiple requirements within 1202. There are corporate level requirements. The gross asset test is either up to 50 million or 75 million in tax basis. If property is contributed, which Stan will talk about later, it is measured differently if the entity converts through C Corporation. Again, we'll talk about that a little bit later. The next corporate level requirement is, and we'll talk about on the next slide, is the stock was to be issued by a corporation that uses at least 80% of its assets in active fit business. We'll get more into it on the next slide. Like I mentioned, it must be held by a non-corporate taxpayer. We'll dive into that a little later. It compelled by a partnership or an S corporation. There are transfers that you have to be aware of. There's a few slides coming up. It must be acquired by the taxpayer original issuance. It cannot be acquired from another shareholder wants to sell it to you. It cannot be acquired, sold from a friend or family member. You have to be issued directly by the corporation and then there's a minimum three to five year holding period depending on when the stock is issued.

So this is an area we see a lot of action. Some businesses get tripped up on, but 80% of the assets must be used by the corporation, the act of conduct of one or more qualified trade businesses for substantially all of the holding period. Now, I understand that's a mouthful. Substantially all is generally accepted as 80% of the holding period. What is a qualified trader business? The tax code doesn't tell us what it is. It tells us what it's not any professional services, consulting, hospitality, oil and gas, any trader business with a principal asset is the reputation or skill of one or more employees. Essentially, if the business is using the likeness of one employee, that would likely disqualify them. There are exceptions as far as the active asset rule for reasonable working capital needs, RD expenses, startup expenses, portfolio securities, there's a 10% limit by value. If the company holds more than that. We've seen companies get tripped up on that. They decide to park extra cash in portfolios. They get dripped up by that, and it's an area that you have to be very aware of. Same thing with real estate holdings. We're going to move on to the next polling question. To benefit from qualified full visit stocks, shares must always be held for five years. Yes, no. What is qualified small business stock. You have 60 seconds,

Kayla Konovitch: Ben. I just want to add in a little nuance, a small nuance here with the holding period. One of the changes is that now with the partial exclusion, it's three, four or five year holding and it's at least three, four or five years, which is actually different than historically. The five year, it was more than five year, you had to have one more day. Now they actually just said at least three or four or five. So that's a small nuance, but we've had every now and then an instance when somebody was literally the day of. So that's actually a small detail, but important.

Ben Aspir: Yeah, absolutely. You'd be surprised how close people come to the holding period.

Kayla Konovitch: To the holding, yeah. Yeah. Eye on the holding period. Yeah. A lot of questions have been coming through regarding the issuer. What is that lifetime? Is it per taxpayer? How does that work? So it's really, it's per issuer. It's per company. So you could have, if you're using the max $10 million or 15 million, it's for that one company, A, B, C corp, that one issuer. So just to clarify that,

Jeff Kelson: I think the last thing to mention is the exclusion is the greater of if it's pre 10 million or 10 times the basis and now 15 million or 10 times the basis, but that 10 times the basis is annual where the 15 or 10 million are lifetime. Right. I think we got the answer.

Ben Aspir: So the correct answer was no and depending on when the shares were acquired, so 65% got the answer correct. Shares acquired post, the one big beautiful bill act does not have to be held for five years. It could be held for less and you can still benefit from 1202 holding period, like I mentioned, three to five years. Stock options warrants, convertible debt do not qualify until QSBS gets the question a lot until it's exercised or converted. What about incentive stock options? Not until the date of exercise restricted stock. This is a potential planning opportunity. If you make an 83 B election on this restricted stock, it must be made within 30 days. That will start the holding period for purposes of 1202 Safe notes, they qualify for 1202 Kayla, we'll talk about that a little bit later. Stay tuned. And in the cases of convertible deferred stock, if you convert that to common stock holding period for the three to five year tests, tax on and entity related transfers, we get this a lot.

Do not contribute 1202 stock into a partnership or an S corporation, you will terminate the 1202 status. What about a distribution of a partnership? Generally it's the status is retained as long as the partner was in the partnership when the 1202 stock was purchased. What about a contribution to a disregarded entity entity like a single member lc that generally will retain 1202 status, but you need to be careful if you add it another partner into that single member LLC, it becomes a partnership and you could potentially terminate the status for that. But questing or gifting qualifies for visit stock that would retain 1202 status. Here's an interesting question. There's a question mark next to it. Distributions from an S corporation through a shareholder, would that terminate 1202 status?

Jeff Kelson: I think first of all, you wouldn't want to do that to begin with because it can incur tax under three 11 B, but if you held it to five years, you would get the QSBS exemption, but it's not probably the best

Ben Aspir: Situation you distribute. Appreciated stock fund S corporation to can trigger a gain. So could contribution status corporation. Again, that would terminate the 12 two status conversion from an LZ partnership that like I mentioned, that would ruin the 1202 status as well. I'm going to turn it over to Stan to talk about the increased

Jeff Kelson: Status. Those things can ruin, that can taint the whole investment by having it personally and putting it into an LLC. I mean it taints everything. It's over. So we have to be very careful what you do with the shares you invest. Thanks Ben.

Stan Barsky: Alright, thanks Ben. And Jeff. As Ben mentioned, 75 million increase in the gross asset limit is one of the major changes to the 1202 in the O-B-B-P-A. Interesting to note that actually is going to increase for inflation for years starting after 2026. So what does this mean? Practically speaking, think about it in terms of previously you would've invested in a $50 million target and you would've been okay if you would've invested in let's call a $60 million target, you would not have been okay or would you have been? One thing to keep in mind with all of these 1202 potential targets and are you within or outside of the gross asset limit is keep in mind the opportunity for right sizing. Right sizing can take many forms. For example, there could be real estate that the target is using that you might not be too interested in buying.

Well, maybe you get the sellers to take out the real estate before you purchase the target and thereby reducing the target size, carving out assets other than real estate like accounts receivable. The other thing to keep in mind is that the limit has to do with the cash and the asset basis of the tax basis of the assets. So that means is if in year one you invest 40 million, but all of that is expensed, for example, on domestic RNC, which is now fully expensed again under the O-B-B-B-A under section 1 74 or a UK claim bonus depreciation of a hundred percent, the tax basis goes down and you no longer have the 40 million. If the money is actually spent and everything's depreciated entity conversions, Jeff will cover shortly. But before then, let's talk about the asset limit. So property contributions are a little tricky and it's worth spending half a minute on them. If you contribute assets to a newly formed C corporation or as Jeff will take you through shortly, you incorporate the partnership or an LLC. Those assets for the gross asset test purposes are taken at fair market value, which means you would ignore your tax basis on those assets and instead you would treat them at fair market value. Valuations become very important as Jeff will go over when you are incorporating a partnership for this reason or if somebody is contributing business assets like maybe IP or software of some kind when they're coming in. And next I'm going to turn over to Jeff.

Jeff Kelson: Thank you Stan. So I'm going to talk and we've seen some already in the questions and answers about what happens if you're already an LLC partnership, tax as a partnership. Well good news, but I'm going to cover the playing field on this because be careful before you do this, that's all I'm saying. Okay. But yes, partnership can very easily be transformed into a C corp through a state law conversion or even more simply through a check the box selection in 88 form 88 32 because that's tantamount to an issue is to shares. So it works perfectly for QSPS and that holding period though begins at the time of that conversion. So you don't get the benefit of how long you held the partnership in that case. It only starts at the moment you convert to the C corp and the 50 million or 75 million gross asset test, depending when you converted, is measured by value at that moment.

So if you're a LLC that's worth more than $75 million now and you convert check the box, you wouldn't qualify because the fair market value would exceed the 75 million. Normally those tests are tax basis of assets but not when you put in property and a conversion of a partnership is deemed to be a property contribution. But there is some benefits to it. It's very funny, if you go locks it, let's say you put in 74 million, that's what the partnership is worth. Yes, you qualify because it's under 75 and then your QSBS basis, not your tax basis. Your QSBS basis will govern how much you can exclude. It'll be 10 times 74 million. So if you're getting up close but not over, you might be able to get the best of both worlds. But you got to be very careful and have valuations done to make sure you're not violating either the 50 million if it did it prior to the date of enactment or 75 million. Just be very careful with that. And again, very important, you don't get the benefit of any built-in appreciation while you held it as a partnership. It's only the appreciation that occurs after you convert to the C corp like the 88 32. So again, you must enlist a valuation to determine what your benchmark is. So from that point on, you will benefit for the exclusion. Any built-in appreciation would not magically be allowed to be excludable. It's permanent. So that's why it's very important to get valuations are very important. Throughout this you'll see a trend.

Kayla Konovitch: And Jeff, I want to add here that the appreciation right prior to conversion, that's taxed at the regular capital gains tax rate. So the 20% plus another 3.8% for net investment income tax, unlike non-excludable, like if you're getting a 50% or 75% exclusion, that would be taxed at a 28%. So there's a difference. This is just taxed at the regular capital gains rates. The prior built in appreciation prior to conversion. And you see

Jeff Kelson: That is a great point. So she pointed out any precon conversion appreciation would just be taxed normal capital gain rates in the year to sell it is not taxed at that collectible rate. 28%. That's only for the partial exclusions. Alright, keep going S corp. This one is trickier. Remember how I said how easy the L LSC is? Get an 88, 32, do it. You're golden. Not with an S-corp. So many people have come to us and say, Hey, I just revoked my mean. I terminated my S selection or I merge my S into a C corp and that doesn't work. Why? Because that's not deemed to be an issuance of shares. So you have to go through some capital restructuring. What we normally see is something like an F reorg where NewCo takes over the company that you want to be A-Q-S-B-S or vice versa. So it does take some gymnastics and there was a case, Theto case that right on point where an S corp merged into a C corp and they thought they would benefit from QSBS and the ruling was no, you just merely terminated your arrest election.

You didn't do anything to establish an issuance to share. So you got to be very careful in an that it takes structuring. It's not as easy as an LLC, nowhere it is easy as an LC. So keep that in mind. You can not merely terminated. I can't say that enough. I get that question all the time. S-corp take restructuring can be done. Okay? QSBS holding period. Again, when you do that restructuring, that establishes the date that you start measuring the three, four, or five years. So again, you don't get any built-in holding period from when you had the S corp just like the LLC. And that 50 and 75 M gross asset test is also measured by value of the assets of the S corp that somehow ending up in the C corp. So again, that could be a tough situation to make sure you run it, but also could be a benefit for this crazy QSBS basis, which has no relation to your tax basis for purposes of the 10 times basis exclusion.

And again, very similar to the LLC, only post-conversion appreciation is eligible. So any built-in appreciation at the time of this reorganization, it'll always be taxed down the line. It's only benchmarked again and it's the post-conversion appreciation. Again, valuation. There's the valuation again. So you know what the benchmark is, you don't want to have it 10 years later saying, what was it worth back then? So yeah, let's move on. I'm going to give you, bear with me on this. We try to do maybe too much into an example. So I'm going to try to take it slowly, but this will always be there. You can always review this at your leisure if that's what you enjoy doing. So in this example, Jane and John, unrelated on 1 1 20 formed a partnership, okay? Nothing interesting about that A-B-C-L-L-C. But you notice five years later and after the date of enactment they converted to a C corp, maybe they checked the box, very simple, treat it as an issuance all good.

At the time that fair market value, the assets was 7 million and the tax basis of those assets was zero. A lot of times taking bonus depreciation, whatever, or you can have goodwill so clearly under the 75 million, but you'll notice that 7 million of built-in depreciation will have to be taxed if it's realized down the line, that's never going to have 1202 available to it. Okay? But that's each about three and a half million each, right? 50 50 partnership, A, B, C core, formerly A, B, CLLC assume meets all the requirements. The 1202, we're not going into that, but there are a lot of requirements of 1202, qualified trade, a business, active trade, a business, no redemptions, a whole host of stuff. So I don't want to brush over that, but we just wanted to get into more interesting planning, but just bear in mind that qualifying usually requires some sort of review and very helpful to get a memo and valuation that the stock does qualify. That's very important to have and Stan will talk about some cases that have spoken to that. And then July 10th, 2020,

Ben Aspir: Yeah, I was just going to say it's important at the time of conversion that the partnership has a valuation performed so they can value the

Jeff Kelson: Valuation. Then

Ben Aspir: Basis

Jeff Kelson: Always valuations are so important. So you notice here July 10th, 2028 is three years and four days after you converted. So guess what? Under the new law you met the three year rules and you sell it. So you get 50% benefit, 50% benefit. And just to make it a more complicated, James sells her entire 50% share at that time thinking she's going to get the 50% benefit. And again, I keep pointing out that remember QSBS basis and tax basis share the tax base. Not always the same thing because of property contributions, but let's go to the next slide. That's me. All right? I'm going to unpack this. I know it's complicated. We're try to do a lot in here, but if you have this, it's a great review, so let's go slowly. Jane had a 50 million long-term gain, right? She had no basis sold it for 50 million.

There's nothing complicated there. Well, how much is eligible for 1202? Remember she bought it after the date of enactment. So the three year rules in play, well, she can get a 15 million exclusion, but hold on, she only held it three years, so she only gets half of that, right? Remember three years to get a 50% exclusion under the O-B-B-B-A rule. So she can exclude seven and a half, but don't stop there. It's the higher up that or 10 times the basis and you're saying, Hey Jeff, you just told me her basis was zero, tax basis was zero, but her QSBS basis was three and a half because established at half, she's 50% owner. So she got a Qs BS basis for half the fair market value. So 10 times that is 35 million she can exclude again and she's going to elect that one that's better than seven and a half.

I learned that 35 7 and a half, but at a 50% exclusion rate. So she can exclude 17 and a half million dollars, still not the whole 50 million, but a nice amount. She could have done some planning, but we'll cover that later. So she can exclude 17 and a half million. She pays tax in the remaining gain. That remaining gain is two pieces. That's the amount over the 35 million and that's also the built-in appreciation of three and a half million. So three and a half million plus the gain over the 35 million. So that's 32 and a half million that you'll have to pay capital gains tax at, but it's not at the same rate just to make things more confusing. The 17 and a half that is excludable, that's half of the 35 million gain is taxed at the collectibles rate of 28%. Don't ask me why that's in the code, it's in section one H, but it's been there for over 35 years to sort of take some of the benefit away from QSBS or the historic 1202 because it was a 1202 before QSBS and that's taxed at 28 plus 3.8 NI assuming that gain.

So she pays taxes 17 point a half million to 31.8 and the remaining 15 million, which was just the amount that exceeded, excuse me, the remaining gain is taxed at 23.8. So all told, and that's the gain above the limit of 1202 and that's also takes into account some of the built-in appreciation. We've packed a lot in here, I know, but I'm just trying to show you that there's a lot to do when there's a realization and she pays tax at 9 million. So the savings to her in this was 2.78. That's basically the 17 point a half million that she was able to exclude at 15.9. So man, I know, I understand, but still big benefit to Jane. But as when you start doing all this work, you really got to be aware of all the different moving parts. So I'm not going to spend a lot more time on that.

You see, it's a little complicated, but this was a complicated example and just to make things a little more unclear, if there's an installment sale, what do you do? Do you apply the exclusion to the amount you received in the first year or do you prorate it to the installments or do you back load it? I probably wouldn't want to do that, right? So yeah, there's some ambiguity in that we think there's a position you can probably apply it to the first amounts, which is the most beneficial. So yeah, yeah, don't forget the installment sale adds a little bit of complexity or earn out for instance. Alright, so you'll have this through review just saying that there's a lot going on sometimes in these realization events. So Jeff, are you better off remaining a pass through? I mean, think about it. You get the 20% tax rate if you're an active pass through owner, I cover that one of the bullets and you get the QBI deduction if you're qualified.

Not all businesses qualify for the 1 99 a 20% deduction. Well this is what you got to consider. Is the ultimate sale going to be a sale to stock or the assets? If it's going to be a sale to stock, then yes. I mean the very beneficial, assuming it's not a lot of built-in appreciation, but even then it's probably beneficial to go QSBS if you think your exit is going to be a sale stock. But a sale of assets, the QSBS exclusion does not apply to the inside gain. So the C corp would pay the 21% tax on the sale of assets. So that's something to take into account because buyers might pay less for the stock than they would for the assets. They buy the assets to get a step up and they can get some tax benefits over time. But if the delta between its stock price and the asset sales not that big, which is kind of narrowing these days, again, it could favor the QSBS conversion.

Also, as we know there are pass through entity tax elections. The pass throughs get, I mean the C corp gets deduction for the state taxes too, but any undistributed income for a pass through owner does increase their basis. So that's beneficial in a C corp. That doesn't happen if there's distributions of income in the pass through that's not taxable. We've already paid the tax, but in a C corp it's taxable dividends, so it's a double tax. So if you're counting on a lot of distributions, then you might want to think twice about going to A-Q-S-B-S or factor that in at least to your analysis. Again, I talked about if an active pass through owner, you only pay a 20% capital gains rate. If you're not, you get to passive, you get 23.8. Also the individual income rate is 37% as we know the highest rate or the C corp rate is 21.

So if there is current income, you are paying less tax as a C corp. That's true. It might not be 37, it could be 30 if you get the QBI deduction. So that could narrow that. So there's so much to consider. It is not, it's not a black and white. It's very fact specific. And you got to go through the analysis carefully. The worst case scenario is you go QSBS, you go C corp to qualify for QSBS. Lo and behold you don't even keep it three years and you sell the assets. So now you pay the inside tax at 21% on the outside tax at 23.8, it's not a good result. So you got to be certain you're going to hold it for a period of time, optimally more than five years, or you could get double tax or at least partially double tax. And again, if you have losses in the C corp, you don't get an immediate benefit. It carries forward in that operating loss as we know, if you get a loss in a pass through and you have basis, the owners can use those losses currently. I hope that there's a lot to unpack if you're thinking of going, if you're already underway and even if you're establishing the company from the get go, there's a lot to think about. It's not a black and white issue, but a lot of times the QSBS is the way to go. Okay, we got so

Ben Aspir: Illustrate what Jeff just discussed. Let's go through a hypothetical scenario. A partnership, a C corporation five years held the member to get the a hundred percent exclusion, the stock has to be held for five years. The total aggregate taxable income for each C corporation and the partnership being equal 10 million, their total tax paid for the partnership would be 29.6 million, which is 37% the top tax rate. And then we're assuming they get the benefit of the 20% QBI deduction. So that gives an effective tax rate of 29.6%. The corporation would pay the flat 21% on the $10 million. So 2.1 million of total tax paid in the first five years. And then partnerships are generally not taxed on distributions to the extent they have basis. Corporations are taxed on distribution to tax as dividends, so they'll be taxed at 23.8%. So that would be an additional $1.8 million in tax paid by the corporation.

So up until sale, the partnership would've paid 2.96 million of tax. The corporation would've paid $3.98 million tax. Here's where 1202 comes into flight. If the partnership sells, assuming a $50 million sales price and $5 million tax basis, that gives us a $45 million capital gain taxed at 20%. Assuming the partner material participates in the partnership for total tax paid from inception through exit $11.9 million. If there was a stock sale in the C corporation, there would be no gain on sale of the C corporation if it was a stock sale. So there would be an $8 million savings C corporation if they meet all the requirements of 1202 and they hold for five years, corporation meets all the requirements. We spoke about significant savings over close to $8 million savings from a partnership to C corporation. Like Jeff mentioned, if you have an asset sales, it's different equation. If it's held for less than five years, depending on when the stock was issued, you may get 50 or 75%.

So there's a lot that goes into it, but we just wanted to highlight the difference between a partnership, a corporation, assuming all the dominoes fall in place. Let's move on to our next polling question. Taxable gain from the sale of qualified small business stock may be taxed at 28%, yes or no? We'll have 60 seconds. Just a few good questions we've got from the audience. It's great to see that everyone's engaged QSBS shares issued 3 93. Do they qualify? No, do not. However, the same corporation, if they issued shares after 93, after the date of enactment in 93, those shares could potentially be issued.

Kayla Konovitch: Then actually want to add in, sorry, a couple of comments here. The expansion of the gross asset test is really, it's a tremendous benefit here and I can tell you from a venture and a private equity perspective, later stage companies and growth equity, even buyout companies, especially if they're in the lower to middle market, may now qualify because they can go after some of these larger targets. But what's also interesting is that historically if the company didn't qualify because it exceeded the 50 million gross asset test, say it was 65 million, so they didn't qualify. Now if that company would issue stock right after starting from July 5th, 2025 going forward, they actually could now qualify with new issuances as long as they historically at the time and right after are meeting the $75 million test. So it's a really interesting opportunity that you can re-look, revisit new issuances that historically didn't meet the test. So that's an important factor. And I think that we are actually at the poll because I want to make sure we're going to have time to get through. Yeah,

Ben Aspir: We'll give everyone 10 more seconds before we advance.

Kayla Konovitch: Okay.

Ben Aspir: So I'm going to ask this question. We've gotten many times about somewhat specific to healthcare, but managed service organizations, it's very highly fact dependent. It's a very gray area. Depends on the managed service organization agreement. The correct answer, oh, sorry for a second. The correct answer was yes. The non-acute part of 1202 would be taxed at 28%. So 79% got the answer correct.

Kayla Konovitch: Okay, thanks Ben. So the second real opportunity area is the holding period. We now have opportunity for earlier liquidity, right? If you're just going to sell earlier, you can still receive a partial exclusion of the benefits. So as Ben referenced earlier, you can now have three, four or five year hold. So there's really a lot of opportunity here and we'll talk about lot identification safes and section 10 45 rollover, all with a new view given the reduced holding period. Okay, so focusing on lot identification or it's referenced as specific id. If you have multiple tranches of stock and you do a partial sell, the default method is FIFO. It's first in first out. However, if you identify the lots that you want to sell, you can choose the optimal outcome. So very important, this actually needs to be documented and you have to show specific ID that these are the lots are the shares of stock that I'm selling on this exit.

So historically we would optimize right earlier sales to preserve the five-year holding period with identifying specific lots in order ultimately to provide a lower capital, lower gains currently with preserving the future, right? Five-year holding period. So now there may be more opportunity to receive a partial exclusion while still preserving the three, four, or five-year holding period. So there should be an analysis that is done to determine how can you receive the maximum exclusion. And part of that analysis one is looking at when do you think ultimately is the timeline for exiting on the remaining lot? What's your cost basis? There may be different cost basis in varying lots and also how long have you been holding it to date? So you factor in a couple of items and you really can come up with varying scenarios that you can play out of how do we maximize the exclusion of game?

And again, also while utilizing lot identification, you can also tap into and optimize the 10 times basis or the $15 million exclusion. There's a way to sort of optimize that as well. And Jeff is going to go into that a bit later when he speaks about stacking and packing. Overall, there really is a benefit here for greater flexibility in timing of the QSBS exits and maximizing that opportunity with specific id. And I'm just thinking maybe for next webinar, we actually showcase an example of how we optimize your portfolio with a specific ID that might be helpful. Now the other item I wanted to go over is safes, right? The focus here is when can we start the clock? When does the holding period begin? And that is determined by what the characterization of the safest. Is it debt, is it equity or is it something else?

So just to really start with first an overview of a safe. What is the safe? A safe is a simplified agreement for future equity. Essentially it's a contract between an investor and typically a startup company where if there's a triggering event in the future, they would receive equity whether it was a future around the financing or a sale of the company. And there are certain key features that are typically found in a safe agreement. There's no maturity date. It means outstanding until the safe, until it actually converts and it doesn't typically have any accrued interest. There's certain terms on conversion, there's a repurchase and dissolution rights, voting rights, and a lot of these factors we consider it when we're reviewing a safe agreement to overall identify and determine is this considered debt equity or maybe a variable prepaid forward contract. So it's important to understand the safe and this actually it was issued back in, I believe it was 2013 with Y Combinator.

They had created these templates that made it really simple, certainly from a legal perspective. However, from a tax perspective, they're not as simple and you do need to really read it and understand it. And sometimes people change the terms can then change the treatment as well. So ultimately our focus is what's the character of the safe? It can either be treated as debt as equity or variable prepaid forward contract. And again, it's a facts-based analysis in order to determine is this debt, is this equity? So if it is determined that it's debt, what's the treatment? Ultimately it would not be eligible for qualified small business stock because it's a debt instrument right? Now, if it's convertible debt, then that's different, right? Then on conversion you could look at measuring and holding periods. So that's a potential. But typical a debt instrument itself is not eligible for QSBS.

The company who receives the borrower ends up having well no taxable event upon receipt of the cash. They have interest expense, which is deductible subject to the 1 63 J limitations. And of course if the debt is canceled, there may be a cancellation of debt income. And then to the lender, ultimately they pick up interest income. But again, there's no QS bs eligibility here. The second option is, is this treated as equity? And again, it's basically you have to review the agreement. We're happy to help with that and determine if there are equity like features. So if you get there, then the benefit is that at the time of issuance of the safe is when the holding period would begin for determining and QSBS eligibility. So there's a big upside, at least from A-Q-S-B-S perspective of if this is treated as equity, you can start the holding period sooner.

And then the third is, is this a variable prepaid forward contract? Essentially your really putting down on deposit to receive shares at a future date to the company. There's no immediate tax taxable event, but once they actually deliver on the stock, there may be a gain or loss depending on cash versus the basis of that doc. And then to the receiver, the recipient of stock, the investor at the time they make payment, it's not taxable. There's no consequence there. The holding period doesn't start, it was just a deposit. But once they received the stock, that's when you would measure QSBS eligibility and that's when the holding period can begin. So again, there's definitely a lot of opportunity. We're seeing many safes, many, many startups. It's simple instrument to execute on and it's very common and popular. And I will say that lately the safe agreements we've been reviewing, many of them we believe we feel are treated as equity. But again, you need to review it and each safe, it's not the same even though you think sometimes you're using a template, so you have to be very careful around it, but there really is opportunity here that can start your holding period sooner.

Okay, so another area of opportunity is section 10 45, the rollover provision, right? It's the sister provision to section 1202. This is where you own QSBS stock. You held it for more than six months, but you didn't yet meet the holding period of the now three, four, or five year holding period and you sell it. But what you do is you immediately reinvest within 60 days, you reinvest those proceeds into another qualified small business. The benefit of that is really threefold. There's three opportunities here. One is that you get to defer your current tax. Two is that the holding period tax on, if you held it, let's say one year, you only need two more years now to meet the partial exclusion, right? To meet a three year holding period. So there's a attack on of the holding period, which is really a great benefit. And third is that at the end, the backend on exit, if it met all the test, you can still get the exclusion on the backend.

So it's really a great opportunity. The question I think here and now is that now that we have this partial exclusion for three, four year, how often is this going to come up? First of all, it was always difficult to execute because you have to have identified another QSBS or within the 60 days and executed on it. So it was never simple. And two is now you have partial exclusions. So are people going to tap into this and utilize this strategy? And there's definitely questions here of we get questions. Could you do 10 45 and 1202, both at the same time? What we were looking into is if you're eligible for a partial exclusion, let's say because of 50 or 75% exclusion, the remaining cannot be rolled over into a 10 45. It's not eligible. However, if you had qualified small business stock but you were limited because of the 10 times basis or the $10 million exclusion amount, the remaining portion may be rolled over. But you have to keep in mind there is a calculation here, and if you're not rolling over the full proceeds, you're not getting a hundred percent deferral either. So there's definitely what to consider here. And there's certainly some opportunity. We see it in the venture world a little bit more in the funds because they can recycle capital and they're already identifying a lot of other opportunities. So they might be able to roll it over, but it'll be interesting to see how this plays out.

Okay, so the third opportunity area is really the increased exclusion of gain or the 10 times basis that's still in play. And here we're going to discuss carried interest, meriting fine joint versus married, filing, separate stacking, packing, multiple tranches and transactions over one year, which tap into the specific ID line identification. And then of course, entity conversion is also a big benefit because you're now, you can get a $15 million exclusion potentially. So that's all the more, so people might look into entity conversion. So I want to just focus here for a moment. On the married filing joint married filing separate in the new updated provisions for July 5th, 2025. Going forward, it actually specified that the $15 million gain exclusion, if you're married filing separate, you're only entitled to seven and a half million. And that's really important because historically with a $10 million gain exclusion, there was always this open question, are you eligible for as a merit filing separate? Are you eligible for 5 million or 10 million exclusion? So it's very clear here, they said specifically merit filing separate. It's a seven and a half million dollars exclusion.

Okay, so carried interest. I'm bringing this topic up now because carried interest is all the more valuable right now, especially when profits interest and carried interest typically has zero basis, but now the exclusion of gain went up to $15 million. So this is definitely a hot topic and something to really focus in on. Our question here is your carried interest or profits interest eligible for the exclusion of gain? And it's a big question, it's a gray area. And the reason we don't have, it's this question and there's uncertainty here, or you'll hear commentators some saying yes, some saying no is really because the partnership interest is actually not defined under section oh two. It doesn't give us any sort of definition. There's no meaning for regulations or any case law, legislative history to actually specify or define what a partnership interest is. However, under section 10 45, the rollover provision that we just mentioned is the treasury regulations there clearly specify that only a capital interest is eligible for the rollover.

So it certainly begs the question under section 1202 is the intent. Can you utilize a carry interest or a profits interest and still be eligible? So it's certainly a gray area, it's ambiguous. So where it comes down is that what's the position on it? Is this more likely than not that you believe there's a more than 50% chance of success in court that this actually would hold up? Or do you believe that there's only substantial authority, which is about a 40% chance of success? Or third is their reasonable basis, which is closer to about a 25% chance of success in court. So there's a difference here because if it's a reasonable basis, then in order to sign that tax return, you need to disclose the position, which obviously most people don't want to do. So there's definitely question here, and this is something that we always tell our clients and prospects. It has to be discussed between the taxpayer, the client and their advisor to see what their comfort level is and where they believe what the strength of their position is. So it's certainly something to consider and have a conversation about. And then there is a nuance. Stan, do you want to address vesting with carried and trust?

Stan Barsky: Sure, Kayla, as Kayla is suggesting, there's different types of profits, interests that could be issued, some profits interests are vested on day one of the time of the grant. And then it's just a question of the asset depreciating and the carry growing in value. The other potential wrinkle is what do you do with carried interests that are not even vested on day one? So not only are they not in the money on day one, but also if the service provider leaves before the interest vests, then the interest is forfeited. And a typical vesting schedule might be something like three or four years or something along those lines. Does that add additional uncertainty? Potentially adds more pressure on top of a regular carried interest. If the carried interest is subject to vesting for non 1202 purposes, there is very clear express guidance under federal tax rules what you're supposed to do with that kind of interest. And people make protective 83 B elections and follow certain safe harbor procedures issued by the Internal Revenue Service. And the question that arises is, would those safe harbors, et cetera, extend for the purposes of 1202? And that also is subject to discussion and scale suggests between client and advisor.

Kayla Konovitch: Thanks, Dan. That's really important, especially in the fund context when we're working with carried interest, I think we need to move along

Jeff Kelson: Stacking and packing. These are great opportunities to increase.

Kayla Konovitch: Jeff, sorry, I think we need to push the last polling question and we'll go right back to stacking and packing.

Jeff Kelson: Okay, yeah, I can talk about it all.

Kayla Konovitch: Okay, yeah, yeah, you start. Thank you.

Jeff Kelson: Stacking pivots off to 15 million or 10 million exclusion. So it's a way to gift perhaps into a non-grant tour. Trust shares of the stock that have maybe 10 or 15 million of built in gain. So you can multiply the 15 million exclusion by the owner and perhaps say, put it into a non-grant tour trust for their child. Now you can get $30 million of exclusion or 20 depending when the stock was acquired. Preen enactment post. So that's called stacking. So you can do it to multiple, you can do two non grantor trust for two different children. So you can stack that $15 million exclusion. Packing is different. Packing is working off of the other. Remember it is 10 times basis or 10 or 15 million, whichever is greater. So packing gives you an ability to increase the utilization of the 10 times basis. Maybe a year before the sale or six months before the sale you put some money in.

Oh, I think we got 52% saying no. Okay, so packing is a way you can put money in. Perhaps you'd have to get some more shares for that. You're not just putting money in and not getting anything. That wouldn't be an issuance of shares. But if you put some money in yes, and you only hold it six months, you probably don't one, have a big gain on that when you sell it. And two, you might, it's short term, but it doesn't matter because there's no gain or a small gain attributable to that piece. But what it does, if you put in 200,000, multiply by 10, it gives you 2 million more in the other pieces you own. So it's a way to increase that 10 times basis. Another way is you can put in property into it and get a fair market value QSBS basis or even if you put in some of your own intangible properties.

So there's a lot of ways, or you sell one stock QSBS, it maybe is breakeven, you didn't even hold it five years, but that basis would, if you sell in the same year as A-Q-S-B-S that you are trying to get the exclusion, you can use that to maximize your 10 times basis. So there's a lot of potential planning on that. Let's go to the next. So there's been some recent developments and we have a fellow partner here, a retired partner who says, don't forget the state. So most of the states do conform to 1202 treatment. New Jersey is the newest kid on the block. It will allow it for realization events after 1 1 26. So it's prospective, but in a way prospective and retroactive because if you sell between now and the end of the year, you're not under that. But if you sell it after January 1st, you are so New Jersey residents might want to look to time that states don't conform. You see it here, Alabama, California, Mississippi, Pennsylvania, California has been attempting, never done it. And a partial conforming in Hawaii. By the way, big states like New York do conform. So interesting on that. Most states do in New Jersey, the new kid.

Additional considerations.

Stan Barsky: Alright, yeah

Jeff Kelson: Ahead on this one. Have confusion we talked about.

Stan Barsky: Yeah, so we're running a little bit short of time. We'll get through all these slides, but we're going to skip a few of these points, especially things like 10 45 that have been mentioned already. I do want to spend a minute on capital infusions and that's very important because let's say you're invested in the company and it needs additional capital and let's say it's still at the QSBS stage so that you could conceivably get yourself additional shares and qualify those as well versus make it a capital contribution. If you are the sole shareholder or you are investing prorata alongside with every other shareholder, well what you can do is you can sort of decide how much longer you are going to keep the stock and that's going to inform which path you want to take that as well as how much you expect the gain to be.

Because what happens is with a capital infusion, remember the exclusion is the greater of 10 or 15 million or 10 times your basis. Well, that 10 times multiplier does not take into account capital infusions, whereas if you have additional shares issued, those get the benefit of that additional 10 times your basis basis. The downside to additional issuances of course, is that you're going to have additional holding period. So it's going to start fresh on those newly issued chairs and you have to hold the stock for three to five years depending on what it is that you want to get out of by way of exclusion amount. The other point here, I think worth mentioning is a very sort of, I want to say pernicious and almost like a gotcha type rule that Jeff is going to take you through with respect to the interplay between 1202 exclusion and net operating losses. Jeff?

Jeff Kelson: Yeah, just a word for the A trap for the unwary. If you have a 1202 realization event, you say, Hey, great, I get a hundred percent exclusion, but you also have an NOL carryover. There's a very funky rule in section 1 72 for individual NOL carryovers that even though that 1202 gain is excluded, the NOL would eat into it and you lose that NOL to the extent of excluded gene or if you have a loss in the ear. Just something to be mindful of and you see that now because 4 61 L when your business loss is in excess of whatever, 600,000 carries phone in NOL, you can really get hurt by this if you're not mindful of the year you're selling. And if you have any of these NOLs carrying over, you lose that NOL number to the extent that you have is absorbed by even the Excludable 1202 gain trap for the unwary. Be mindful and also look out for future legislation.

Stan Barsky: Thank you Jeff. Alright, just a couple of slides left. So documentation is very important here and I'm going to skip this slide because it comes up in the next slide as well. How we can assist. So the thing to keep in mind and what we are hearing from clients and our controversy colleagues who help clients with IRS audits is that the IRS and has seen through some recent court decisions, the courts as well, they don't just want to take the taxpayers word for determining whether all the 1202 requirements were satisfied, and as this presentation has given you a flavor for, there's a lot of different nuances and requirements. So what you want to do and you want to make sure you have in place is the documentation, not just for the Thor new or potentially ambiguous gray areas of the rules, but even the rules that you think are very clear and you very clearly satisfy. You want to have contemporaneous documentation with when you are investing or selling the QSBS. We discussed earlier on in this presentation, Jeff, especially the need to document valuations if you're contributing assets or incorporating a partnership, and I think one of the questions was something like, well, how do we determine the valuation? The answer is get an appraisal if that's what it takes. If you're contributing a truck with a Kelley Blue Book value, that might be good enough, but in most cases you may want to get an appraisal.

Something as simple as share certificates, purchase and sale agreements to establish the dates for the holding period. Things like financial statements to show the cash holdings in the cash balances of the company. Those are all very important documents to get ahold of and to retain. And you might think, well, yeah, that all makes sense, but in practice what happens is after you or your client has sold the QSBS, they might be three years removed from the sale by the time the IRS starts auditing it. At that point, the company might not be around or the sellers might not be on good terms with the company, whatever the case may be, the documents may be hard to come by. So it's very important to document and to maintain all of that. The way Eisner can assist is when we put together 1202 reports, we not only aim to maximize the earnings and to appraise you of what you need to watch out for if you still continue to hold the stock to maintain eligibility, but also we help you gather and retain the documents as well so that in the case of an IRS audit, you are prepared for it.

Thank you. Back to you, Kayla.

Kayla Konovitch: Thank you, Stan. Yeah, very important. The documentation is definitely one of the key highlights here. It's really imperative that we have a documentation in place to support the position. I know we're out of time. Just want to thank everybody for joining today's webinar and I know there's a lot of opportunity here. We're here to help. We have a dedicated team for 1202 to really help and assist here, so feel free to reach out to us. Thank you.

^{Transcribed by Rev.com AI}