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Editorial 9 MIN READ

QSBS in December 2020: the statute hasn't moved, the use case has

Thirty months after our first pass, IRC § 1202 is word-for-word the same, but the pandemic pushed a new wave of biotech and health-tech founders toward C-corp formation, and a new administration is talking about capping the exclusion

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 8 sections
  1. What the statute still says, and still does not
  2. The exclusion percentages and the cap are untouched
  3. What 2020 changed around the statute
  4. Why the political calendar matters now
  5. The planning order, restated for 2020
  6. The traps, lightly updated
  7. A rule of thumb
  8. Sources

founder who formed a qualifying C-corporation on January 2, 2020 is eleven months and change into a five-year clock that, if it runs, will let them walk away from a sale owing zero federal tax on up to $10 million of gain. IRC § 1202 has not changed a comma in 2020. What has changed is who is now paying attention to it.

This is a 2020 update to our 2018 QSBS planning guide. The statute is the same. The planning order is the same. The population of founders who need to read it has grown considerably in the nine months since COVID closed the offices and opened the venture checkbooks.

What the statute still says, and still does not

Qualified Small Business Stock under § 1202 requires the same five conditions we laid out in 2018, and the statute has been quiet through two Congresses and one pandemic.

The issuer has to be a domestic C-corporation. § 1202(c)(1). LLCs, S-corps, partnerships, and foreign corporations are all out. This is the rule that sends every serious QSBS conversation back to the formation papers, because there is no retroactive fix.

The corporation has to satisfy the $50 million aggregate-gross-assets test under § 1202(d) at all times from August 10, 1993 through the moment immediately after the stock in question is issued. Contributed property is measured at fair market value on the contribution date, not basis. A 2020 Series B that pushes post-closing gross assets over $50 million is usually the last round in which the company can issue QSBS, and only if the closing balance sheet immediately after the round stays under the line.

The active-business test under § 1202(c)(2) and (e) still requires that during substantially all of the taxpayer's holding period, at least 80% of the value of the corporation's assets is used in the active conduct of a qualified trade or business. Cash is an active-business asset for the first two years after receipt, and thereafter only as reasonably required working capital. A company that raised a $60 million Series C in the spring of 2020 and is still sitting on most of it in a money-market fund in December 2022 has an 80% problem brewing.

Original-issuance acquisition is still required under § 1202(c)(1)(B). Stock bought from a departing founder does not qualify. Stock received in a § 368 reorganization or § 351 contribution can carry QSBS status forward under § 1202(h), but the default planning answer for any new issuance remains: issue new stock from the company.

The five-year holding period under § 1202(b)(2) runs from the date of issuance, with the same two timing rules that trip people up. Options and warrants start their clock on exercise. Restricted stock under a § 83(b) election starts its clock on grant; restricted stock without an election starts its clock on each vesting event. The 30-day § 83(b) window still cannot be extended.

The exclusion percentages and the cap are untouched

§ 1202(a) still ties the exclusion percentage to the acquisition date: 50% for stock acquired before February 18, 2009, 75% for stock acquired between February 18, 2009 and September 27, 2010, and 100% for stock acquired after September 27, 2010. The 100% rate was made permanent in December 2015 by the Protecting Americans from Tax Hikes Act (P.L. 114-113). Any founder who forms a qualifying C-corp in 2020 gets the 100% rate on any stock they hold long enough to clear the five-year gate, as a matter of current statute.

The cap at § 1202(b)(1) is still the greater of $10 million (reduced by prior excluded gain from the same issuer) or ten times the taxpayer's aggregate adjusted basis in QSBS of that issuer disposed of in the year, per taxpayer, per issuer. Married filing jointly is still one taxpayer. Trusts can still be used to multiply the cap across related parties, with all the same caveats that the IRS has still not issued comprehensive guidance.

The excluded-trades list at § 1202(e)(3) is still the list it was in 2018. Services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services. Any business whose principal asset is the reputation or skill of one or more employees. Banking, insurance, financing, leasing, investing, or similar businesses. Farming, including the raising or harvesting of trees. Businesses involving extraction of products for which percentage depletion is allowed. Hotels, motels, and restaurants.

What 2020 changed around the statute

The pandemic changed the mix of companies showing up at the QSBS intake. Two shifts are worth naming.

First, venture dollars flowed disproportionately into healthcare and biotech through 2020. PitchBook and NVCA's Q3 2020 Venture Monitor recorded $36.8 billion of U.S. VC investment in Q3 2020, with biotech & pharma and healthtech representing outsized shares of deal value. The diagnostic, therapeutic, and device companies getting funded through 2020 are, in most cases, product businesses for § 1202 purposes: manufacturing is squarely within the active-trade-or-business concept, and a company whose value sits in an FDA-approved therapy or a 510(k)-cleared device is usually not trading on the reputation or skill of a particular employee. The fault line the 2018 guide flagged, where "telemedicine whose product is the clinicians themselves" risks the health-services exclusion at § 1202(e)(3), now runs through more companies than it did, because more of what got funded in 2020 was explicitly pitched as telemedicine. The operational question is unchanged: where is enterprise value? If the answer is "our doctors," the statute has a problem with you. If the answer is "our software, our data, our diagnostic," the statute is comfortable.

Second, the LLC-to-C-corp conversion volume has risen. Companies that were run as LLCs for the first year or two on the theory that pass- through simplicity was enough, and that now face a 2020 or 2021 priced round from an institutional lead, are converting. The mechanics, under 6 Del. C. § 266 for a Delaware LLC and under Rev. Rul. 84-111 (1984-2 C.B. 88) for the tax treatment, have not changed. What has changed is that the 21% flat corporate rate under § 11, combined with the permanent 100% QSBS exclusion, tips the arithmetic more decisively toward the C-corp form for any venture-track company than it did before the Tax Cuts and Jobs Act. For the mechanics of the conversion itself, our April 2020 piece walks through the statutory conversion, the § 351 contribution, and the revenue-ruling treatment.

Why the political calendar matters now

The policy weather has shifted. The Biden campaign's tax plan, released during the 2020 campaign and still the reference document at the time of writing, proposed taxing long-term capital gains and qualified dividends at ordinary rates for taxpayers with more than $1 million of income, and proposed a 28% corporate rate. The published campaign materials did not specifically target § 1202. A Tax Policy Center analysis of the Biden plan, published in March 2020, also did not identify § 1202 repeal as a scored revenue item.

That said, any future reconciliation bill that raises capital gains rates materially would change the QSBS calculus for high-income founders, because the value of a 100% exclusion scales with the rate that would otherwise apply. A 100% exclusion at 20% is worth 20 cents on the dollar; a 100% exclusion at 39.6% is worth nearly twice that. A Congress interested in revenue may also, separately, revisit the exclusion itself, whether by reducing the percentage, capping the cap, or narrowing the excluded-trades list.

None of this is law in December 2020. What is true is that the planning value of starting the § 1202 clock now is higher the more uncertain the out-years become, because stock already issued retains its status under the rules in effect at issuance under ordinary grandfather principles, and any changes are more likely to apply prospectively.

The honest posture is: form the C-corp now, issue the stock now, file the § 83(b) now, and do not build a life plan around the assumption that the statute will be here in its present form for the next decade.

The planning order, restated for 2020

Three things move the QSBS outcome more than anything else you do in the first year.

Incorporate as a Delaware C-corporation and issue founder stock on day one, at a nominal price. The cheaper the stock and the earlier the issuance, the longer the five-year clock has been running when the exit happens, and the less likely the 10x-basis prong of the cap matters. A founder who pays $0.0001 per share for 5 million shares has $500 of total basis, which makes the $10 million prong govern any realistic exit. Delaware is the default because every downstream investor assumes it; the § 1202 rules do not require Delaware.

File § 83(b) within 30 days of issuance for any stock subject to vesting. Without the election, the QSBS clock restarts on each vesting event, which usually pushes the five-year gate past any realistic liquidity window. Our 2020 § 83(b) guide covers the mechanics, which did not change in 2020 despite a pandemic that disrupted almost everything else about IRS correspondence.

Model the $50 million gross-assets line at every financing, before the closing balance sheet is final. If the round will cross the line, the founders and early employees should, where possible, receive any additional QSBS they expect to receive in the same closing, before the new cash lands. This is unglamorous work and it is where the dollars are.

Two second-order items are worth watching in 2020 specifically.

PPP loans, under the CARES Act (P.L. 116-136, enacted March 27, 2020), do not affect the § 1202 tests directly, but a PPP loan that is on the books at the measurement date increases gross assets by the loan amount for the § 1202(d) test. A company that took a PPP loan in April and is issuing new QSBS in September should model the gross- assets figure against the ceiling with the loan included. Forgiveness reduces gross assets when it is recognized, but that recognition followed its own slow path in 2020.

The 2020 Social Security wage base is $137,700 under SSA's annual Contribution and Benefit Base announcement. That number does not touch § 1202 directly. It does touch the adjacent LLC-vs-S-corp payroll-tax analysis that founders choosing between a pass-through and a QSBS-eligible C-corp are often running in parallel. A founder who concludes a C-corp is not right for them and wants the S-corp reasonable- compensation play is working against a higher wage base every year.

The traps, lightly updated

The 2018 trap list still applies without material change. Redemptions within the § 1202(c)(3) windows still taint QSBS on new issuances. Unclean § 351 conversions still break the chain. Cash hoarding still threatens the 80% test. Professional-services framing still risks § 1202(e)(3). Cap confusion is still a marital-status problem.

One 2020-specific version of the cash-hoarding trap is worth flagging. A company that raised a large 2020 round into a pandemic market and is deliberately holding cash because the board is unsure when to deploy it has a legitimate operational reason for the posture. That reason does not automatically satisfy "reasonably required working capital" under § 1202(e)(6). The record the company wants is a written memorialization, at each year-end, of the active-business reasons the cash is on hand: planned clinical trials, contemplated acquisitions, runway through a specified milestone. A board minute that says "we raised more than we need because the window was open" is a gift to an examining agent.

A rule of thumb

If the company is a product business, plans an exit rather than a distribution stream, and can be formed as a C-corp before the first priced round, start the § 1202 clock now, file § 83(b) within 30 days, and assume the statute you get is the statute at issuance, because that is the only version the next Congress cannot take back from you.

Sources

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