QSBS Part VI: Why You Probably Shouldn’t Try to Qualify for the Exclusion Under Section 1202 of the IRC

In episode 52 of How Tax Works, Matt Foreman discusses why too many people are becoming too focused on the exclusion for QSBS, why many businesses shouldn’t bother restructuring to get QSBS, and the proper way to evaluate and balance the various considerations

How Tax Works, hosted by Falcon Rappaport & Berkman LLP Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions.

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Transcript

Matthew Foreman [00:00:00]:
Hello. Welcome to the 52nd episode of How Tax Works. I'm Matt Foreman. In this episode I will discuss why you probably shouldn't try to get the exclusion under section 1202 of the Internal Revenue Code or why QSBs qualified small business stock isn't for you. How Tax Works is meant for informational entertainment purposes only. This may be attorney advertising and it is not legal advice. Please, please, please hire your own attorney, which could be me who knows. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law.

Matthew Foreman [00:00:44]:
Regulations, case law and guidance demystify how tax shape the financial and business decisions that we all make. Before we get started, let's go through some administrative stuff. New episodes every two weeks. The next episode we'll discuss. I'm not sure, but I'm pretty sure I'm going to do the taxation to cannabis specifically. 280 Cappy 8590 Sure. I have to actually do it. If you have any questions, comments or constructive criticism, you can email me my FRB email address which you can find via your favorite search engine.

Matthew Foreman [00:01:11]:
Upcoming webinars and speaking engagements are on the How Tax Works landing page on the FRB website. So let's talk about 1202 QSVs. But before I'm going to kind of explain how I do these this for the podcast. A lot of times I just sort of sit down, I take out some source materials, cases, other things like that. They go through it. I work through an outline and then I work through it. I end up with about four or five pages of notes, sometimes one page of notes and with just a general outline. And I end up with four to five pages, you know, spiral notebook, handwritten pages on about five pages.

Matthew Foreman [00:01:49]:
That's what turns into about, I would say 18 to 24 minutes of content. That, that's what I found. Three to four minutes per page. However, this one I'm doing differently because I could do this one in incredible depth and do a multi part. I already did a three parter in qsbs. I'm not doing it. I'm gonna do this. This whole thing is a single page of notes.

Matthew Foreman [00:02:10]:
All right, Short notes. Wind me up, let it rip, right? Just go after it, talk about it, make sure, you know, in a more coherent and I can say narrow sense. What I'm trying to do is when I have a potential client come along, I generally have a 30 minute call with them and in the 30 minute call I ask them a bunch of questions, learn about me. We go through a whole Bunch of stuff. And what ends up happening is that I think is really important, interesting, whatever is, the conversation about QSBS goes in a pretty predictable way. First off, there are some that very overtly qualify and it makes a lot of sense. So I'm not going to so much go into that. What I'm going to talk about the ones why maybe you shouldn't.

Matthew Foreman [00:02:53]:
Right. This is what I'm doing. I have it written on my sheet of paper. Don't use 1202. That's it. That's. That's the theoretical title. This.

Matthew Foreman [00:03:00]:
I'm sure I'll come up with a better title by the time this gets released in a bit. So what is qsbs? If you don't know what QSBS is Qualified Sole Business stock and why it's important, then I highly recommend listening to the 17th, 18th and 19th episode of my episodes of my podcast, which I recorded over a year ago. At this point, I also have an update episode and I have an episode on the common mistakes and misconceptions. Listen to those that. That is worth the hour and a half to two hours of your life. I think if you're asking the question what is QSPs? If you're not asking what is QSPs, but you know, I'm going to say that I am doing the entire thing under the idea that what is qsbs? Can answer in one sentence. It is an exclusion from income. So there's no tax based on the gain on the sale of a C corporation, not an S, not a partnership, not an LLC that you've held for a period of time that engages in certain areas of business in certain industries, specifically excluding finance and banking and anything that can be considered consulting or what I'm going to call information, medical law, accounting, things like that.

Matthew Foreman [00:04:11]:
Those are. Those are ones that are excluded. It is broader than that. I go through it more detail. There's a reason that I have five episodes. This is a six episode on this topic. That's it. So why not QSBs? In case you're wondering, I'm on line five right now of my notes.

Matthew Foreman [00:04:26]:
So first one is you don't qualify. I get this with some level of regularity where someone like wants to get QSBs, but what they own is a. An S corporation that they've owned since 1978 that holds real estate. And like real estate generally doesn't really qualify because a lot of times real estate, it's not because it's real estate. Real estate's actually not problematic. It's because a lot of times it's triple net leases. So it's not an active business. It's not, you know, a lot of them are consulting businesses.

Matthew Foreman [00:05:01]:
They're consulting with technology, but the bulk of the time is really consulting technology. Still not doing all the work. You don't qualify because you're an S corp that you just checked the box from a C corp. You didn't properly reorganize, you weren't qualifying at the time. You form the company. Even if it's a C corp now you do. What if it's not QSPS stock? It's not QSPs. It's not qualified small business stock from the start.

Matthew Foreman [00:05:23]:
It doesn't morph into it. So I think it's really important make sure you qualify. Make sure you've met the mechanical requirements, make sure you're in the proper industry, make sure you're not carrying too much cash. That's it. That, that kicks out a surprising number of people, particularly the consulting one. I've been told that I may not spend enough time analyzing whether it's really consulting or they really are in some other industry. And that's, that's fine. I found for the most part that if you don't feel pretty comfortable about it the first two, three minutes you're not getting there or it doesn't really get you there.

Matthew Foreman [00:05:57]:
Also, you know, look, why is it not worth it? Okay, the first one is a lot of states have decoupled. So you know, people are like going after QSBs and they're not going to get it in their state. So they're not going to get it in California. They're going to get half of it in Massachusetts. Massachusetts, a 50% state, they're going half of it in Arkansas. I think that's another 50. New Jersey recently joined the club. So welcome.

Matthew Foreman [00:06:21]:
So you know, look like maybe it's not worth it because you lose. You know, you're still paying tax in those states. So that may not be helpful for a lot of profitable businesses especially. It's really not worth it. QBI section 199 cap A. Look, that's a 20% deduction. And every business that qualifies for 1202 qualifies for 199 cap A. Every single one.

Matthew Foreman [00:06:42]:
And I'll tell you how I know that it doesn't always work the inverse, but every single one does. And I'll tell you why I know this. It's because the qualifications for qbi are in 1202 C3 or E3. I forget I have to look it up. But they're within 1202 so it's the same one. Okay. I think that's really important to, to, to do it. So you know that I should note that a lot of states have actually decoupled from 199 cape.

Matthew Foreman [00:07:06]:
Candidly, I think from a policy perspective it's kind of a nightmare and it's not a great idea. But here we are. But it's still 20% federal brings you from 37 down to about 30. You know, 3, 3.7 times 2 even I can do that. 7.4. So it's a little bit low 30 but you know, we're wobbling through it. The Second one is PTETs pass through any taxes. If you live in a state that has higher taxes or any taxes and has a ptet, right.

Matthew Foreman [00:07:31]:
You are losing that ptet. You are losing that ptet. And I think that's important. I'll talk about that a little more later. But I think that and QBI are the biggest ones for profitable businesses. If you're pulling a couple million dollars out, right. Your effective federal tax rate, if you live in like New York state, you know, even if it's like an 8% rate, right. Your, your effective federal tax rate is like 26, 28%.

Matthew Foreman [00:07:54]:
If you become a C corp, you're either dividending, you know, using a dividend for profitable business or you're paying yourself with a wage which is subject to W2 and payroll taxes. So you're going to get that rate up to around 50, maybe a little higher. So you're, you're kicking the total rates, right? You have about 26 plus state, 2034 total versus federal. If you have a C corp, 48, 50, 50. You know, so it's a pretty big bump. So if you're a profitable business, it may not be worth the exit benefit that may happen. We'll talk about more of that later very soon. To later.

Matthew Foreman [00:08:31]:
Right. Or you're just paying more taxes now to hopefully work. Right. So sometimes, look, take the money out, be a profitable business. That's really important. The second one is, look, I'm going to sell this for $10 million. I don't want to pay tax. Like I don't mean to sound rude.

Matthew Foreman [00:08:47]:
10 million is not worth it. It's not worth, it's not worth it. Especially if it's a profitable business. If this is a non profitable business, you're taking no money out of it. Yeah, QSPs, that's, that's fine. But you really want, especially for profitable business, people ask you like, what's the number? What's the magic number? And I don't, I don't think there is one. I don't think there's ever a threshold that, like, you have to do it. But I always say, look, at 30 million, let's have the conversation at 50 million, which really have the conversation.

Matthew Foreman [00:09:12]:
You want significant growth. Remember, the exclusion is, is generally used to be 10, now it's 15. So it's a different conversation, although really not that different or 10x basis. But basis is really book basis, not tax basis. So if you have a company that's worth 10 million, you convert it. You could theoretically have $100 billion exclusion. But if you sell it for 10 million, okay, I guess, you know, but that means business didn't do that well. So I'm not really sure it makes a difference.

Matthew Foreman [00:09:39]:
Yellow is your taxes. But C Corps are different. If you're pulling money out of it, you know, you really want big growth. You want explosive, significant, substantial, real, real large growth. The other one is, look, you have to wait five years. You know, if you restructure into this, you're waiting five years. I view like, oh, you know, I want to, I want to go after QSBs. I'm going to sell, you know, early next year, early 2027.

Matthew Foreman [00:10:00]:
And I'm like, okay, that's cool. You definitely don't want to be QSPs, because then you're just a C corp and you don't get QSBs. So you have to wait five years. Again, some states have decoupled, and I think that's really important. And people say, look, there's probably someone going, no, no, it's three years now. Didn't you, didn't you read the new bill? Did you read OB Thrice? And yeah, I have. I've read it. But the three years is 15.

Matthew Foreman [00:10:22]:
It's not full because the three years is a 50% exclusion. So the rate is not if you were to sell as S Corp or partnership that you own 100% of or, well, that's not true. It's going to be a partnership that you own 5050. Right. The tax rate for capital gains is, is 20%, not even 23.8 because it's active. So therefore net investment income tax doesn't kick in. Right? So 20%, if you were to do it and you sell it, the sale of stock, if you're getting QSBs on half of it, it uses for the other Non excluded portion that not the 50% you don't exclude. What happens is that's taxed at effectively the full rate, which is 31.8%.

Matthew Foreman [00:11:03]:
So your effective rate on the full on the amount that would be otherwise Excluded is effectively 15.9%. Half of 31.8, which is 28% highest capital gains rate plus, plus 3.8% net investment income. So you're going from 20 to 15.9. Congratulations. You have say 4.1%. That's a number. It's a real number. But I actually don't think you end up ahead.

Matthew Foreman [00:11:25]:
And I'll talk about that after music in a little bit. 4%. That 59 drops to 795 and five years. It is, look, it's, it's full. You get the full. But it's not the whole thing. I always talk about this. I'm going to talk about this more later.

Matthew Foreman [00:11:39]:
But if you sell the assets, you get the pass through entity tax. You know, you get ptets. States are sort of aware of it. It's not explicit. There's some question, I guess in theory they could change their laws to not allow that you're getting the pass around any tax. Especially if a state decouples. That could be big. If it's a really, really large one, you're not getting the ptet.

Matthew Foreman [00:11:59]:
The state taxes could be a significant factor. So the rates can be lower than you think. Especially the 15, nine for three years. We're going to get some music in here and then I'm going to go through the other half of the sheet of paper and we'll do that. All. Foreign. We're back. Don't use, don't use 1202.

Matthew Foreman [00:12:34]:
Right. Don't go after it. So the biggest one that I talk about and people are like, oh no, this will never happen, is you sell it for less. Okay. The only time, first off, you have to sell the stock. That's actually something interesting. I've run into a number of people who are like, oh, I, you know, I know all about qsb. Yes.

Matthew Foreman [00:12:51]:
I've done so much research. And then like, what do you mean you have to sell the stock? I'm like, man, come on, work with me here, dude. You know, there's no depreciation, there's no amortization for the buyer. And so I think it's really important that the buyer is going to pay less. And someone said, you know, I worked on a deal and they, they said, no, no, it's fine, we won't pay you know, we don't have to pay less. You know why they didn't pay less? Because you got too low already. You could have pushed them up. You could have gotten a gross up for the state taxes.

Matthew Foreman [00:13:18]:
You're going to get a gross up. You could have pushed them harder on things. They already paid an amount they're comfortable with. So if they're paying the actual maximum, they're going to pay less because they want depreciation, how much you ask for and 10%, give or take. You know, people say oh, you know, you lose the step up and it's 20% corporate, this and that. But there's time value of money. Maybe it's, maybe it's ordinary, but most of the investors can't take the deductions anyway. The passive activity loss rules.

Matthew Foreman [00:13:44]:
So it's about 10% is really what the haircut ends up being for C Corp. So instead of selling it for 10, you're going to send it, sell it for nine. Is that enough? Maybe, but the tax rate is 20%, you know, 25, 28. So you're giving up a big chunk of that. It's not that big. You had a C Corp, maybe it was profitable business, you're not pulling money out as fast, etc. Etc. Two, you know, now you also point out the non excluded portion.

Matthew Foreman [00:14:10]:
So let's say you sell it for 50 million, but you only have a $10 million exclusion. That's fine. The next 40% is 23.8% corporate, 23, 8% federal, plus you know, whatever the state rate is. Right. So it bumps up your non excluded portion by at least 3.8%. Because if you're a pass through and you're active in the business, you don't have to pay the net investment income tax so you're going to sell it for less. There's still some taxes that could be imposed. It's an exclusion, not an exception.

Matthew Foreman [00:14:34]:
So net investment income tax is not imposed on the excluded portion. But that's, that's, that's neither here nor there. You need, candidly I think, I think you need explosive growth. Not 2x, you know, you know, especially not a formation. You need 5 or 6x. You know, you need a big number. If an operation 5 to 6x. So if, if your company's worth 10 million and you put it in, you could have a hundred million dollar exclusion, you know, based on that.

Matthew Foreman [00:15:02]:
So like the multiplier is done. But if that formation, you want a 10x, you want a big number, you're putting your time Your effort, your sweat into it. And I think that's really important, that you really need the big growth. You're losing the PT, you're losing the QBI, which is 199 Cafe. Those are significant, right? One thing I actually thought was interesting and I've come to this sort of conclusion is, you know, I'm working on M and A deals and the seller ends up being like, hey, I want to gross up because I'm paying, you know, I'm paying ordinary income tax on some of the assets because I'm not selling the stock, right? And my answer to that question, I always say is well, actually I think you're doing better. And I'll tell you why. Because even if you don't get QBI on the amount, you're getting P10 on it. And for example, if the tax rate is 23.8% for capital gains and 37% for, for ordinary income, the ability to deduct capital, deduct the state taxes will lower your overall rate by 3ish.

Matthew Foreman [00:16:05]:
If you live in New York, 3ish%, live in New York City, 4ish percent. That's your federal benefit of state fbos. And I think that what I've sort of common people is very few businesses, especially ones sold at those multiples have, you know, depreciation recapture, ordinary income items that are large enough to really matter. Okay? So what ends up happening is they basically get, end up with the password entity tax on the state taxes and if they sold the stock in the company, they wouldn't. So my counter argument to that is that's nice, you get a PTET that offsets it. You know, go, go pound sand, go do something else. I don't care. And that's really big.

Matthew Foreman [00:16:45]:
The PTET on sale is really large even though it increases taxes because you're not, you know, doing that PTEC sort of brings you back to where you were. Whereas otherwise, you know, pre, pre tcja, you know, it really, it was worse to buy the assets. Now I'm not convinced. Especially for companies where the, the ordinary income items or depreciation recapture are, you know, 2, 3, 4% of the total. They have to be 10 to really even out. So I actually think it's better to sell the assets. And so you're, you're not getting the PTET. PTET's pretty significant.

Matthew Foreman [00:17:20]:
I think that's important. The next sort of thing is that, look, rollover is a challenge if you're doing QSPs, right? Because to do rollover, you, you, you you know, if you're gonna do a reorg, you have to maintain 40% of it for it to be tax free because you would just do an F. You just excuse me, do an A reorg. A A is going to take precedence most likely. And so you have to roll over 40. You know, if you want to roll over 10, like it's so much easier if you just have a pass through. Even if it's an S corp, you're just going to F reorg than rev, you know, Rev Rev Proc. 99.5996 and deal with those.

Matthew Foreman [00:17:57]:
And I think that's sufficient. And it's important, you know, even if you have anti turning assets and things like that, you can work around it. So I think it's really important to say that the rollover becomes much more of a challenge. Do you want to roll over 40%? I know there's a case says 38 but the regs say 40 and I don't really want to mess with that. So I think it's really good one. And there's no F reorg into the rollover. Right? You can't f reorg a C corp and get Rollover and get USBs because then you're selling the assets. I have seen businesses that ended up selling the assets of C Corp where they were trying to sell it as USPS and they couldn't find a buyer.

Matthew Foreman [00:18:37]:
Some buyers will never underline that word. Never buy stock due to historical risks. Stuff wasn't done right. They're not sure they elected something right. They have something else. Some just kind of like it's sort of on the slide. But they don't trust what you've been doing. You haven't been categorizing your employees as employees, contractors correctly calling them contractors and their employees.

Matthew Foreman [00:18:58]:
They might not want to buy that. They can buy the assets and not buy the risk. That's what they're going to do. And you lose QSBs. So it has a real and material risk to it that I have long found to be be larger than they are. I think for profitable businesses. I really tell people, look like, talk to your accountant. I, I can do this, I've done it.

Matthew Foreman [00:19:18]:
But talk to your accountant. Have them put together a model, you know, how much more will they pay? What that kind of stuff. And people like, oh, they'll just empty it out, you know, in, in salary, salaries, payroll taxes, salary, doesn't get ptet, things like that. And I think it's really important to do the math and figure out like what are the chances that you actually sell, you know, a $10 million company in six years for $700 million, for $50 million? Right? Maybe, maybe you do, but what if you don't? Are you willing to risk the idea that you now either have to reelect s wait five years or you're just going to pay higher taxes on, on the sale of assets? You know, what, what is your, what is your risk tolerance? And there are people who will say, your virus tolerance is pretty high. I think I'm fine. And then there are people who will say, I'm not, you know, I'm not doing that. No way. Not happening.

Matthew Foreman [00:20:13]:
Not. Not a chance. I think it's really important to think through what you're doing and how you're doing it and what you're trying to accomplish. Because when people say, oh, you know, there's no tax in qsbs, that's true. But the most important thing to me, and I'll leave you with this thought, is that you don't want to increase your overall taxes because you're going after an exit that requires a very specific fact pattern. And that's, I think what a lot of people do is they take a risk they're not doing. And this isn't like, look, when you have no good options, you know, studies have shown people are very risk tolerant when they have no good options. You have better options.

Matthew Foreman [00:20:57]:
Just be like, S Corp's not the best in the world. First person to say, I don't think they're good, but a lot of times they're better than a C. And I think that's really important. All right, that was the 52nd episode of How Tax Works, which is not the last one of the second year because I had two and the AI one, the 53rd one will mathematically, I believe, be the last. I'll double check that to make sure this isn't a year and because of when they're released that we actually had 27 in a year. So this is not the end of year two, the next one or the one after that. I have to figure it out. Will be.

Matthew Foreman [00:21:30]:
Hope you learned something new episode in two weeks. 53rd episode which is about cannabis tax 280 Capi. So, so digging, digging deep into that one and we'll, we'll pass it along to the right, to the right hand side. Thank you so much for listening. Enjoy the sa.