SECTION 1202 QUALIFIED SMALL BUSINESS STOCK

SECTION 1202 QUALIFIED SMALL BUSINESS STOCK

AUGUST 17, 2020

David B. Strong

Partner

Wilson Sonsini Goodrich & Rosati Professional Corporation

Direct Phone: (650-849-3049) E-Mail: dstrong@

AUSTIN BEIJING BOSTON BRUSSELS HONG KONG LONDON LOS ANGELES NEW YORK PALO ALTO SAN DIEGO SAN FRANCISCO SEATTLE SHANGHAI WASHINGTON, DC WILMINGTON, DE

DAVID B. STRONG PARTNER DIRECT PHONE: (650) 849-3049 E-MAIL: DSTRONG@

David Strong is a partner in the Palo Alto office of Wilson Sonsini Goodrich & Rosati, where he focuses on mergers and acquisitions, joint ventures, and private equity and venture capital investments. He also has substantial experience with respect to the tax aspects of a wide variety of capital markets transactions for domestic and foreign issuers, including initial public offerings and convertible note offerings.

Dave has worked on transactions across a broad range of industries, including consumer, healthcare, manufacturing and industrial services, media and entertainment, mining and natural resources, real estate, technology, life sciences, and internet and telecommunications.

Dave is a former chair of the Corporate Tax Committee of the Tax Section of the American Bar Association, a fellow of the American College of Tax Counsel, and a frequent speaker on corporate and other tax matters at local, regional, and national seminars and continuing legal education programs. Dave is admitted to practice in New York and Colorado. He is not admitted in California.

For a listing of publications and speaking engagements, as well as representative M&A, private equity, venture capital, and capital markets transactions on which Mr. Strong has served as lead tax advisor, consult Mr. Strong's professional biography at:

SECTION 1202 QUALIFIED SMALL BUSINESS STOCK

I. EXECUTIVE SUMMARY..................................... 1 A. General Benefits and Eligibility. ................. 2 1. Potential 100% Exclusion for Stock Acquired After September 27, 2010. ........................ 2 2. Stock Held by a NonCorporate Taxpayer In a Qualifying C-Corp........................... 3 B. Overview of Requirements.......................... 4 1. Stock of a C-Corporation Acquired at "Original Issuance." ........................................ 4 2. Qualified Small Business Requirement. ................................... 4 3. Active Business Requirement. ........ 4 4. Five-Year Holding Period. .............. 5

II. STOCK OF A C-CORPORATION ACQUIRED AT "ORIGINAL ISSUANCE".......... 5 A. Stock of a C-Corporation. ........................... 5 B. "Original Issuance" Requirement................ 5 1. In General. ....................................... 5 2. The Concept of "Property."............. 6 3. Restrictions on Redemptions......... 10 4. Partnership Transfers..................... 10 5. Section 83(b) Elections. ................ 11

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6. Convertible Securities, Options, Warrants.......................... 12

7. Stock Acquired by Gift or Upon Death of Holder. .................. 13

8. Stock Received in Certain Corporate Transactions.................. 13

9. Stock Held Through PassThrough Entities. ........................... 14

III. QUALIFIED SMALL BUSINESS REQUIREMENT .................................................. 15 A. In General. ................................................. 15 B. Aggregate Gross Assets Test..................... 16 C. Submission of Reports to the IRS. ............ 17

IV. ACTIVE BUSINESS REQUIREMENT............... 17 A. In General. ................................................. 17 B. Special Rules. ............................................ 20 1. Start-Up and R&D Activities. ....... 20 2. Stock In Other Corporations.......... 20 3. Working Capital. ........................... 21 4. Real Estate Holdings. .................... 21 5. Computer Software Royalties. ...... 22

V. FIVE-YEAR HOLDING PERIOD REQUIREMENT .................................................. 23 A. In General. ................................................. 23 B. Offsetting Short Positions. ........................ 24

VI. AMOUNT OF GAIN SUBJECT TO EXCLUSION ........................................................ 24 A. Section 1202(a) Exclusion......................... 24

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B. Section 1202(b) Limitation on Taxpayer's Eligible Gain........................... 28

C. Section 1202(i) Basis Rules. ..................... 29 VII. POTENTIAL ROLLOVER OF GAIN

(SECTION 1045) .................................................. 32 A. In General. ................................................. 32 B. Specific Requirements............................... 33

1. Non-Corporate Taxpayer............... 33 2. Sale of QSB Stock. ........................ 33 3. Six-Month Holding Period. ........... 33 4. Section 1045 Election.................... 34 5. Character of Gain. ......................... 34 6. Purchase of Replacement QSB

Stock Within 60-Day Period. ........ 35 C. Rollover of Gain In Partnership

Context. ..................................................... 35 1. Rollover by Partnership................. 35 2. Rollover by Partner. ...................... 38 3. Rollover of Directly Held QSB

Stock Through a Purchasing Partnership..................................... 39 4. Other Partnership Transactions. .... 39 VIII. PRACTICAL PLANNING CONSIDERATIONS ............................................ 40 A. Pre-Investment Planning. .......................... 40 B. Making the Investment. ............................. 41 C. Issues Requiring Ongoing Evaluation / Operational Covenants. ............................. 42 1. In General. ..................................... 42

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2. Availability of Look-Through Rule for Subsidiaries. .................... 42

3. No Portfolio Stock or Securities. ...................................... 43

4. Subsequent Infusions of Cash; Working Capital. ........................... 43

5. Maximum Real Estate Holdings. ....................................... 43

6. Shareholder Holding Periods......... 43

7. Redemptions. ................................. 44

8. Subsequent Transactions / Restructurings................................ 44

9. Subsequent Changes In Law or Changes In Interpretation. ............. 44

D. Planning for Exit. ...................................... 45

1. Exits Before the Expiration of the Five-Year Holding Period. ...... 45

2. Exits After the Expiration of the Five-Year Holding Period. ...... 45

E. Tax Filing Requirements and Document Retention.................................. 49

F. Selected Potential Planning Opportunities and Traps for the Unwary. ..................................................... 50

1. Potential Funding Rounds May Exceed $50 Million ....................... 50

2. Low Tax Basis In Assets Relative to Equity Value ............... 52

3. Shareholder That Is More Than 50% Controlled by a C Corporation.................................... 53

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4. QSB Stock Subsequently Transferred to a Partnership .......... 55

5. Holding Companies ....................... 55 6. Stock Held In S Corporations........ 57 7. Partnership Incorporations ............ 59

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SECTION 1202 QUALIFIED SMALL BUSINESS STOCK

I. EXECUTIVE SUMMARY

This article provides general information regarding U.S. federal income tax incentives available to non-corporate holders of "qualified small business stock" ("QSB stock") as defined under Section 1202 of the Internal Revenue Code.1

In general, under current law, Section 1202 allows a non-corporate taxpayer to potentially exclude up to 100% of the amount of eligible gain realized from the sale or exchange of QSB stock held for more than five years.

The amount of gain that is eligible for exclusion by a taxpayer with respect to QSB stock held in a particular corporation is subject to an annual limitation equal to the greater of either:

(i) $10 million (reduced by the aggregate amount of eligible gain taken into account by the taxpayer in prior taxable years with respect to dispositions of QSB stock of such corporation); or

(ii) 10 times the aggregate adjusted bases of QSB stock issued by such corporation and disposed of by the taxpayer during the taxable year.

In addition, Section 1045 allows a taxpayer to potentially roll-over gain from the sale of QSB stock that has been held for more than 6 months.

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Unless otherwise specified, all "Section" references are

to the U.S. Internal Revenue Code of 1986, as amended (the "Code"), or

applicable Treasury Regulations promulgated thereunder.

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