In Leto v. United States^[1], the taxpayer reincorporated an S corporation business into a C corporation, then the taxpayer later sold the shares in the C corporation and tried to exclude the gain from such sale under section 1202. The court denied the taxpayer’s gain exclusion under section 1202; however, proper structuring could have saved some, if not all, of that gain exclusion.

Background
The company was formed as an Arizona limited liability company that elected to be taxed as an S-corporation. Years later, the company was reincorporated as a C corporation in Delaware, although it is unclear whether the reincorporation was for raising funds from outside investors, hopes of obtaining benefits under section 1202, or both. This reincorporation was effected by having the company merge into a newly-formed Delaware C corporation, with the C corporation surviving. As part of the merger, the taxpayer received C corporation stock in exchange for his LLC interest in the company.

After more than five years lapsed, the taxpayer sold his stock in the company (now a C corporation). The taxpayer did not originally claim any gain exclusion pursuant to section 1202 when he filed his federal income tax return. One year later, the taxpayer filed an amended return to exclude gain from his stock sale pursuant to section 1202. The IRS rejected the taxpayer’s amended return, claiming that the taxpayer’s stock did not constitute qualified small business stock.

QSBS Requirements
As described in more detail here, qualified small business stock (“QSBS”) must satisfy the small business, original issuance, and active trade or business requirements. At issue in Leto was the original issuance requirement. A taxpayer must receive stock directly from the issuing corporation in exchange for money or other property (not including stock) in order for such stock to constitute QSBS.^[2]

The Issue
The primary issue was whether the taxpayer had contributed stock in exchange for his stock in the new C corporation. The Justice Department argued that when the LLC elected to be taxed as an S corporation, the LLC’s memberships interests became stock for federal tax purposes. Because the LLC membership interests were “stock” for federal tax purposes, the conversion of the LLC to a C corporation was — according to the Justice Department — a stock-for-stock exchange. The taxpayer responded that the LLC membership interests were not stock because Arizona, like many states, does not treat them as stock.

The court rightly agreed with the government. The meaning of stock in section 1202(c)(1)(B) is determined by federal law, not by state law^[3]. Thus, under Treasury Regulations Section 301.7701-3(g)(1)(i), when the LLC elected to be taxed as an S corporation it was deemed to be a partnership that contributed all of its assets to an S corporation in exchange for stock and then liquidated by distributing all the stock to its partners. Thus, after making the S corporation election, the LLC interests were stock for federal tax purposes.

Potential Solution

With proper planning, the taxpayer could have salvaged some, if not all, of the section 1202 benefit. The facts of the case do not provide detail on whether the taxpayer’s sale was an isolated sale or whether his sale was in connection with a complete sale of the company. If the sale was a complete sale of the company (i.e., all of the corporate shareholders sold their shares to a buyer (or buyers)), then the taxpayer could have utilized his full benefit under section 1202 under a different structure. If the sale was of less than all of the company stock, then the taxpayer could have recognized some benefit under section 1202, although likely substantially less.

Once the LLC owners decided to reincorporate their business in Delaware, they could have caused the LLC to contribute all of its assets and liabilities into a newly-formed Delaware C corporation, instead of merging the LLC out of existence into a new corporation. Under that structure, the LLC (taxed as an S corporation) would have contributed its assets in exchange for stock (rather than a stock for stock transaction) and became the sole shareholder of the new C corporation. Under this structure, the LLC’s stock in the C corporation would qualify as QSBS and the LLC’s owners would recognize benefits under section 1202 upon a future sale by the LLC of its stock in the C corporation.^[4]

Alternatively, for ease of restructuring^[5], the LLC (taxed as an S corporation) could have reorganized pursuant to the typical F reorganization structure outlined in Situation 1 of Revenue Ruling 2008-18, with the addition of a few extra steps, to obtain QSBS. Those steps would be:

Step 1: The shareholders of the LLC (taxed as an S corporation) form a new corporation (“NewCo”).

Step 2: The shareholders contribute 100% of their stock in the LLC (taxed as an S corporation) (“OpCo”) to NewCo in exchange for shares in NewCo.

Step 3: NewCo elects to treat OpCo as a qualified subchapter S corporation.

Step 4: OpCo is converted from a corporation to a limited liability company (or in the case of an LLC that previously had a Subchapter S election in effect, the LLC would file Form 8832 and elect to be treated as a disregarded entity).

Step 5: NewCo forms a new corporation (“C Corp”).

Step 6: NewCo contributes 100% of the LLC interests in OpCo to C Corp in exchange for 100% of the shares of C Corp.

The final structure is a three-tiered structure illustrated as follows:

Upon a sale five or more years in the future, if NewCo sold all of its stock in C Corp, NewCo would recognize eligible section 1202 gain that would flow through to its shareholders on a K-1, and Newco’s shareholders would be able to exclude such gain from income, subject to limitations.^[6]

However, what if the taxpayer in Leto was the only shareholder wanting to exit the structure? To still obtain some of the gain exclusion under section 1202, NewCo could sell part of its stock in C Corp (e.g., 20%), then used those proceeds to redeem out the taxpayer. Unfortunately, due to the S corporation income allocation rules^[7], the taxpayer would not receive his full section 1202 benefit, even though he was completely redeemed out of NewCo, because the gain from that partial stock sale would be allocated proportionately to all of NewCo’s owners, not just to the redeemed taxpayer.

Conclusion
While many parts of section 1202 appear simple, many nuances are lost among taxpayers until it is too late. These nuances are especially pronounced in reorganizing a business (such as partnerships and S corporations) to take advantage of section 1202 and in structuring certain family trusts to multiply the exclusion limitation. Taxpayers who intend to form a company to utilize section 1202 or who are about to claim section 1202 exclusions on their tax returns should carefully evaluate their business structure and the likelihood of the IRS challenging the exclusion upon a future sale.

[1] Leto v. United States, No. CV-20-02180-PHX-DWL (D. Ariz. 2022).

[2] § 1202(c)(1)(B)(i) (emphasis added).

[3] See generally United States v. Nat'l Bank of Commerce, 472 U.S. 713, 722 (1985) ("State law define[s] the nature of the taxpayer's interest in the property, but the state-law consequences of that definition are of no concern to the operation of federal tax law.").

[4] See § 1202(g).

[5] Pursuant to this alternative restructuring, the historic operating company would remain in place (albeit converted to an LLC), which would permit existing bank accounts, employees, assets, contracts, etc. to remain with the historic operating company instead of needing to transfer those accounts, assets, and/or employees to the new C corporation.

[6] Id.

[7] See § 1366(a) (requiring an S corporation’s gain to be allocated proportionately among all shareholders).