Substantiating §1202 Gain Exclusion Eligibility
Just recently, we were focusing on a §1202 stock eligibility question for a client, and we decided to listen to a §1202 webinar to determine whether the speakers had focused on a particular issue. (As a reminder, §1202 provides up to a 100% gain exclusion on the sale of qualifying C corporation stock.) Unfortunately, they did not; however, the speakers reminded us of a relatively recent §1202 case (one of just a few cases addressing §1202 issues),
Ju v. United States, 170 Fed. Ct. 266 (2024), wherein the Claims Court did not grant a taxpayer’s motion for summary judgment as to eligibility for the §1202 gain exclusion, because the taxpayer was unable to establish that the corporation met the §1202 eligibility requirements during substantially all the period the taxpayer held his stock.
It is critical that a taxpayer maintain adequate records that, among other requirements, the corporation, at all times after August 10, 1993 (or, if later, the date of the corporation’s formation), and immediately after the taxpayer’s capital infusion to acquire the §1202 stock, met the $50 million gross asset test and that the corporation met the active trade or business requirement for substantially all the taxpayer’s holding period of the stock. Obtaining representations from the corporation that all the §1202 requirements have been satisfied as of the date of a taxpayer’s capital infusion into the corporation and that the corporation will not do anything thereafter to jeopardize the §1202 eligibility of the shares is all well and good (and clearly recommended). However, in addition, the taxpayer should try to obtain the corporation’s financial statements for all relevant periods (both before and after the taxpayer’s acquisition of the §1202 stock) and other underlying financial data necessary to be able to demonstrate the continuing §1202 status of the stock.
Depending on the magnitude of the taxpayer’s investment, due diligence may dictate a review of these financial statements and other relevant data by the taxpayer’s tax professional before an investment is made. While there theoretically can be blips in the corporation’s asset configuration between reporting periods, having such financial data hopefully would satisfy a taxpayer’s burden of proof as to §1202 eligibility. For instance, as discussed at the
Tax Forum, because of the uncertainty of §1202 status when a C corporation conducts business through an entity taxed as a partnership, irrespective of representations by the corporation that it has never, and will not, conduct business through a partnership, it is good practice to examine the financial documents to ascertain that such is the case.