Section 1202 of the Code provides special benefits to certain stock in C corporations that meet the requirements. The gain from the sale of 1202 stock (acquired after September 27, 2010) is excluded from a non-corporate owner’s taxable income up to the greater of $10 million or 10 times their tax basis in the stock. With the reduction in corporate income tax rates in 2017, conducting business through a C corporation that qualifies as a qualified small business has gained popularity. It is easy to see why when a shareholder could save tax of $2 million or more on the sale of stock!

There are numerous requirements that must be met in order for stock to qualify as 1202 stock. The corporation must be a C corporation, the stock must be acquired at original issuance, the corporation must engage in a “qualified business” (e.g., no legal or medical services businesses, no finance, etc.), its gross assets must not exceed $50 million prior to or at the time of the stock issuance, and the stock must be held for 5 years prior to sale.

The ability to exclude gain on sale of 1202 stock is highly desirable but as might be expected is not without its challenges and traps for the unwary. One such potential trap is that the transfer of 1202 stock to a partnership will cause the stock to lose its status as 1202 stock and a subsequent sale of that stock will be fully taxable. Unfortunately, the statutory language on this point (Section 1202(g)(2)(A)) is not particularly clear. That section provides that gain on the sale by a partnership of stock which is 1202 stock in the hands of that partnership is not included in income. Since 1202 stock must be acquired at original issue, a partnership that receives a contribution of 1202 stock fails that original issue requirement and the stock is no longer 1202 stock. This consequence is more clear in the legislative history than the language of the Code section.

Bottom Line: Don’t transfer 1202 stock to a partnership. If 1202 stock is to be held by a partnership, transfer money or property to the partnership and have the partnership acquire the stock at original issue.

“The difference between try and triumph is just a little umph!” — Marvin Phillips