As discussed in prior installments of Did You Know,  Section 1202 of the tax code makes the gain on the sale of certain corporate stock nontaxable.  This is not a deferral. It will never be taxed in the future. One of the many requirements for stock to qualify for this treatment is that it must be issued by a C corporation (not an S corporation).  Unfortunately, if you have an S corporation, simply terminating its S corporation status (i.e., converting to a C corporation) will not be effective with respect to stock issued while the corporation was an S corporation. Stock issued after conversion to a C corporation could qualify as section 1202 stock (if all the other requirements are met). However, any appreciation on the existing stock issued by the S corporation will not qualify for tax free treatment.

One way that it may be possible to get the benefit of Section 1202 for future appreciation of the outstanding stock of the S corporation would be for the S corporation to contribute its assets to a newly formed C corporation in exchange for stock. The stock issued by the C corporation in exchange for the assets may qualify as section 1202 stock (again if all other requirements are met).  When the S corporation (after 5 years) sells the Section 1202 stock, gain from appreciation on the stock accruing after the contribution will not be taxable (subject to applicable limits).  Note that for the contribution of the assets to the new C corporation to be a non-taxable transaction, it must be undertaken for bona fide business reasons other than just tax benefits.  For example, a potential business reason may be that the corporation was seeking to raise capital from an entity that is not eligible to be an S corporation shareholder.  Each case will need to be evaluated on its particular merits.

Bottom Line:   With careful planning, it may be possible to make future appreciation on S corporation stock tax free under Section 1202.  
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Photo of James Duffy James Duffy

Jim is a partner in Taft’s Tax practice and practices principally in the areas of federal tax law; tax credit financing; individual, partnership and corporate tax planning; M&A; tax-exempt organizations and general commercial and corporate law.

Jim has been actively practicing in the

Jim is a partner in Taft’s Tax practice and practices principally in the areas of federal tax law; tax credit financing; individual, partnership and corporate tax planning; M&A; tax-exempt organizations and general commercial and corporate law.

Jim has been actively practicing in the area of the New Markets Tax Credits (NMTC) program since its inception in 2001. He has organized community development entities (CDEs) and represented CDEs, borrowers and other parties in structuring and closing numerous NMTC transactions. Jim also advises clients regarding Qualified Opportunity Zone matters.

Jim advises LLCs, partnerships, corporations and individuals in connection with the formation of new companies, mergers and acquisitions, formation of joint ventures, like-kind exchanges, ownership succession planning, and general business operations. These clients are involved in a variety of industries, including banking, venture capital, real estate, construction, consulting and investing.

Jim also advises charitable and non-charitable tax-exempt organizations, including health care entities, schools, religious and civic organizations. In addition to advising management of these organizations with respect to matters pertaining to general operation and maintenance of tax-exempt status, Jim has assisted clients in forming, restructuring and dissolving tax-exempt organizations, as well as forming donor- advised funds.

Prior to joining the firm, Jim worked at the law firm of Lewis Rice and Fingersh in St. Louis, Missouri, where he concentrated his practice in federal and state taxation. He also clerked for the Hon. Robert P. Ruwe of the U.S. Tax Court in Washington, D.C.