Under Section 1202(h)(4) the holder of QSBS can exchange their stock for other QSBS or non-QSBS stock when electing Section 351(a). Section 351(a) allows the holder to conduct a tax-free transaction, exchanging either corporate stock or property. Immediately after the exchange, the company issuing new stock in exchange for the QSBS has to have control of the QSBS corporation in terms of Section 368. Under Section 368 control means at least 80% of the voting power and at least 80% of the number of shares of other issued stock. If the QSBS is exchanged for newly issued QSBS the stock will (i) maintain its holding period, (ii) defer any existing gains, and (iii) accumulate more Section 1202 QSBS tax gains to be included in the exclusion when the second QSBS is sold. Under Section 351(a) the QSBS can be exchanged for non-QSBS as stock and still maintain the first two caveats above, but it will not accumulate any new Section 1202 QSBS gains. When the non-QSBS is sold the built-in QSBS gain will be excluded but any new gains will be taxed at the taxpayer’s corporate tax rate.
If a company was acquired in a tax-free stock transaction the company acquiring the QSBS company would issue new stock in exchange for controlling ownership of the QSBS company. When the newly issued stock in the acquiring company qualifies as QSBS then nothing would change in terms of tax exclusion or holding period for the QSBS holder. The only caveat when the newly issued stock of the acquiring company is non-QSBS is that any gains after the issuance of the stock would not qualify for the QSBS tax exclusion; therefore, the only gain on allowed on the sale of the new stock would be the built-in gain from the original QSBS.
Below is an case study on Section 351 tax-free transaction.
In 2012, ABC Corp raised $20 million in funding with an investor leading the round with a $5 million investment. The newly issued stock qualified as QSBS. Three years later the ABC Corp was acquired under a Section 351(a) tax-free stock exchange transaction. The acquirer exchanged newly issued non-QSBS for 100% of the stock in ABC Corp with a value of 2x the value the investors paid for their stock in ABC Corp. Therefore the lead investor received $10 million worth of non-QSBS from the acquirer. After the lead investor held onto the stock for two more years to meet the five year holding period, he sold the stock for $15 million. Since the stock received was non-QSBS, the total QSBS tax exclusion would equal the built-in gain at the time of the exchange of $5 million ($5 million x 2) and the taxable gains would be the $5 million earned over the two years post Section 351 transaction.
Although the investor still has to pay taxes on the $5 million he saved $1.19 million ($5 million x 23.8%) in taxes from the Section 351 transaction.
How do report Section 351(a) tax-free QSBS exchange on my taxes?