SECTION 1202 QUALIFIED SMALL BUSINESS STOCK

1 SECTION 1202 QUALIFIED SMALL BUSINESS STOCK AUGUST 11, 2011 David B. Strong Partner Direct Phone: (303) 592-2241 E-Mail: 5200 REPUBLIC PLAZA 370 SEVENTEENTH STREET DENVER, COLORADO 80202-5638 TELEPHONE: FACSIMILE: MORRISON & FOERSTER LLP NEW YORK, SAN FRANCISCO, LOS ANGELES, PALO ALTO, SACRAMENTO, SAN DIEGO, DENVER, NORTHERN VIRGINIA, WASHINGTON, TOKYO, LONDON, BRUSSELS, BEIJING, SHANGHAI, HONG KONG David B. Strong Partner Direct Phone: (303) 592-2241 E-Mail: Dave Strong represents a wide range of corporate, pass-through, and individual clients in connection with the tax aspects of complex domestic and international transactional matters, including mergers and acquisitions, joint ventures, private equity and venture capital investments, restructurings, distressed situations, and initial public offerings and other capital markets transactions.

2 Mr. Strong currently serves as the vice chair of the Corporate Tax Committee of the Tax SECTION of the American Bar Association and he is scheduled to chair that committee beginning in 2013. Mr. Strong is also a frequent speaker on corporate and other tax matters at local, regional, and national seminars and continuing legal education programs. Mr. Strong received his from Stanford Law School and his in Taxation from New York University. Prior to moving to Denver, Mr. Strong worked for several years as both a transactional tax attorney and as an investment banker in New York City. For an outline of prior publications and speaking engagements, as well as a listing of representative M&A and capital markets transactions on which Mr.

3 Strong has served as lead tax advisor, consult Mr. Strong s complete professional biography at: i SECTION 1202 QUALIFIED SMALL BUSINESS STOCK I. EXECUTIVE SUMMARY .. 1 A. General Benefits and Eligibility .. 1 1. 100% Exclusion STOCK Acquired After 9/27/10 & Before 1/1/12 .. 1 2. STOCK held by a Non-Corporate Taxpayer In a Qualifying C-Corp .. 2 B. Overview of 2 1. STOCK of a C-Corporation Acquired at Original Issuance.. 2 2. QUALIFIED SMALL BUSINESS Requirement .. 3 3. Active BUSINESS Requirement .. 3 4. Five-Year Holding Period .. 3 II. STOCK OF A C-CORPORATION ACQUIRED AT ORIGINAL ISSUANCE .. 3 A. STOCK of a C-Corporation .. 3 B. Original Issuance 4 1. In General .. 4 2. The Concept of Property.

4 4 3. Restrictions on 7 4. Incorporation of a Partnership .. 8 5. SECTION 83(b) Elections .. 9 6. Convertible Securities, Options, Warrants .. 9 7. STOCK Acquired by Gift or Upon Death of Holder .. 10 ii 8. STOCK Received in Certain Corporate Transactions .. 10 9. STOCK held Through Pass-Through Entities .. 11 III. QUALIFIED SMALL BUSINESS REQUIREMENT .. 12 A. In General .. 12 B. Aggregate Gross Assets 12 C. Submission of Reports to the IRS .. 13 IV. ACTIVE BUSINESS REQUIREMENT .. 14 A. In General .. 14 B. Special Rules .. 15 1. Start-Up and R&D Activities .. 15 2. STOCK In Other 15 3. Working Capital .. 16 4. Real Estate Holdings .. 16 5. Computer Software Royalties .. 17 V. FIVE-YEAR HOLDING PERIOD REQUIREMENT.

5 17 A. In General .. 17 B. Offsetting Short Positions .. 18 VI. AMOUNT OF GAIN SUBJECT TO EXCLUSION .. 19 A. SECTION 1202(a) 19 B. SECTION 1202(b) Limitation on Taxpayer s Eligible Gain .. 19 C. SECTION 1202(i) Basis Rules .. 20 VII. POTENTIAL ROLLOVER OF GAIN ( SECTION 1045).. 21 A. In General .. 21 iii B. Specific 22 1. Non-Corporate 22 2. Sale of QSB 22 3. Six-Month Holding Period .. 22 4. SECTION 1045 23 5. Character of Gain .. 23 6. Purchase of Replacement QSB STOCK Within 60-Day Period .. 23 C. Rollover of Gain In Partnership 24 1. Rollover by 24 2. Rollover by Partner.

6 26 3. Rollover of Directly held QSB STOCK Through a Purchasing 27 4. Other Partnership Transactions .. 27 VIII. PRACTICAL PLANNING CONSIDERATIONS .. 28 A. Pre-Investment Planning .. 28 B. Making the Investment .. 29 C. Issues Requiring Ongoing Evaluation / Operational Covenants .. 30 1. In General .. 30 2. Availability of Look-Through Rule for Subsidiaries .. 30 3. No Portfolio STOCK or 30 4. Subsequent Infusions of Cash; Working Capital .. 31 5. Maximum Real Estate 31 6. Shareholder Holding Periods .. 31 7. 31 iv 8. Subsequent Transactions / 31 9. Subsequent Changes In Law or Changes In Interpretation .. 32 D. Planning for Exit .. 32 1.

7 Exits Before the Expiration of the Five-Year Holding Period .. 32 2. Exits After the Expiration of the Five-Year Holding Period .. 33 E. Tax Filing Requirements and Document Retention .. 37 1 SECTION 1202 QUALIFIED SMALL BUSINESS STOCK I. EXECUTIVE SUMMARY This article provides general information regarding federal income tax incentives available to non-corporate holders of QUALIFIED SMALL BUSINESS STOCK ( QSB STOCK ) as defined under SECTION 1202 of the Internal Revenue In general, under current law SECTION 1202 allows a non-corporate taxpayer to potentially exclude up to 100% of a substantial portion (or possibly all) of the gain realized from the sale or exchange of QSB STOCK held for more than five years. In addition, SECTION 1045 allows a taxpayer to potentially roll-over gain from the sale of QSB STOCK that has been held for more than 6 months.

8 A. General Benefits and Eligibility. 1. 100% Exclusion STOCK Acquired After 9/27/10 & Before 1/1/12. The SMALL BUSINESS Jobs Act of 20102 amended SECTION 1202 to provide for a temporary 100% exclusion from gross income for regular income tax purposes for QSB STOCK purchased after September 27, 2010 and before January 1, 2011, and comparable 100% exclusion from alternative minimum tax ( AMT ) purposes. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010,3 extended the January 1, 2011 end-date for acquiring QSB STOCK eligible for the 100% regular income tax and AMT exclusion to January 1, 2012 . 1 Unless otherwise specified, all SECTION references are to the Internal Revenue code of 1986, as amended (the code ), or applicable Treasury Regulations promulgated thereunder.

9 2 Pub. Law No. 111-240 (Sept. 27, 2010). 3 Pub. Law No. 111-312 (Dec. 17, 2010). 2 The Obama administration has proposed making these 100% exclusions permanent, but the status of this proposal is 2. STOCK held by a Non-Corporate Taxpayer In a Qualifying C-Corp. In general, in order to qualify for the benefits of SECTION 1202 a non-corporate taxpayer must acquire and hold STOCK in a qualifying C-corporation. The benefits of SECTION 1202 do not directly apply to equity interests acquired and held in pass-through entities, such as S-corporations or partnerships. However, as discussed in more detail later in Part of this article, an individual taxpayer s allocable share of gain attributable to a sale of QSB STOCK by a pass-through entity may potentially qualify as gain eligible for the SECTION 1202 exclusion.

10 B. Overview of Requirements. There are four main requirements that must be satisfied before gain on the sale of STOCK is potentially eligible for the exclusion under SECTION 1202. Each of these requirements is briefly mentioned immediately below and then discussed in more detail in Parts II through V of this article. 1. STOCK of a C-Corporation Acquired at Original Issuance. Sections 1202(c)(1) (lead-in language) and (c)(1)(B) generally state that QSB STOCK means any STOCK in a C-corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993, if such STOCK is acquired by the taxpayer at original issue (directly or through an underwriter) in exchange for money or other property, or as compensation for services performed for such corporation (other than services performed as an underwriter of such STOCK ).