Qualified Small Business Stock

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8749]

RIN 1545-AU34

Qualified Small Business Stock

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 50-

percent exclusion for gain from certain small business stock. The final

regulations reflect changes to the law made by the Omnibus Budget

Reconciliation Act of 1993 and provide guidance to the issuers and

owners of the stock of certain small businesses.

DATES: This regulation is effective December 31, 1997. For dates of

applicability of these regulations, see Sec. 1.1202-2(e).

FOR FURTHER INFORMATION CONTACT: Catherine A. Prohofsky of the Office

of the Assistant Chief Counsel (Income Tax and Accounting) at 202-622-

4930 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

Background

Section 1202 of the Internal Revenue Code allows a taxpayer (other

than a corporation) to exclude 50 percent of certain gain from the sale

or exchange of qualified small business stock held for more than 5

years. This document contains amendments to the Income Tax Regulations

(26 CFR part 1) that provide guidance relating to the effect of

redemptions on the availability of this exclusion.

On June 6, 1996, the Federal Register published a notice of

proposed rulemaking (IA-26-94), 61 FR 28821, relating to the effect of

certain redemptions on the 50-percent exclusion of gain from the sale

or exchange of qualified small business stock under section 1202. The

proposed regulations provide that these redemptions are disregarded in

determining whether the anti-churning rules of section 1202(c) are

violated.

Four comments responding to this notice were received. A public

hearing was held on October 3, 1996. After consideration of the

comments, the proposed regulations under section 1202 are adopted as

modified by this Treasury decision.

[[Page 68166]]

Summary of Comments and Modifications

The notice of proposed rulemaking requested comments on how to

determine when an independent contractor has terminated services. One

commentator suggested that the determination of whether services of an

independent contractor were terminated should be based on all the facts

and circumstances, with termination conclusively presumed if no further

services were provided for six months. The IRS and Treasury Department

have not adopted this suggestion, but are continuing to study this

issue and request additional comments.

Commentators suggested an additional exception for all redemptions

occurring in the ordinary course of business or for legitimate business

reasons. The final regulations do not incorporate this suggestion. The

exceptions in the final regulations relate to redemptions that are

incident to certain events affecting a shareholder. Because of the

extraordinary nature of these events and the fact that they are

generally not within the control of the issuing corporation, the

exceptions are unlikely to lead to avoidance of the requirement that

qualified small business stock be purchased at original issue. The IRS

and Treasury are concerned, however, that a much broader exception for

redemptions that arise out of the ordinary business needs and purposes

of the issuing corporation, and are not incident to extraordinary

events affecting its shareholders, would be much more likely to

undermine the original issue requirement.

Two commentators requested that the final regulations be effective

for stock purchases by an issuing corporation at any time after August

10, 1993. The effective date has been modified in response to this

suggestion. The final regulations will apply to stock issued after

August 10, 1993. Thus, regardless of the date on which a redemption

occurs (or on which the redeemed stock was issued) the redemption is

treated as provided in the final regulations for purposes of

determining whether stock issued after August 10, 1993, is qualified

small business stock.

The Chief Counsel for Advocacy of the Small Business Administration

recommended the inclusion of an exception for redemptions occurring in

connection with the divorce of a shareholder. This suggestion has been

adopted. The final regulations provide that redemptions of stock

occurring incident to the divorce of a shareholder are disregarded in

determining whether redemptions exceed de minimis amounts.

The Chief Counsel for Advocacy also requested that the IRS and

Treasury Department analyze the current use of section 1202. No

exclusion under section 1202 can be claimed until 1998 because stock

must be issued after August 10, 1993, to be qualified small business

stock, and must be held for more than 5 years to qualify for the

exclusion. Thus, the available tax return data do not provide the

information necessary to analyze the current use of section 1202.

Minor clarifying changes in the regulatory language have also been

made.

Special Analyses

It has been determined that this Treasury Decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C chapter 5)

does not apply to these regulations, and because these regulations do

not impose a collection of information on small entities, the

Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply.

Pursuant to section 7805(f) of the Internal Revenue Code, the notice of

proposed rulemaking preceding these final regulations was submitted to

the Chief Counsel for Advocacy of the Small Business Administration for

comment on its impact on small business.

Drafting Information

The principal author of these regulations is Catherine A.

Prohofsky, Office of the Assistant Chief Counsel (Income Tax and

Accounting). However, other personnel from the IRS and Treasury

Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.1202-2 is also issued

under 26 U.S.C. 1202(k). * * *

Par. 2. Sections 1.1202-0 and 1.1202-2 are added to read as

follows:

Sec. 1.1202-0 Table of contents.

This section lists the major captions that appear in the

regulations under Sec. 1.1202-2.

Sec. 1.1202-2 Qualified small business stock; effect of

redemptions.

(a) Redemptions from taxpayer or related person.

(1) In general.

(2) De minimis amount.

(b) Significant redemptions.

(1) In general.

(2) De minimis amount.

(c) Transfers by shareholders in connection with the performance of

services not treated as purchases.

(d) Exceptions for termination of services, death, disability or

mental incompetency, or divorce.

(1) Termination of services.

(2) Death.

(3) Disability or mental incompetency.

(4) Divorce.

(e) Effective date.

Sec. 1.1202-2 Qualified small business stock; effect of redemptions.

(a) Redemptions from taxpayer or related person--(1) In general.

Stock acquired by a taxpayer is not qualified small business stock if,

in one or more purchases during the 4-year period beginning on the date

2 years before the issuance of the stock, the issuing corporation

purchases (directly or indirectly) more than a de minimis amount of its

stock from the taxpayer or from a person related (within the meaning of

section 267(b) or 707(b)) to the taxpayer.

(2) De minimis amount. For purposes of this paragraph (a), stock

acquired from the taxpayer or a related person exceeds a de minimis

amount only if the aggregate amount paid for the stock exceeds $10,000

and more than 2 percent of the stock held by the taxpayer and related

persons is acquired. The following rules apply for purposes of

determining whether the 2-percent limit is exceeded. The percentage of

stock acquired in any single purchase is determined by dividing the

stock's value (as of the time of purchase) by the value (as of the time

of purchase) of all stock held (directly or indirectly) by the taxpayer

and related persons immediately before the purchase. The percentage of

stock acquired in multiple purchases is the sum of the percentages

determined for each separate purchase.

(b) Significant redemptions--(1) In general. Stock is not qualified

small business stock if, in one or more purchases during the 2-year

period beginning on the date 1 year before the issuance of the stock,

the issuing corporation purchases more than a de minimis amount of its

stock and the purchased stock has an aggregate value

[[Page 68167]]

(as of the time of the respective purchases) exceeding 5 percent of the

aggregate value of all of the issuing corporation's stock as of the

beginning of such 2-year period.

(2) De minimis amount. For purposes of this paragraph (b), stock

exceeds a de minimis amount only if the aggregate amount paid for the

stock exceeds $10,000 and more than 2 percent of all outstanding stock

is purchased. The following rules apply for purposes of determining

whether the 2-percent limit is exceeded. The percentage of the stock

acquired in any single purchase is determined by dividing the stock's

value (as of the time of purchase) by the value (as of the time of

purchase) of all stock outstanding immediately before the purchase. The

percentage of stock acquired in multiple purchases is the sum of the

percentages determined for each separate purchase.

(c) Transfers by shareholders in connection with the performance of

services not treated as purchases. A transfer of stock by a shareholder

to an employee or independent contractor (or to a beneficiary of an

employee or independent contractor) is not treated as a purchase of the

stock by the issuing corporation for purposes of this section even if

the stock is treated as having first been transferred to the

corporation under Sec. 1.83-6(d)(1) (relating to transfers by

shareholders to employees or independent contractors).

(d) Exceptions for termination of services, death, disability or

mental incompetency, or divorce. A stock purchase is disregarded if the

stock is acquired in the following circumstances:

(1) Termination of services--(i) Employees and directors. The stock

was acquired by the seller in connection with the performance of

services as an employee or director and the stock is purchased from the

seller incident to the seller's retirement or other bona fide

termination of such services;

(ii) Independent contractors. [Reserved];

(2) Death. Prior to a decedent's death, the stock (or an option to

acquire the stock) was held by the decedent or the decedent's spouse

(or by both), by the decedent and joint tenant, or by a trust revocable

by the decedent or the decedent's spouse (or by both), and--

(i) The stock is purchased from the decedent's estate, beneficiary

(whether by bequest or lifetime gift), heir, surviving joint tenant, or

surviving spouse, or from a trust established by the decedent or

decedent's spouse; and

(ii) The stock is purchased within 3 years and 9 months from the

date of the decedent's death;

(3) Disability or mental incompetency. The stock is purchased

incident to the disability or mental incompetency of the selling

shareholder; or

(4) Divorce. The stock is purchased incident to the divorce (within

the meaning of section 1041(c)) of the selling shareholder.

(e) Effective date. This section applies to stock issued after

August 10, 1993.

Approved: December 22, 1997.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 97-33987 Filed 12-30-97; 8:45 am]

BILLING CODE 4830-01-U