Can a corporate distribution which exceeds earnings and profits and basis both generate gain which is excludable under §1202?

The legal reasoning behind the answer to this question is based on the provisions of the Internal Revenue Code (IRC) and Treasury Regulations that govern corporate distributions, earnings and profits, basis, and the partial exclusion for gain from certain small business stock under §1202.

According to Subsection 301(c) of the IRC, a corporate distribution is treated in the following manner:

(1) the portion of the distribution which is a dividend (as defined in section 316) is included in gross income;

(2) the portion of the distribution which is not a dividend is applied against and reduces the adjusted basis of the stock; and

(3) the portion which is not a dividend, to the extent that it exceeds the adjusted basis of the stock, is treated as gain from the sale or exchange of property.

Subsection 1202(a) of the IRC provides a partial exclusion for gain from certain small business stock. However, this exclusion is subject to several conditions and limitations. For instance, Subsection 1202(c)(1) defines "qualified small business stock" as 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 corporation is a qualified small business, and such stock is acquired by the taxpayer at its original issue in exchange for money or other property (not including stock), or as compensation for services provided to such corporation.

Furthermore, Subsection 1202(h)(4) provides that in the case of a transaction described in section 351 or a reorganization described in section 368, if qualified small business stock is exchanged for other stock which would not qualify as qualified small business stock but for this subparagraph, such other stock shall be treated as qualified small business stock acquired on the date on which the exchanged stock was acquired.

However, Subsection 1202(h)(4)(B) limits the application of this section to gain from the sale or exchange of stock treated as qualified small business stock by reason of subparagraph (A) only to the extent of the gain which would have been recognized at the time of the transfer described in subparagraph (A) if section 351 or 368 had not applied at such time.

Therefore, based on the above legal details, a corporate distribution which exceeds earnings and profits and basis can generate gain. However, whether this gain is excludable under §1202 depends on whether the stock meets the definition of "qualified small business stock" under Subsection 1202(c)(1) and whether the gain would have been recognized at the time of the transfer if section 351 or 368 had not applied, as per Subsection 1202(h)(4)(B).

Sources:

Rev. Rul. 74-164

Rev. Rul. 74-337

§ 1202. Partial exclusion for gain from certain small business stock

PLR 200230002

Rev. Rul. 76-186

Rev. Rul. 86-131

§ 301. Distributions of property

Rev. Rul. 70-521

Rev. Rul. 71-102

PLR 9210031