A recent development in the U.S. Court of Federal Claims case Ju v. United States serves as a reminder to maintain sufficient documentation for a qualified small business stock (“QSBS”) position. Generally, Internal Revenue Code (“IRC”) section 1202 provides shareholders a federal income tax exclusion on the eligible gain on the sale of QSBS held for more than five years, if all requirements are met. Among these requirements, the aggregate gross assets of the issuing corporation must not exceed $50 million at any time since incorporation through immediately after the stock issuance.

The court in Ju v. United States confirmed the taxpayer bears the burden of proof to demonstrate that the aggregate gross assets test has been satisfied at the time of issuance. The court also rejected the taxpayer’s claim that he owned certain shares prior to the date his settlement agreement states they were transferred to him. As a result, the holding period requirement could not be met with respect to those shares.

Background

Dr. Tongzhong Ju is a named inventor on two patents developed while he was employed by the University of Oklahoma. Following the university’s policy, Dr. Ju assigned his rights in both patents to the university, which then licensed them to Selexys Pharmaceuticals Corporation (“Selexys”) for cash and stock in November 2003. The university’s licensing policy entitled an inventor 35% of the gross revenues from the patent license, including equity. However, while all cash revenue is distributed as received, stock issued to the university was instead held by its controller’s officer until the employee’s departure.

In 2015, a dispute arose between Dr. Ju and the university over the patent revenue, and the parties entered into a settlement agreement. According to the agreement, Selexys had previously issued 583,921 shares of common stock to the university and 18,017 shares to Dr. Ju. The settlement terms directed Selexys to reissue 53,441 shares of common stock to Dr. Ju that were currently held by the university.

In 2016, Dr. Ju sold his Selexys stock and reported the income as long-term capital gain. In 2019, he filed for a tax refund claiming a gain exclusion for the sale of QSBS under IRC section 1202. In the ensuing litigation on the refund claim, both parties moved for summary judgment.

How Much and When

Dr. Ju took the position that the holding period had been met because he had effectively held the Selexys stock since 2003, despite a formal issuance in his name a year before the sale. The court rejected the argument that he held the stock as a matter of law based on the university’s contractual obligations. In its review, the court concluded there was no evidence in support that Dr. Ju and the university regarded the shares as Dr. Ju’s during the period between 2003 and 2015.

Based on the 2015 settlement agreement and stock certificate, the court agreed that the holding period was not met with respect to the 53,441 shares. As a result, the court granted the government’s cross-motion for summary judgment on the issue, and Dr. Ju was not entitled to a gain exclusion under IRC section 1202 with respect to those shares.

For the original 18,017 shares issued in 2003, Dr. Ju submitted the only available financial records for the sake of the aggregate gross assets test, covering the period during 2009 through 2011. As these later records reported gross assets of only $2.15 million, Dr. Ju claimed that they served as credible evidence that the corporation never approached the $50 million threshold and shifted the burden of proof to the government. The court disagreed and confirmed the burden of proof still fell to Dr. Ju to present sufficient evidence for the relevant period.

Substantiation Risks

Given the court’s stance in Ju v. United States, taxpayers seeking a gain exclusion under IRC section 1202 on the sale of QSBS must consider the available supporting documentation for the various requirements. An oversight in how the shares are issued or failure to obtain adequate records from the corporation can create critical issues in claiming a QSBS position. Planning for QSBS tax benefits ideally takes place well before the sale of stock.