Industry experts are currently pondering whether the 100% stock gain exclusion currently available under Sec 1202 will be the new game changer in response to the newly enacted tax provision code section that expands the ordinary tax treatment under asset sale taxation regime involving contributed and or self-created patent, IP, secret formulas, and modeling processes whether patented or not. This new provision is effective for all asset sale transactions consummated for taxable years beginning after December 31, 2017.
The 100% Sec 1202 exclusion provision is only applicable to small business stock issued after September 27, 2010 and is only available to small qualifying, domestic, C Corporation businesses that never elected S Corporation status, and have aggregate gross assets not exceeding $50M immediately after incorporation. The qualifying stock must be originally issued stock and includes certain qualifying stock options exercised.
The Sec 1202 specifically carves out all businesses engaged in professional personal services, including the fields of health, law, engineering, accounting, actuarial science, arts, athletics, brokerage services such as consulting, where the principal asset is the reputation or skill of one or more of its employees. The Sec 1202 eligibility inclusion criteria is very specific and narrow with limited interpreted guidance and excludes businesses within certain specified industries, such as banking, financing, insurance, leasing, investing, farming, and the operations of hotel, motel, restaurant, and farming. This also includes those engaged in the extraction of depletable products and other similar businesses.
Sec 1202 Tax Tip
The real tax benefit of Sec 1202 planning concept is creating the maximum exclusion foundation base during the product pre-development formation stage cycle. Therefore, the game changer structuring moves to truly maximize your Sec 1202 exclusion benefit is to initially organize your business model as a partnership for tax reporting purposes and conducting all the research and development phase activities including product innovation internal testing up to the beta/prototype production life cycle as a partnership tax reporting form before converting to a corporation.
For example, assume that your product invention will cost approximately $2M to bring to beta/prototype testing stage. Ideally, you would organize as an LLC taxed as a partnership and raise $2M from friends, angel investors, or strategic investors. Furthermore, assume that the preview estimated fair market value of your beta/prototype after 18 months is in the range of $5M based on costs replacement valuation principles.
Based on this example, the game changer tax planning structuring planning concept application is being able to efficiently convert the current business model from a partnership to a qualifying Sec 1202 corporation tax reporting form around the 18-month time frame and generate a $45M Sec 1202 maximum exclusion for your efforts. Under Sec 1202 tax provision construct mechanics, provided your holding period in the stock of the newly formed corporation is at least 5 years after incorporation, the maximum eligible exclusion limitation will be the FMV of your initial capital contribution at incorporation date of $5M times 10, less the pre-contribution valuation of $5M. Thus, the maximum Sec 1202 exclusion provided that all the contributing partners qualify would be $45M. Make sure you work with a sophisticated investor to maximize on the Sec 1202 eligibility exclusion planning strategy.
The Sec 1202 exclusion is a very powerful tax provision when properly planned, but in certain unique instances, you might get more after-tax net proceeds from negotiating a deemed asset sale transaction and being able to utilize all your tax attributes including net operating losses and research and development credits carried overs. Please note that the utilization of these tax attributes is subject to certain tax inherit limitations required under Sec 382 through 384 beyond the scope of this blog.
When planning your optimal tax structure, you need to consider all business and tax matters and sit down with your tax advisor. Run the math and project your net after-tax proceeds using hypothetical scenarios analysis.
If you would like to discuss your particular situation including how to spin-off valuable IP, or to take advantage of Sec 1202 eligibility exclusion, please call a Aronson tax advisor at 301.231.6200,