Getting familiar with section 1202 also known as the qualified small business stock is a powerful tool for those looking for tax relief. If you are an established high tech company doing business with the government or private industry, your business may have progressed from being a small one or two person cash basis S corporation to a multi-shareholder accrual basis C corporation (C Corp)—perhaps with venture capital or private equity investments. As a business owner, you have probably heard about all of the disadvantages of a C Corp for income tax purposes: double taxation on profits and distributions, inability to use cash-basis accounting if gross receipts exceed $5 million, losing out on self-employment tax savings by utilizing distributions and taking a modest but reasonable salary.
However, there are also benefits that are afforded to C Corporations and their shareholders. One of those benefits is favorable tax treatment provided to some C Corporation shareholders by IRC Section 1202.
Section 1202 Qualified Small Business Stock (QSBS) Capital Gains Exclusion
There is a potential tax break that can help level the tax playing field for C Corps. It is the Section 1202, Small Business Stock Gain Exclusion. It was one of many tax extenders that were made permanent through the Protecting Americans from Tax Hikes (PATH) legislation that was passed in December 2015.
Typical of tax law, some conditions must be met to be able to utilize Section 1202. For C corporation stock to be recognized as QSBS:
- The corporation must use at least 80% of its assets value in the active conduct of a qualified trade or business
- The corporation’s aggregate gross assets cannot exceed $50 million
- The corporation cannot purchase any of its own stock from shareholders or related persons within a four year period beginning two years before the issue date of the stock
- The shareholder must own shares of stock in a C corporation that meets the above requirements.
- The shareholder must be an individual (Grantor Trusts are acceptable).
- The shareholder must own shares for five years to qualify for Section 1202 gain exclusion.
- A shareholder cannot redeem more than 5% of the corporation QSBS for two years starting one year before the date of issue.
- 50%, 75%, or 100% of capital gains on the sale of stock can be excluded based on stock acquisition dates, per the table below:
How it Works
The shareholder is limited to $10 million of the gain exclusion per issuer of stock, or 10x the adjusted basis of all qualified stock of the issuer, whichever is greater. Any additional gain related to the stock is taxed at 28% (not 20%). Example:
Per the case below, for stock acquired after September 28, 2010, the tax savings are even more significant:
Section 1045 Exchange
In addition to the Section 1202 provision, if you are not ready to retire, or the purchaser of your company wants current management to retain some ownership, Section 1045, Small Business Stock Rollover of Gain, gives the owner of QSBS an option to reinvest the stock sale proceeds in the QSBS of another company. To qualify:
- You must meet all the Section 1202 corporate and shareholder requirements discussed above, except that you only need to have purchased your stock six months before the sale to qualify for Section 1045 treatment. QSBS must be held for five years to be eligible for Section 1202 capital gain exclusion.
- You must reinvest in QSBS of a new company within 60 days of the sale of your QSBS.
Whether you choose to take advantage of the Section 1202 capital gain exclusion, the Section 1045 gain deferral, or both is a decision that should be made in conjunction with a knowledgeable tax advisor. This article is a general discussion of the Sections 1202 and 1045 tax rules. Tax law is complicated, and everyone’s tax position is unique. This article does not cover the many nuances and exceptions to the general rules that were discussed.
If you are in the process of selling your company or are considering an exit strategy, please contact Aronson LLC to determine whether taking advantage of the Section 1202 QSBS gain exclusion and the Section 1045 QSBS small business rollover would be beneficial to you.
For more information, contact Fred Fanucci at 240.364.2578 or firstname.lastname@example.org; or Jack Koniszewski or Mario DeLuca at 301.222.8217.