Section 1202 Gain in Tax Return Preparation for Companies: Explained

Section 1202 offers a compelling opportunity for shareholders to claim a federal income tax gain exclusion of at least $10 million when selling qualified small business stock (QSBS) held for over five years. This gain exclusion stands out as one of the most enticing tax advantages for founders and venture capitalists. Recent legislative developments have failed to curtail Section 1202’s benefits, enhancing the likelihood that QSBS issued today will still qualify for the 100% gain exclusion in 2027 and beyond.

This article serves as a valuable resource for founders and venture capitalists weighing the possibility of structuring their business activities and investments to meet the criteria for Section 1202’s gain exclusion. Throughout this journey, the article references previous in-depth discussions on various QSBS planning matters.

It’s important to note that Section 1202’s gain exclusion doesn’t apply to corporate stockholders. However, individuals, trusts, and pass-through entities like partnerships, LLCs, and S corporations, can all potentially qualify for this benefit. On the flip side, foreign stockholders and tax-exempt entities may not benefit from this exclusion due to their capital gains generally being tax-exempt.

Investing in QSBS through a traditional IRA may not be advantageous since the IRA isn’t taxed on stock sales (thus, the Section 1202 exclusion isn’t needed), but the IRA holder will be taxed on distributions, which aren’t protected by Section 1202. Opting for a Roth IRA doesn’t make sense either, as the holder isn’t taxed upon stock sale, regardless of QSBS status. The more thoughtful approach might be to use a Roth IRA for non-QSBS investments and purchase QSBS in a taxable account to leverage Section 1202’s gain exclusion.

Recent years have shed light on a tax incentive that largely went unnoticed by sellers of qualifying C corporations. Section 1202, the qualified small business stock gain exclusion, has emerged as a prominent tax planning strategy. As potential increases in capital gains tax rates loom, understanding this gain exclusion’s tax benefits and the associated corporate and shareholder requirements becomes vital for effective tax planning.

What is Section 1202, Commonly Known as the Qualified Small Business Stock Gain Exclusion?

Section 1202, introduced in 1993, serves as an incentive for investments in small businesses. It offers individuals the opportunity to avoid taxation on up to 100% of the taxable gain realized from the sale of qualified small business corporation stock, often referred to as QSBS. Remarkably, this tax benefit isn’t limited to tiny enterprises; even relatively substantial businesses can qualify as “small businesses” under this provision.

This gain exclusion applies to stock issued after August 10, 1993, and it hinges on the greater of $10 million or 10 times the aggregate adjusted basis of the stock at the issuance date. Currently, Section 1202 can result in substantial federal income tax savings of up to 23.8%. Any potential future increases in the federal long-term capital gain tax rate would amplify the tax advantages of Section 1202 accordingly. The extent of gain exclusion available to shareholders depends on their investment date in the corporation. Furthermore, numerous states follow federal guidelines, leading to even more significant savings. The table below provides a summary of the federal gain exclusion and potential savings.

Key Features of Section 1202

• Stock purchased after September 27, 2010, and held for a minimum of five years, provided it meets the criteria for qualified small business stock (QSBS), may be eligible for a complete exclusion of 100% of the gain when sold.
• Recent changes in tax laws, including the Tax Cuts and Jobs Act, have made QSBS more appealing due to revised corporate tax rates. Potential future alterations in tax regulations and rates further enhance the attractiveness of QSBS.
• To qualify as QSBS, certain conditions must be met. The stock must originate from a C corporation and be acquired by noncorporate taxpayers through an initial issuance in exchange for money, property, or as compensation for services. Additionally, the C corporation must satisfy active-trade-or-business and $50 million aggregate-assets prerequisites.
• Regarding the aggregate assets requirement, contributions of money or property exchanged for stock are counted as part of the corporation’s assets. Consequently, careful planning is essential to prevent the loss of QSBS eligibility due to surpassing the $50 million aggregate asset limit.
• Transfers involving QSBS in Section 351 contributions and Section 368 reorganizations are eligible for QSBS treatment. However, if the received stock doesn’t qualify as QSBS, the Sec. 1202 exclusion applies solely to the built-in gain of the surrendered QSBS.
• Stock redemptions may also qualify for gain exclusion under Sec. 1202. Adherence to regulations regarding timing and the amount of redeemed stock is crucial to preserve QSBS treatment for the redeeming shareholder’s stock or potentially for the corporation’s entire stock.
• Sec. 1202 stipulates that transfers through gift, death, or from a partnership to a partner (with limitations) typically won’t disqualify the transferred stock from the original issuance requirement. Nevertheless, the treatment of other transfers remains uncertain due to a lack of IRS guidance.

Let’s Delve into a Practical Scenario to Illustrate the Potential Tax Benefits

Imagine a scenario involving Dana Scully, who acquired stock in X-Files Ventures on March 1, 2015, for an investment of $3 million. Fast forward to September 1, 2022, when Dana decided to sell the stock for $30 million, resulting in a substantial $27 million gain. If the stock qualifies for Section 1202, Dana would be eligible to exclude 100% of up to $27 million of her gain (the greater of $10 million or 10 times her initial investment of $3 million). Consequently, Dana’s entire $27 million gain would be tax-exempt, leaving her with no tax liability.

In contrast, without the Section 1202 benefit, Dana would have been subject to a 23.8% tax rate on her entire gain, leading to a tax liability of approximately $6,426,000. Furthermore, since Dana’s state imposes a 5% tax rate on capital gains and follows federal Section 1202 treatment, she would have been required to pay an additional $1.35 million in state taxes.

By leveraging Section 1202, Dana achieved remarkable tax savings, totaling nearly $7.8 million on a transaction worth $30 million.

As with many valuable tax incentives, the qualification requirements for Section 1202 are intricate and harbor potential pitfalls. The Internal Revenue Service (IRS) offers limited guidance in this domain, adding complexity for taxpayers navigating these rules.

Requirements to Qualify for Section 1202 Gain Exclusion

To benefit from Section 1202, stock must meet eight specific requirements. While each has nuances requiring careful consideration, here is an overview:

Shareholder-Level Requirements

• Eligible Shareholder: Stock must be held directly or indirectly by an eligible shareholder, which includes individuals, trusts, and estates. Special conditions apply to partnerships and S corporations.
• Holding Period: Stock must be held for over five years, typically starting from the date of issuance. Various scenarios can modify this holding period.
• Original Issuance of Stock: The stock must have been acquired through its original issuance after August 10, 1993. Certain exceptions apply for stock received through inheritance or gifts.

These requirements are essential for individuals seeking to capitalize on Section 1202’s substantial tax advantages.

Let’s Explore the Prerequisites That Corporations Must Meet to Qualify for Section 1202 Benefits

Corporate-Level Requirements

• Eligible Corporation: The corporation must qualify as an eligible corporation at the time of stock issuance and throughout most of the shareholder’s holding period. Eligible corporations include domestic C corporations, with a few exceptions (e.g., IC-DISC, former DISC, RIC, REIT, REMIC, or cooperatives). An S corporation is ineligible, but an LLC electing C corporation taxation qualifies. Additionally, while the corporation must be domiciled in the US, its activities, or those of its subsidiaries, can be domestic or international.
• $50 Million Gross Assets Limitation: The corporation’s tax basis in assets cannot exceed $50 million from August 11, 1993, through immediately after stock issuance. This evaluation is conducted at each stock issuance and isn’t reevaluated later. Consequently, stock issued when the corporation’s assets are valued below $50 million on a tax basis remains qualified, even if asset values subsequently rise.
• Redemption Transactions: To discourage the use of Section 1202 capital for stock redemptions, Congress set guidelines to disqualify stock issued shortly before or after a redemption. Even a 5% redemption can be considered significant, while related party transactions lower the threshold to 2%. Some exceptions apply, including redemptions due to death, disability, or service termination.
• Qualified Trade or Business Requirement: The corporation must engage in a “qualified” trade or business, broadly defined as any business except those explicitly excluded. Ambiguity in these terms leaves room for interpretation by both taxpayers and the IRS.
• Active Business Requirement: At least 80% of the fair market value of the corporation’s assets must be actively used in the qualified trade or business. This condition should be met for most of the shareholder’s stock holding period. A corporation can engage in activities related to excluded businesses if these assets represent less than 20% of its total. Additionally, working capital or research support can constitute up to 50% of the corporation’s assets.

In Failing to Meet this Requirement, a Corporation Automatically Disqualifies if,

• 10% or more of its net assets consist of stock or securities in other corporations in which it doesn’t own over 50%.
• 10% or more of its gross assets consist of real property not actively used in the qualified business.

Conclusion

In conclusion, the Section 1202 gain exclusion offers a compelling incentive for non-corporate investors to support small businesses. Although it promises substantial tax savings, navigating the complexities of qualification can be intricate. It is highly advisable to seek guidance from an experienced tax attorney well-versed in Qualified Small Business Stock (QSBS) planning to maximize the benefits of this provision.

Should you encounter any challenges or require further clarification, do not hesitate to reach out to our team of experts for tailored assistance with your tax return preparation and Section 1202 inquiries. Your financial success is our priority.

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