By Bennett Allison and Gabriela Mandiuc
The choice of tax structure is a question frequently posed to CPAs. Should I operate as a sole proprietor, a partnership, an S corporation, or a C corporation? It can be confusing and somewhat overwhelming.
Establishing a C corporation qualifying under IRC Sec. 1202 for gain exclusion treatment may be a clever tax planning strategy. A taxpayer aiming for this treatment would typically be someone owning a business with rapid growth potential, that would operate the business on a roughly break-even basis over the near term, and that would be looking to exit the business past a five-year holding period. The potential benefit for this taxpayer is a gain exclusion up to the greater of $10 million or 10 times his or her basis in the Sec. 1202 stock.
Sec. 1202 stock or qualified small business stock (QSBS) is nothing new. It’s been around since 1993 but didn’t get much attention until the Small Business Jobs Act of 2010. This act increased the gain exclusion for the sale of qualified stock to 100 percent (up to the greater of $10 million or 10 times basis) for stock acquired after September 27, 2010. The limit of $10 million or 10 times basis is per shareholder and per corporation, which means that each shareholder is allowed a gain exclusion up to these limits for each QSBS he or she may own.
So, you may be thinking that Sec. 1202 is a no-brainer. “Let’s set up all future businesses to qualify.” But, it’s a bit trickier than you think. Sec. 1202 stock needs to meet certain very specific requirements. Below is a list of some of the key requirements:
- Must be a C corporation.
- Non-corporate shareholders (individuals, trusts, estates) must hold the stock. Partnerships and S corporation’s shareholders must meet additional requirements in order to qualify.
- Gross assets of the corporation must not exceed $50 million at all times from August 10, 1993 through immediately after the issuance of the QSBS.
- Stock was acquired at its original issue from the corporation after August 10, 1993 (i.e. not purchased from an existing shareholder).
- Stock issued after September 27, 2010 (to qualify for 100 percent gain exclusion).
- At least 80 percent of corporate assets are used in the active conduct of a business.
- Stock is held for more than five years before it is sold.
Personal service activities (health, law, etc., or any business where the principal asset is the reputation or skill of one or more of its employees), banking and financial services, farming, mineral extraction, and hotels and restaurants are ineligible activities that do not qualify. Therefore, you need to be careful that you meet ALL of the Sec. 1202 requirements (including the seven items listed above) and that your business doesn’t fall under one of the ineligible categories.
Sec. 1202 tax savings example:
Jack forms ABC Corporation (C corporation) to develop software used in the shipping industry. ABC issues 1,000 shares of stock to Jack on January 1, 2015 in exchange for $10,000 in cash (corporate assets $10,000). ABC immediately takes off but needs more capital to expand, so on November 1, 2015 ABC issues 1,000 additional shares to Jill in exchange for $1,500,000 in cash (corporate assets $1,600,000). After years of phenomenal growth, Jack and Jill agree to a December 31, 2021 third-party purchase of all of their stock in ABC for $40 million.
Jack’s gain in his 1,000 shares of ABC is $19,990,000 ($20 million sale price less basis of $10,000). Of Jack’s total gain, $10 million is excluded. The remaining $9,990,000 of gain gets taxed at a 23.8 percent top tax rate.
Jill’s gain in her 1,000 shares of ABC is $18.5 million ($20 million sale price less basis of $1.5 million). Of Jill’s total gain, $15,000,000 ($1.5 million X 10) is excluded. The remaining $3.5 million of gain gets taxed at a 23.8 percent top tax rate.
Sec. 1202 stock (QSBS) offers a tremendous tax savings opportunity for taxpayers in a start-up/high-growth mode. While the requirements must be carefully followed, Sec. 1202 is a rare chance for meaningful tax savings to be applied against large gains.
Due to its complexities, Sec. 1202 is not an area of the Internal Revenue Code to be taken lightly. Does Sec. 1202 apply to your corporation? Should you pursue the benefits of Sec. 1202? If you live in a state that has an income tax, does it allow for a gain exclusion?
You’ll need a good CPA to help with these and other questions.
On November 19, 2021, The House of Representatives passed H.R. 5376, the Build Back Better Act. One of its provisions would be to amend Sec. 1202 to disallow the 100 percent gain exclusion from the sale of Sec. 1202 stock if the taxpayer’s adjusted gross income is over $400,000 or if the taxpayer is a trust or estate. While the bill is not yet law, it should be monitored closely in relation to this topic.
The professionals at Sol Schwartz & Associates are here and ready to help.