A burgeoning tech entrepreneur had an idea she believed could fetch $100 million in five years. She set up her business as a C-corporation—an unconventional move for a small startup. Why? Because she understood the potential of qualified small business stock under Section 1202.
If you’re starting a small business with the intention of eventually selling it, understanding the Section 1202 exclusion and leveraging qualified small business stock could be your silver bullet for financial success and protection from long-term capital gains.
What are the implications of the Section 1202 exclusion?
Section 1202 is a game-changer for investors eyeing small businesses. It offers a remarkable opportunity to exclude gains from stock investments in qualified small businesses, provided certain criteria are met. Specifically, investors who purchase and hold stock for more than five years in qualified small businesses are excluded from paying taxes on stock gains. The gains excluded under Section 1202 also sidestep the 3.8% tax typically applied to most net investment income, which can be a substantial advantage for investors.
Structuring your business for success
Under current tax law, structuring an entity as a C-corporation may afford shareholders unparalleled tax benefits when the stock of the corporation is qualified small business stock (QSBS):
- Since it was first enacted, the maximum gain exclusion under Section 1202 has increased from 50% to 100% on sales of QSBS.
- Depending on when the QSBS was acquired, Section 1202 allows non-corporate taxpayers to exclude from gross income 50%, 75%, or 100% of the gain from the sale or exchange of QSBS that is held for more than five years.
- An additional benefit is the flat 21% corporate tax rate under the Tax Cuts and Jobs Act.
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But what makes a business ‘qualified’ under Section 1202?
A qualified small business (QSB) is a domestic C-corporation with assets not exceeding $50 million post-stock issuance. It caters to specific industries, including technology, retail, wholesale, and manufacturing. Sectors that don’t qualify include businesses in hospitality, personal services, finance, farming, and mining. It’s worth noting that there is limited guidance on most of these industry terms, leaving room for interpretation by both the IRS and taxpayers.
To qualify for the stock gain exclusion, an investor must acquire stock directly from the corporation, hold it for at least five years, and ensure that 80% of the corporation’s assets are actively involved in qualified business operations. The benefits? Exclusions of up to 100% on gains from the sale of such stock, subject to specific limitations. Many states also follow the federal treatment, resulting in even more savings.
Shareholder level requirements
- Shareholders cannot be corporations; ownership must reside with individuals, either directly or indirectly through a pass-through entity.
- QSBS must be held for over five years before disposal.
- Acquisition of stock must occur when originally issued after August 10, 1993, through exchange for money, property (excluding stock), or as compensation for services rendered.
Corporation-level requirements
- Eligible corporations include domestic C-corporations meeting small business criteria at the stock issuance and throughout most of the holding period.
- Qualifying trades or businesses do not involve services in certain fields—like health, law, engineering, or financial services—that are reliant on personal reputation or skill.
- The corporation should satisfy an active business requirement, ensuring at least 80% of its assets are engaged in qualified trades or businesses.
- The corporation’s aggregate gross assets should not exceed $50 million from August 10, 1993, onward.
- The issuing corporation should refrain from purchasing any stock from the taxpayer within a four-year period starting two years before the stock issue date.
- The issuing corporation must avoid significant stock redemption within a two-year period, commencing one year prior to the issue date (significant redemption constitutes redeeming stocks exceeding 5% of the total company stock value).
Consider a taxpayer who, after five years, sells QSB stock at a profit. If all criteria align—original issue acquisition, five-year holding period, and active business use of assets—they can potentially exclude 100% of the stock gains from federal tax. It’s a tax-saving strategy that rewards strategic planning and patience.
Seek professional assistance with the Section 1202 exclusion
Maximizing the benefits of Section 1202 demands meticulous planning and forethought. Come back to the example at the beginning of this article. The entrepreneur and her investors benefitted from Section 1202 because of her shrewd moves in the early days of her business. You can see from the qualifications that the sale of the business needed to be timed carefully in order to reap the tax benefits for her plan.
We recommend seeking expert advice to help you navigate the intricate requirements, ensure your business structure aligns with the criteria for qualified small business stock, and position you for tax-efficient gains upon sale. Contact us to schedule a consultation with one of our financial advisors.
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