Does Your Small Business Qualify for the Section 1202 Exclusion?

February 20, 2018 — What if you could grow your money through investing and keep all of the gains? Section 1202 presents an amazing opportunity for both entrepreneurs looking to invest in tech companies and certain other start-ups and the founders of these companies. These provisions allow investors, other than C corporations, to exclude up to 100% of the gain on qualified small business stock (QSBS) on their federal (and potentially state) returns. Businesses that qualify include domestic C Corporations in the technology, retail, wholesale, and manufacturing fields, and are often startups.

The allowable exclusion is as follows (subject to the limitations outlined below):

• 100% exclusion of gain on QSBS held more than 5 years and acquired after Sept 27, 2010
• 75% exclusion of gain on QSBS held more than 5 years and acquired after Feb 17, 2009, and before Sep. 28, 2010
• 50% exclusion of gain on QSBS held more than 5 years and acquired before Feb 18, 2009

The total amount that may be excluded under 1202 is limited to the greater of $10 million (reduced by prior year eligible gains) or 10 times the taxpayer's basis in the QSBS (generally, the amount paid for the stock).

The stock must be acquired at original issue by the taxpayer from the C corporation in exchange for money or other property (not including stock) or as compensation for services. Single taxpayers use $5 million in lieu of $10 million in applying the limit.

Qualified Small Businesses

At the time the stock is issued, the corporation must be a "qualified small business", which means:

• The sum of cash and the adjusted basis of property held by the corporation (the "aggregate gross assets") did not exceed $50,000,000 at all times on or after August 10, 1993 and before the issuance; and
• The aggregate gross assets immediately after the issuance, including amounts received in the issuance, does not exceed $50,000,000

To qualify, the corporation must use at least 80% of its assets (determined by value) in the active conduct of one or more qualified trades or businesses during substantially all of the taxpayer's holding period for such stock. A qualified trade or business means any trade or business other than any:

1. Trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,
2. Banking, insurance, financing, leasing, investing, or similar business,
3. Farming business (including the business of raising or harvesting trees)
4. Business involving the production or extraction of products of a character with respect to which a depletion deduction is allowed (e.g. mining), or
5. A hotel, motel, restaurant, or similar business.

Section 1045: Deferral of Gain on QSBS

Section 1045 provides a deferral of the gain from the sale of QSBS held more than six months where the proceeds are invested in replacement stock meeting the QSBS requirements. This can be beneficial when an investor does not meet the 5-year holding period requirement of Section 1202. When the 1045 deferral election is made within the 60 days beginning on the sale date, the gain is only recognized to the extent the amount realized from the sale of the stock exceeds the cost of any QSBS purchased during the 60 day period.

The basis of the replacement QSBS is reduced (in the order acquired) by any gain deferred on the sale of the QSBS.

State Treatment

State treatment of the excluded federal gains may vary based on an investor’s residency. Minnesota, North Dakota, Illinois and Iowa follow the federal treatment of Section 1202 stock gains, allowing residents to reduce their resident state taxable income by the allowable exclusion as well. Wisconsin has varying conformity dates based on when the stock was acquired.

Other Considerations

For a seller to obtain the benefit of the §1202 exclusion, the sale has to be structured as a sale of stock, not a deemed or actual sale of assets. In many situations, buyers will discount the price they are willing to pay on a stock sale over an asset sale when they are purchasing all or most of a trade or business.

As businesses start to analyze entity structure in light of the new tax law changes, the potential impact of the Section 1202 exclusion on the sale of qualified small business stock should be taken into account.

Does your company qualify to be a small business but is not a C corporation? If the company was an S corporation at any time the stock was held, the stock can’t qualify under §1202. However, a properly structured conversion of an LLC or partnership which meets the qualified small business requirements can create §1202 stock. In this instance, your basis for §1202 gain exclusion purposes will be the greater of the fair market value of your interest at that time or your basis in the LLC interest, leaving a potential for exclusion up to the full amount of the gain from appreciation in the stock occurring after the C corporation conversion. The QSB stock is treated as acquired on the day of the conversion.

Because of the way the Section 1202 provisions are written, the LLC conversion rules may actually provide benefit in situations where a substantial amount of further appreciation in stock value is anticipated, even though you lose the ability to exclude your gains attributable to the period it was an LLC.

Consider a software engineer, Jane, who forms her first business in November of 2010 to develop an app targeted at allowing individuals to rent out their cars to other people when they aren't using it. Jane is able to come up with $50,000 to make her initial investment in the newly formed venture. In early 2013, the company does a round of financing and issues preferred shares to new investors at a total company valuation of $25 million. Jane retains a 10% investment. Assume in 2019 Jane sells her 10% interest for $23 million, or a total gain of $22,950,000.

If the company starts out as a C Corp, Jane’s tax and §1202 basis is $50,000. When the company sells, Jane’s exclusion is limited to $10 million (the greater of 10 times their basis in the QSBS or $10 million). Jane would recognize a long-term capital gain of $12,950,000. (Total gain of $22,950,000, less $10 million)

Alternatively, if the company formed as an LLC and converted in 2013, Jane’s basis for purposes of determining her §1202 gain is $2.5 million. Jane’s total stock gain under §1202 is $20.5 million ($23M less $2.5M). Because $20.5 million is less than 10 times $2.5 million, this is completely excluded from taxable income. Jane would recognize long-term capital gain income on the remaining $2,450,000 ($10.5M less than the alternative scenario), which equals the total taxable gain of $22,950,000 less the $20,500,000 excludable under Section 1202.

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