Section 1202 can eliminate the double tax burden on C corporations entirely with proper tax planning. But buyer beware – there are hurdles, limitations, and traps to navigate. Section 1202 allows certain non-corporate taxpayers to exclude from 50 to 100 percent of gain from the sale of “qualified small business stock” (QSBS) held for at least five years. This provision was designed to provide relief for investors who risk their funds in small businesses, many of which have difficulty attracting equity financing. QSBS includes certain stock issued after August 10, 1993, in a domestic C corporation conducting a qualified active business. Generally, the gain exclusion is 50, 75, and 100 percent for QSBS acquired after August 10, 1993, February 17, 2009, and September 27, 2010, respectively. In addition, the excluded amount of gain is also exempt from both the individual alternative minimum tax as well as the 3.8% tax on net investment income.
To the extent that bias against C corporation status remains following the reduction in the corporate income tax rate and capital gain/dividend rate, section 1202 may reverse that bias in favor of C corporations by eliminating a second level of tax for some taxpayers, while subjecting the first level of tax to the 21% percent rate.
The amount of gain a shareholder may exclude from gross income upon the sale of QSBS originally issued after September 27, 2010, is limited to the greater of $10 million or 10 times the shareholder’s adjusted tax basis in the stock. The $10 million shareholder gain limitation takes into account all gain recognized from the sale of QSBS in each issuing corporation. The 10 times exclusion amount is a yearly limitation based on the shareholder’s gain from the disposition of QSBS in each corporation each year.
QSBS is generally stock issued in a domestic C corporation, as opposed to a foreign corporation, an S corporation, a partnership, or an interest in a wholly-owned limited liability company treated as a disregarded entity. QSBS usually must be acquired at original issuance in exchange for money, property (other than stock), or services provided to the issuing corporation. If stock is issued in connection with the performance of services, the stock will be treated as originally issued at the time of the taxpayer’s income inclusion, including upon a section 83(b) election for restricted stock. A taxpayer must hold QSBS for more than five years before disposition to benefit from the section 1202 exclusion.
The shareholder’s holding period generally begins on the day after the date of issuance, regardless of whether the property contributed would otherwise take a tacked holding period for capital gain purposes. At the time a corporation originally issues QSBS, its aggregate gross assets must not have exceeded $50 million (after giving effect to the issuance). Aggregate gross assets are equal to cash plus the aggregate adjusted basis of property. The adjusted basis of property contributed to a corporation in a transaction in which tax basis otherwise carries over is equal to the fair market value of that property at the time of the contribution. All corporations that are treated as part of the same parent-subsidiary controlled group are treated as one corporation in calculating aggregate gross assets.
The issuing corporation must conduct an active qualified trade or business (active business) for substantially all of the taxpayer’s holding period in the QSBS. At least 80 percent of the corporation’s assets, by value, must be used in the active business during this period. Assets used in start-up activities (e.g., R&D) are considered active business assets for these purposes. While investment assets are generally non-qualifying, those reasonably expected to be used within two years of formation in an active business or held to meet reasonable working capital needs are considered qualified assets.
An active business must be a qualified trade or business, a term defined by exclusion. A qualified trade or business is one other than: 1) any 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 in which the principal asset of that trade or business is the reputation or skill of at least one of its employees; 2) any banking, insurance, financing, leasing, investing, or similar business; 3) any farming business (including the business of raising or harvesting trees); 4) any business involving the production or extraction of products of a character for which a deduction is allowable under section 613 or 613A; and 5) any business of operating a hotel, motel, restaurant, or similar business.
For the majority of the time since 1993, the section 1202 benefits have been far less than under current law. Half of the gain was still taxed at 28 percent, which resulted in an overall effective tax rate of 14 percent. The regular capital gains tax rate was only 15 percent so the overall benefit of one percent (15 -14 percent) was minimal. Now with the 100 percent exclusion, the tax benefit is substantial. Section 1202 will now impact choice of entity determinations for some and provide traps for the unwary for others. For example, the benefit of a stock sale under section 1202 may largely be negated by the benefits of an asset sale to a buyer, particularly with increased expensing and bonus depreciation following the 2017 tax reform. But as with most acquisitions of businesses, such tax factors and attributes are merely a point for purchase price negotiations.
If you have any questions, please contact our tax department.