Exceptional Investor Tax Benefits Available

By Mitchell Kopelman, partner, and Ori Epstein, partner

Owners of qualified small business stock may be eligible for a 100 percent tax exclusion that’s been retroactively applied to acquisitions of stock made Jan. 1, 2012 through Jan. 1, 2014. Read on to learn how you could benefit and how Aprio can help.

Originally enacted in 1993, Section 1202 of the Internal Revenue Code remains one of the most overlooked code sections. Changes to the section made in 2010, and the recent extension of those changes in the American Taxpayer Relief Act of 2012, make this section far too valuable to ignore.

Although available for only a short window of time, Section 1202 exclusion can provide exceptional tax benefits for the investors willing to hold an asset at least five years that is acquired between Sept. 27, 2010 and Jan. 1, 2014.

Through 2008, Section 1202 allowed individual owners of qualified small business stock to exclude from tax up to 50 percent of the gain when they sold the stock. Beginning in 2009 until Sept. 27, 2010, the exclusion increased to 75 percent.

Beginning Sept. 28, 2010 through Dec. 31, 2012, the exclusion increased to 100 percent. With the recent fiscal cliff legislation, the 100 percent exclusion has been retroactively applied to acquisitions of stock made Jan. 1, 2012 through Dec. 31, 2014.

Prior to the December 2010 legislation, an additional alternative minimum tax of seven percent was assessed on the excluded gain. This additional tax has been waived as well for investments made through Jan. 1, 2014 as a result of the recent fiscal cliff legislation.

For an investment to qualify for these benefits, the following rules apply regarding the character of the stock and the holding period:

  • Shares must be issued by a C corporation whose assets before and after the issuance did not exceed $50,000,000
  • Shares must be issued to an individual or entity other than a C corporation
  • Corporations that own stock in another corporation do not qualify for the exclusion
  • Shares must be acquired by the taxpayer at their original issue date
  • Shares must be held by the taxpayer for more than five years
  • The 100 percent exclusion is limited to the greater of $10,000,000 of gain on a per issuer basis or 10 times the basis of the stock in the taxpayer’s hand

There are no special reporting requirements for corporation that issues the stock or the investor. Taxpayers elect the exclusion on their tax return when the shares are sold.

The investment can be made directly by an individual or by an investment vehicle, such as a venture capital or private equity firm, entities typically taxed as partnerships. The nature of the gain, if held for five years, will be passed through to the individual owner of the partnership, and the exclusion is elected at the individual taxpayer level.

Section 1202 exclusion is especially attractive to venture capital funds, private equity funds and individual investors, who have invested since Sept. 28, 2010 and/or plan to invest into a C corporation by Jan. 1, 2014. This exclusion will bolster the after-tax return on investments.

The extension of this exclusion, coupled with the fiscal cliff increase in individual income tax rates and talk of a decrease in corporate income tax rates, could make this exclusion invaluable. LLC unit holders could concert their interests in the LLC to shares of stock in a newly-formed corporation and be eligible for the provisions of Section 1202 on future gains, as well as shelter current earnings from their company against the higher individual income tax rates.

As an added bonus, the qualifying capital gains that are excluded from income would also not be subject to the 3.8 percent Medicare contribution tax on net investment income.

If you would like some specific guidance on this matter or other matters, please feel free to email either Mitchell Kopelman at mitchell.kopelman@aprio.com or Ori Epstein at ori.epstein@aprio.com.

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