What’s All the Talk About a $10 Million Tax-Free Capital Gain?
October 6, 2021
Shareholders in qualified small businesses (“QSBs”) may be eligible for a 100% tax exclusion due to an often-overlooked section of the Internal Revenue Code (“IRC”): Section 1202. This benefit can be critical in attracting capital investment or talented employees. Particularly with startups and technology companies, there is a huge potential advantage to founding shareholders, early investors, and new employees – i.e., the people who often fall into the QSB category by way of investment or stock incentives. Read on to learn more about this benefit and how Aprio can help you take advantage.
What is Section 1202?
Section 1202, originally enacted in 1993 and then made permanent with the Tax Cuts and Jobs Act of 2017, provides favorable tax treatment to those who invest in emerging and small businesses organized as C corporations. Specifically, the provision allows investors to exclude up to 100% of the gain realized from selling QSB stock without the imposition of an additional 7% alternative minimum tax for the excluded gain. Investors also have the opportunity to benefit retroactively from this 100% exclusion for stock acquisitions dating back to September 28, 2010.
All qualifications and requirements considered, taxpayers could benefit from a 100% tax exclusion for a capital gain of up to $10 Million.
What Qualifies for the Section 1202 Exclusion?
For an investment to qualify for these benefits, the following requirements must be met with respect to the character of the stock and the holding period:
- Shares must be issued by a C corporation whose gross assets before and immediately after the issuance did not exceed $50 Million.
- 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 5 years.
- The 100% exclusion is limited to the greater of $10 Million of gain on a per issuer basis or 10 times the basis of the stock in the taxpayer’s hand.
Who Can Benefit from the Section 1202 Exclusion?
The investment can be made directly by an individual or by an investment vehicle, such as a venture capital or private equity firm, which are both entities typically taxed as partnerships. The nature of the gain, if held for 5 years, will be passed through to the individual owner of the partnership, and the exclusion is elected at the individual taxpayer level.
The Section 1202 exclusion is especially attractive to venture capital funds, private equity funds, and individual investors, who plan to invest now or have invested since September 28, 2010. The exclusion will bolster the after-tax return on investments.
LLC founders could also benefit by converting their interests in their LLC to QSB stock in a newly formed corporation. This action would make them eligible for the provisions of Section 1202 on future gains, as well as shelter current earnings from their company against the high individual income tax rates.
Section 1202 can create a significant benefit for tech startup companies as well. Emerging companies currently operating at a loss position due to research and development expenses could seek to convert and attract investors through the issuance of QSB stock.
What is Required to Claim this Benefit?
There are currently no special reporting requirements for electing the Section 1202 exclusion, either for the corporation that issues the stock or for the investor. Taxpayers elect the exclusion on their tax return when the shares are sold. However, it is considered best practice for the corporation to engage a tax advisor, like Aprio, to compile a Section 1202 Report that shares the tax position with the selling shareholders.
The corporation can then share the report with all the selling shareholders, which they can use with a customized addendum. For instance, some shareholders may have purchased shares when the company was already a C corporation, while others may have obtained those shares from an LLC or S corporation conversion. Each scenario creates a unique tax position for the shareholder, which the report can illustrate.
The Bottom Line
A Section 1202 exclusion could be invaluable for investors, so the potential benefit should not be ignored. However, it’s important to work with a knowledgeable advisor to maximize your position and to ensure you meet all the necessary requirements.
Beyond the potential reporting needs, there may also be other tax planning opportunities related to Section 1202 and the ownership of shares that Aprio could help you navigate. Since the $10 Million limit is at the shareholder level, Aprio can assist you in determining if there is a benefit in transferring shares among spouses, trusts, and other structured entities.
Please contact Cardell McKinstry to investigate how you can best take advantage of this unique tax planning opportunity.
About the Author
Cardell is a partner in the Transaction Advisory Services group at Aprio. Cardell has over 15 years of tax consulting experience serving clients across a wide range of industries, including construction, distribution, financial services, manufacturing and telecommunications. Cardell focuses on advising financial and strategic clients on the tax aspects and structuring of taxable and tax-free transactions. These include mergers and acquisitions, dispositions, restructurings, leveraged buy-outs and recapitalizations.