Section 1202 Could Save Small Business Owners Significant Taxes

Noah Harden

National Wealth Planning Manager

Diana Suhr, CFP?

Assistant Vice President, Senior Wealth Planning Strategist

Key Takeaways:

• If planned accordingly, gains from a sale of qualifying small-business stock could be fully exempt from federal capital gains tax.

• Only certain C-corporation stock qualifies for the Section 1202 tax exemption.

• Qualifying stock must be held for at least five years before the sale to benefit from Section 1202.

Section 1202 does not apply to all companies – but, when it does apply, it can result in a significant tax savings.

A little-known portion of the Internal Revenue Code, Section 1202, allows owners and stockholders of certain small businesses to exclude from federal capital gains tax up to $10 million or 10 times the shareholder’s basis or initial investment, whichever is greater. Although Section 1202 (the small business stock gains exclusion) does not apply to all companies, when it does apply, it can result in a significant tax savings.

What is Section 1202?

Qualified small business stock exemptions were established to encourage the founding of and individual investment in small businesses in the U.S. The exemption was enacted in 1993, but subsequent legislation has made Section 1202 investments more attractive to founders and investors.1? In fact, since 1993, lawmakers have expanded the parameters of Section 1202 no fewer than four times.

In general, if you hold stock in a qualifying small business for at least five years and then sell it, a portion, and in some cases all, of the proceeds could be exempt from federal taxation.2? ?The exemption may also apply to state income tax as well, depending on state law.

Some key qualifications:

• The stock was issued by a domestic C-corporation other than a hotel, restaurant, financial institution, real estate company, farm, mining company or business relating to law, engineering or architecture.
• The stock was originally issued after Aug. 10, 1993, in exchange for cash, or as compensation for a service rendered, as from an employee.
• When the stock was issued, the corporation had $50 million or less in assets.
• The taxpayer has held the stock for a minimum of five years before selling it.
• The corporation satisfies the active business requirements during the taxpayer’s holding period.

How Might Section 1202 Help Your Business?

Section 1202 offers tax savings ideas for small business owners and start-up companies, especially those thinking about a business transition. If you are considering a sale at some point, you and your investors might be able to pay less income tax from that sale by applying Section 1202.

The following are examples of how Section 1202 could apply to small business stock sales and gifts. These examples serve only as jumping-off points; real-life situations will vary and require the input of your tax advisor.

Stock Sale Example

Allen was issued stock in ABC Inc. on Jan. 1, 2000, in exchange for $3 million. On Feb. 1, 2010, Allen sold his shares for $30 million, which resulted in a capital gain of $27 million. With a 23.8 percent federal capital gains tax rate, Allen would have paid $6,426,000 in capital gains tax as a result of the sale. However, assuming the stock qualifies under Section 1202, Allen can exclude up to $30 million of gain from federal taxation (10 times his initial investment). The entire $27 million gain would be excluded, and Allen would pay no federal capital gains tax.

Although this is a simplified example, it illustrates the power of the Section 1202 tax exclusion, which we have found that many qualified business owners and investors have never considered or even heard about.

Gifting Example

On Jan. 1, 2000, Ellen was issued 5,000 shares of DEF Inc. stock in exchange for $1 million. By 2010, the value of those shares grew to $40 million. If she sold the shares, it would result in a $39 million gain. Assuming Ellen owns all the shares at the time of sale, she could exclude up to $10 million of the gain from taxation (the greater of $10 million or 10 times her initial investment). That means $29 million of the gain would be subject to federal tax at an assumed rate of 23.8 percent, resulting in a tax of $6,902,000.

However, what would happen if, in 2004, Ellen had gifted 1,000 shares to each of her four children? Then, at the time of sale, Ellen and each child would own 1,000 shares. With a total gain of $39 million, each of them would yield a $7,800,000 gain. Assuming the stock qualifies under Section 1202, each of the five shareholders could exclude up to $10 million of gain and eliminate federal capital gains tax on their $7,800,000 gain. In other words, the entire $39 million gain would be excluded from federal taxation and result in no federal capital gains tax. That would be a savings of $9,282,000 ($39 million x 23.8 percent).

Again, this is another simplified example, but it shows how Section 1202 could benefit business owners and through forward-thinking and proper planning can create generational wealth.

What Are the Planning Implications for Section 1202?

Given that, at this time, Section 1202 applies only to C-corporation-issued stock that investors have held for at least five years, significant planning should ideally begin more than five years ahead of any stock transaction. You want to ensure that changes to your business structure and any gifts of shares can qualify for a Section 1202 exemption.

Conclusion

Applying Section 1202 to your business transition planning could result in significant tax savings. However, this law applies to very specific small businesses and to certain stock transactions involving them. Working with a CPA is your best bet for determining whether your situation falls in line with the rules and any possible changes.

Consult with your Comerica relationship manager or connect with us here to discuss how taking advantage of Section 1202 might help optimize your tax strategies.

1 https://www.govinfo.gov/content/pkg/USCODE-2011-title26/pdf/USCODE-2011-title26-subtitleA-chap1-subchapP-partI-sec1202.pdf https://en.wikipedia.org/wiki/Qualified_Small_Business_Stock#:~:text=1993%20%E2%80%93%20P.L%20103%2D66%20Section%201202%20Passed,-August%2010%2C%201993&text=It%20was%20introduced%20by%20Martin,or%2010x%20the%20taxpayer's%20basis. 2https://www.investopedia.com/terms/s/section-1202.asp#:~:text=Section%201202%20allows%20capital%20gains,to%20invest%20in%20small%20businesses.

NOTE: IMPORTANT INFORMATION

This is not a complete analysis of every material fact regarding any company, industry or security. The information and materials herein have been obtained from sources we consider to be reliable, but Comerica Wealth Management does not warrant, or guarantee, its completeness or accuracy. Materials prepared by Comerica Wealth Management personnel are based on public information. Facts and views presented in this material have not been reviewed by, and may not reflect information known to, professionals in other business areas of Comerica Wealth Management, including investment banking personnel.

The views expressed are those of the author at the time of writing and are subject to change without notice. We do not assume any liability for losses that may result from the reliance by any person upon any such information or opinions. This material has been distributed for general educational/informational purposes only and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product, or as personalized investment advice.

Comerica Wealth Management consists of various divisions and affiliates of Comerica Bank, including Comerica Bank & Trust, N.A.; Comerica Securities, Inc.; and Comerica Insurance Services, Inc. and its affiliated insurance agencies. Comerica Securities, Inc. is a federally registered investment advisor. Registrations do not imply a certain level of skill or training. Comerica Bank and its affiliates do not provide tax or legal advice. Please consult with your tax and legal advisors regarding your specific situation.