Section 1202 Gain Exclusion Memorandum

Section 1202 of the Internal Revenue Code is one of few planning opportunities available for small businesses and investors which can offer up to 100% tax free gain exclusion upon the sale of qualified small business stock (QSBS) held for at least 5 years. If an investor is funding a startup or investing in a partnership with the purpose of owning early-stage venture capital companies, the 1202 exclusion can also be a compelling reason to structure the underlying business as a C corporation from the date of formation or to convert an existing LLC taxed as a partnership into a corporation via a Section 351 tax free incorporation if certain criteria is met.

Eligibility for shareholders

Stock is not QSBS unless it is acquired directly from a domestic C corporation for cash, property or services. However, QSBS transferred upon the death of a stockholder or transferred as a gift for federal income tax purposes still qualifies as QSBS in the hands of the recipient. Furthermore, partnerships, S corporations and trusts can invest in QSBS, but the rules regarding ownership through flow-through entities is complex and preserving the entire QSBS gain exclusion can be challenging. The stockholder must also be a domestic shareholder and cannot be a tax-exempt stockholder or C corporation stockholder to qualify as an eligible shareholder.

Holding Period and Definition of “Stock”

QSBS can be voting or nonvoting common or preferred stock. However, nonvested stock under substantial risk of forfeiture, stock options and warrants are not “stock” for federal tax purposes. QSBS must be held for more than 5 years and the holding period normally commences on the date of issuance. Generally, the stockholder who holds originally issued QSBS must also be the seller of the QSBS to receive favorable tax treatment.

Gain Exclusion Depends on Date of QSBS Issuance

In order to qualify for 100% gain exclusion, the QSBS must have been originally issued after September 27, 2010. QSBS originally issued after February 17, 2009 and before September 28, 2010, will qualify for a 75% gain exclusion. Finally, QSBS originally issued before February 17, 2009 but after August 10, 1993, is eligible for a 50% gain exclusion. The key issue to note is that for QSBS issued prior to September 28, 2010, there is a portion of the gain that is also subject to alternative minimum tax and the 3.8% net investment income tax.

Aggregate Gross Assets Threshold

In order for the issuance of stock to qualify as QSBS, a $50 million gross asset limit is required to be met. If this $50 million limitation is met, factoring in the cash or other property contributed to the corporation in exchange for stock, then these shares of stock will always qualify as QSBS even if the company fails the $50 million test in the future. Aggregate gross assets means the amount of cash and adjusted tax basis of other assets on the corporation’s balance sheet including the value of property contributed in a Section 351 nonrecognition exchange, a Section 368 tax free

reorganization or a Section 118 capital contribution at their fair market values on the date of contribution including non-booked goodwill. Careful planning may be necessary to avoid failing this gross asset test if the amount of capital raised in a funding round including existing corporate assets is near the $50 million threshold.

80% of Corporation’s Assets must be used in Operation of a Qualified Trade or Business during entire Holding Period of QSBS

The first portion of this Section 1202 requirement is for the corporation to be primarily engaged in one or more business activities that are not excluded business activities under Section 1202(e)(3). The second requirement is at least 80% of the corporation’s assets must be used in business activities that are qualified trade or business activities. Excluded activities include any trade or business involving the performance of services in the fields of:

a) Health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any other trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees

b) Banking, insurance, financing, leasing, investing or similar business

c) Any farming business

d) Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A

e) A business of operating a hotel, motel, restaurant, or similar business or

f) Ownership of, dealing in, or renting of real property shall also not be treated as the active conduct of a qualified trade or business under Section 1202(e)(7).

$10 Million Gain Exclusion Threshold

Section 1202 provides, in relevant part, that each taxpayer has a minimum $10 million gain exclusion based upon the sale of the corporation’s stock. The same taxpayer can also have a gain exclusion cap that is greater than $10 million if the taxpayer paid cash or contributed property in exchange for the QSBS. The 10X gain exclusion cap provides that a taxpayer’s gain is excludable up to 10 times the amount of cash or the value of property contributed to the corporation in exchange for QSBS. With proper planning, a taxpayer may be able to structure the sale or liquidation of the corporation to qualify for both the $10 million exclusion and the 10X gain exclusion if they anticipate a gain of more that $10 million and can either structure gifting prior to the sale or ordering of the sale of a shareholder’s QSBS over more than on tax year.

Final Considerations

Section 1202 is a powerful code section which can enable both investors in venture capital as well as founders to exclude up to $10 million in gain if all the complex criteria and tests are met and adhered to during the holding period of eligible QSBS stock. On another positive note, the Section 1202 provisions are not impacted by the potential sunset at the end of 2025 of the Tax Cuts and Jobs Act temporary tax provisions. Section 1202 should remain a viable planning tool for many years to come. Please feel free to reach out to the author of this article, David Armstrong, who has extensive experience with this code provision and the venture capital community ([email protected] ) or Jeff Ellis ([email protected] ) if you would like to schedule a consultation to learn more about potential Section 1202 gain exclusion planning opportunities.