Thinking about starting a business? What about creating a new product? Or how about investing in a new venture? Entrepreneurs and investors should take note, when forming or even exiting a business, structure is key. The business framework can have a huge tax effect on how any gain will be treated upon sale.
Internal Revenue Code Section 1202, originally enacted as part of the Revenue Reconciliation Act of 1993 and later made permanent in the Protecting Americans from Tax Hikes Act of 2015, provides for exclusion of a substantial portion or potentially the entire gain realized by a noncorporate taxpayer on the sale of qualified small business stock.
Gain exclusion is available at three different levels, dependent on the date of stock acquisition:
• For stock acquired after Aug. 10, 1993, and before Feb. 18, 2009, a 50 percent potential exclusion is available. The taxable gain is subject to a 28 percent rate and also results in an alternative minimum tax preference item equal to 7 percent of the excluded gain.
• For stock acquired after Feb. 17, 2009, and before Sept. 28, 2010, a 75 percent potential exclusion is available. The taxable gain is subject to a 28 percent rate and also results in an AMT preference item equal to 7 percent of the excluded gain.
• For stock acquired on or after Sept. 28, 2010, a 100 percent potential exclusion is available.
To potentially exclude up to 100 percent of gains realized within Section 1202, these seven criteria must be satisfied:
1. Stock must be acquired from an eligible corporation, which means any domestic C corporation, subject to limited exceptions.
2. At least 80 percent (by value) of the assets of the corporation from which stock is acquired must be used by such corporation in the active conduct of a qualified trade or business. A qualified trade or business is any business other than:
• a 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 where the principal asset of such trade or business is the reputation or skill of one or more of its employees;
• any banking, insurance, financing, leasing, investing or similar business;
• any farming business (including the business of raising or harvesting trees);
• any business involving the production or extraction of products of a character with respect that a depletion deduction is allowable; and
• any business of operating a hotel, motel, restaurant or similar business.
3. Not more than 10 percent of the total value of the corporation’s assets may consist of real property that isn’t used in the active conduct of a trade or business.
4. The stock must have been acquired at its original issue, in exchange for money or other property (not including stock) or as compensation for services.
5. The aggregate gross assets of such corporation must not exceed $50 million at all times before and immediately after the acquisition of stock.
6. Stock must be held for more than five years.
7. The stock issuer must not have engaged in certain redemptions of its own stock during specified periods both before and after the date of issuance of the stock.
Other considerations:
The amount of gain excluded is subject to a cap. Excluded gain from any single issuer can’t exceed the greater of $10 million or 10 times the taxpayer’s adjusted basis in the stock.
QSBS gains excluded for regular tax and AMT purposes also are excluded for purposes of the 3.8 percent net investment income tax.
For 1202 purposes only, property exchanged for stock shall have a basis equal to the greater of the taxpayer’s adjusted basis at the date of contribution or the fair market value of the property transferred.
Taxpayers who realize gains from QSBS held at least six months may elect to roll over the gain to the extent they acquire replacement QSBS. But remember these five points: 1. Replacement stock must be acquired within 60 days of the date gain is realized on the first QSBS sale. 2. Rollover is elective and not mandatory. 3. An election must be made by the due date of the income tax return (including extensions) for the tax year the QSBS was sold. 4. The basis in the QSBS acquired is reduced by any deferred gain. 5. The holding period of the replacement QSBS generally includes the holding period of the QSBS sold.
Although the C corp structure is generally viewed as being tax inefficient on asset sales, the potential benefits and tax savings of a 1202 stock are hard to ignore if there’s future potential for a stock sale. Investors and entrepreneurs should consider if their business goals and anticipated holding period align with requirements of 1202 to determine how to structure or restructure their active trade or businesses. Consult your tax adviser to discuss potential planning opportunities presented by 1202.
Jason Griffin is a senior tax associate with BKD LLP. He can be reached at jgriffin@bkd.com.
