§1202 for Qualified Small Business Stock is an often forgotten corner of the tax code. Forward thinking entrepreneurs can open the door to one of the best tax savings opportunities in the world.
Many entrepreneurs, their investors, and advisors are still not aware of a benefit they may be eligible for. Tax code section 1202 allows taxpayers to exclude up to 100% of the capital gains they realize on the sale of qualified small business stock “QSBS” held for at least five years. This has been on the books since 1993 but its benefit has increased quietly over time. Originally the provision allowed 50% of gains to be excluded, then in 2009 it was increased to 75% gain exclusion, and in 2010 gain exclusion increased to 100%. Fast forward to 2018 and the Tax Cuts & Jobs Act reduced C-Corporation federal income tax rates from 35% to 21%. The income tax rate change was a significant one because it reduced the tax disparity for entrepreneurs when choosing between pass-through tax treatment and the double-taxation of C-Corporations for their startups.
Sell your company and like magic pay the IRS ZERO in taxes
How much can §1202 for Qualified Small Business Stock save you? The exclusion for each taxpayer is limited to the greater of (i) $10 million OR (ii) 10 times the taxpayer’s investment. This means that the exclusion for an entrepreneur may be on $10 million of gain, while the exclusion for an investor may be much greater. If, for instance, an investor invests $20 million, they may obtain an exclusion for $200 million of gain ($20M x 10 = $200M).
High level summary of requirements to qualify for gain exclusion under §1202 for Qualified Small Business Stock
- 5 year holding period – holding period must be more than five years and it begins on the date of issuance of the stock of a C corporation
- Must be C-Corporation stock – type of entity matters and entrepreneurs should discuss Qualified Small Business Stock §1202 with their advisors as part of initial structuring
- Must be a small business – aggregate gross assets at all times surrounding stock issuance must be below $50 million
- Active business requirement – QSBS is only available if the corporation satisfies the “active business requirement” during substantially all of the stockholder’s holding period
- Qualified business requirement – similar to law for Qualified Business Income QSBS is not for companies who perform professional services in health, law, accounting, engineering, consulting, athletics, and the list goes on
- Must be original issuance stock – the corporation itself must issue the stock rather than a purchase from another shareholder in a secondary transaction
- Disqualifying redemption – if the corporation redeemed “significant” amounts of stock one year before or one year after the issuance the new stock may not qualify as QSBS
- Original stock must be sold – if the buyer wants to structure your exit as an asset sale (this is common), the exemption is lost
This post is an over simplified explanation of the law surrounding §1202 for Qualified Small Business Stock. The five year holding period requirement may discourage some who have planned for a faster exit. The good news is the company does not file an election to qualify for this beneficial status up front. Stock that qualifies at the time of sale qualify for the benefit.
Next Steps
If you are interested in learning more about the §1202 for Qualified Small Business Stock you may enjoy a longer form article from Forbes columnist Ed Zimmerman.
Please consult your tax advisor prior to embarking on this tax planning journey.
At Proseer we guide entrepreneurs and high net worth families through the intricacies of taxes and accounting. If you have questions about how to structure your startup please send us a note or give us a call 954-686-8687.
