Many small business owners are leaving millions of dollars on the table

In the excitement of starting a new business, and during the headaches associated with growing that business, many entrepreneurs overlook important details that can have huge impacts on their finances. One large blind spot that many people we work with seem to have is the tax implications of selling their business—which is understandable given the number of “immediate” challenges they face on a daily basis. One thing that we urge new businesses to take the time to consider when beginning their journey is Internal Revenue Code Section 1202 (“Section 1202”).

Section 1202 of the Internal Revenue Code provides federal tax exclusions for capital gains on the sale or exchange of a certain type of small business stock. Section 1202 was enacted in 1993 by Congress to create incentives for individuals who start or invest in small businesses. Until relatively recently, Section 1202 was overlooked by small businesses and investors, since it did not provide significant tax benefits; however, the most recent amendment to Section 1202 provided 100% exclusion of capital gains on qualified small business stock (“QSBS”) acquired after September 27, 2010, that is held for at least five years.

In order to take advantage of Section 1202, the holder of QSBS must be a natural person (i.e. not a company)¹ and must own such stock for a minimum of five years from the date it was acquired.² The acquisition date is not always the same for investors as it is for company employees. For example, investors are deemed to have acquired the stock when they purchase it from the company, but employees are deemed to have acquired the stock at the time the employee is granted stock or exercises employee stock options. If the ultimate goal is to take advantage of Section 1202, it is important for the investor or founder to establish the stock meets the QSBS requirements before acquiring it.

Section 1202 outlines what is considered QSBS. To qualify, the company must be domestic c-corporation, acquired by the individual at its original issuance, in exchange for money, other non-stock property, or as compensation for services the individual provided to such corporation.³ The stock needs to have been issued by a “qualified small business” which is a business with aggregate gross assets not exceeding $50 million at the time the stock is issued. Additionally, the company must use at least 80% of its assets in an active trade or business, other than personal services, when the stock is issued or when the employee exercised their stock.

Big corporations tend to enjoy advantages small business aren’t afforded. Section 1202 is an exception to that rule.

Section 1202 also states the small business must participate in a qualified trade or business (“c”) but instead of defining what a QTB is, Section 1202 outlines what it is not. Any trade or 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 business in which the principal asset of such trade or business is the reputation or skill of one or more of its employees is not a QTB.⁴ Additionally, businesses involved in banking, insurance, financing, leasing, or related activities are not a QTB, and neither are any businesses operating a hotel, motel, restaurant, or similar establishment.⁵ Finally, Section 1202 also prohibits farming businesses and any business that receives deductions under Section 613 and 613A of the Internal Revenue Code. (i.e., oil, gas, and properties subject to depletion) from QTB classification.

The Section 1202 exclusion on capital gains is not unlimited, the IRS capped the eligible gain amount at $10 million or 10 times the adjusted basis,⁶ whichever is greater, but the vast majority of small business investors and founders can save millions of dollars in federal taxes if they take advantage of it.

Let’s consider the following hypothetical to illustrate the power of Section 1202. Bob invests $50 million in a new business in exchange for 50% of the company’s stock. The business does well, and five years later the company is valued at $1 billion. One day after the five-year anniversary of his investment, Bob sells his shares to Alice for $500 million. Assuming a capital gains tax of 15%, without Section 1202 Bob would owe the IRS $75 million after the sale. Luckily for Bob, Section 1202 allows him to exclude up to 10 times his adjusted basis of $50 million, which is $500 million. Thanks to Section 1202 Bob gets to keep the entire $500 million.

So, what does this mean for early investors and small businesses? First, small businesses have to make the decision to incorporate as a c-corporation if its investors or founders want Section 1202 to apply. Second, when raising capital, it is smart to limit the size of the offering to prevent the corporation from pushing over the $50 million asset cap, in order to maintain the original stock as QSBS. Third, there is a strong incentive to exercise stock options as soon as possible because as soon as the company’s assets exceed $50 million, newly acquired stock (i.e. freshly exercised options) is no longer considered QSBS.

It is important that small businesses and investors keep a file with supporting information evidencing that the issued stock meets the requirements of QSBS. This is easy for founders of companies, since a copy of the company balance sheet from the year the stock was acquired will suffice, and the articles of incorporation will show that the company is a c-corporation. When an investor or founder files under Section 1202 exclusion, they will want to make sure they have a record in case there is an audit in the future. It is also important that the tax adviser handling their investments is well versed in the QSBS exclusions. Tax advisors can provide up-to-date filing instructions and help investors and small business owners navigate any Section 1202 ambiguity, exclusions, and requirements.

Traditionally small businesses file as LLCs or S-corporations to make filing taxes easier and to avoid double taxation, however, if a small business qualifies as a QTB, the c-corporation route may prove to be more attractive over the long term due to the impact of Section 1202. The distribution of QSBS can be very appealing to early-stage investors, which may help small businesses acquire and maintain start-up capital. The bottom line is that Section 1202 can save entrepreneurs and investors millions of dollars in taxes.

Citations

1. Certain “pass-thru” entities, like S-corporations and partnerships, are permitted to hold QSBS stock, but transfers to such entities will generally cause the QSBS to cease to be treated as QSBS. Any QSBS held via pass-thru entity will be treated the same as QSBS held by an individual to the extent the pass-thru entity meets all requirements otherwise applicable to an individual holder of QSBS.
2. 26 U.S. Code § 1202(b)(2).
3. 26 U.S. Code § 1202(c).
4. 26 U.S. Code § 1202(e)(3).
5. Id.
6. Adjusted basis is calculated by adding the amount of money spent improving an asset, adding legal fees or selling costs, and subtracting any prior tax deductions previously claimed on the net cost of the QSBS. The adjusted basis of any property contributed to the corporation is equal to its fair market value (FMV) on the date of contribution (26 U.S. Code §1202(d)(2)(B)).