The renewed importance of Section 1202

While most accountants are familiar with Code Section 1202 and its exclusion for gain of qualified small-business stock, or QSBS, it has in recent years been neglected despite its potential benefits to small-business founders and venture capital and private equity investors. But with the increase in the exclusion amount and the lower corporate tax rate, it should become increasingly common to structure deals to take advantage of the benefits under Section 1202, according to Timothy Jessell, a shareholder at law firm Greenberg Traurig.

Under Section 1202, noncorporate taxpayers may exclude a percentage of capital gain from the sale of QSBS held for at least five years. The section has been around since 1993, and was meant to spur investment in small businesses and startups. The initial exclusion in effect for qualified small-business stock issued after Aug. 10, 1993, was 50 percent of gain. For QSBS issued between Feb. 18, 2009, and Sept. 27, 2010, the exclusion jumped to 75 percent. And for QSBS issued on Sept. 28, 2010, or later, there is a 100 percent exclusion.

“There are four significant requirements for QSBS,” said Jessell. “The company issuing the stock must be a domestic C corporation; the stock must have been acquired at its original issuance directly from a C corporation for money, property or services; the aggregate tax basis of the company assets immediately after the issuance of the stock must not exceed $50 million; and the company must satisfy an active business requirement.”

The gain eligible for exclusion is limited to the greater of $10 million, reduced by the aggregate amount of gain previously excluded by the taxpayer with respect to the same QSBS, or 10 times the taxpayer’s investment, or tax basis in the QSBS sold by the taxpayer during the taxable year, Jessell noted.

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Under the active business test, at least 80 percent of the value of the corporation’s assets must be used in the active conduct of a qualified trade or business. A qualified trade or business is defined by what it is not: “It’s the usual suspects -- it can’t be one of the specified professional services,” said Jessell. “It’s similar to specified services under Code Section 199A [for deductions for pass-through entities]. In fact, Section 199A cross references these rules, and makes a couple of small tweaks.”

Specifically, a qualified small business cannot be a trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, the performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation or skill of one or more of its employees.

In addition, the business must not be involved in banking, insurance, financing, leasing, investing, or similar business; must not be involved in farming, or any business involving the production of certain natural resources eligible for the depletion deduction; or any business involving the operation of a hotel, motel, restaurant or similar business.

There is no specific form to report Section 1202 gain. Instead, it is reported as long-term gain on Schedule D, with the allowable exclusion entered as a loss below the entry for the gain. The entry should be labeled “Section 1202 exclusion.”

The main factor driving the increased attractiveness of Section 1202 is the Tax Cuts and Jobs Act’s lower corporate tax rate, making C corporations more attractive to founders and venture capital investors.

“Upon disposition, the effective federal income tax rate for QSBS disposed of prior to 2013 was 14.98 percent,” Jessell observed. “The pre-2013 tax rate for non-QSBS gain was 15 percent. As a result, for sales of QSBS prior to 2013, there was little federal tax benefit. But with the non-QSBS tax rate, including 3.8 percent on net investment income,at 23.80 percent today, the 100 percent exclusion results in a tax savings of 23.80 percent.”

“Despite the benefits of Section 1202, it makes sense to do a lot of planning before considering changing to a C corporation,” he said. “For a lot of people, a partnership or S corporation remains the best option, since distributions will only be subject to one level of tax. But this is not important for venture capital investors.”

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