We are excited to announce the arrival of Jeff Thomas, a securities and commercial litigation lawyer, who has joined our firm as special counsel. Jeff brings more than 20 years of federal government and big law experience to assist our business clients. Click here to learn more about Jeff and his experience.
Planning for the most favorable tax treatment on their investment is always a major consideration for investors. Because of a renewed interest in using C corporations as investment vehicles as a result of the reduction to the corporate tax rate to 21% under the Tax Cuts and Jobs Act of 2017, investors have shown a renewed interest in the potential tax benefits under Section 1202 of the Internal Revenue Code (IRC), making understanding its basics important for corporate founders and CEOs and prospective investors alike.
Some background: in August of 1993, Section 1202 of the IRC was added to encourage investments in certain small businesses (referred to in the IRC as “qualified business” entities). Section 1202 allowed taxpayers to exclude 50 percent of gains from the sale of Qualified Small Business Stock (QSBS) issued before February 18, 2009.
This amount has changed over the years; now, investors holding QSBS purchased after Sept. 27, 2010 for five years or more may exclude 100 percent of the capital gains on the sale or exchange of the QSBS. The amount of gain excluded is capped at the greater of $10 million or 10 times the taxpayer’s aggregate adjusted basis in the stock.
What is Qualified Small Business Stock (QSBS)?
QSBS is stock of a “qualified small business” within the meaning of the IRC. Generally, a “qualified small business” is a C corporation whose aggregate gross assets do not exceed $50 million before and immediately after the QSBS’s issuance and whose aggregate gross assets have not exceeded the $50 million threshold at any time after August 10, 1999. Further, the stock must be of an active domestic C corporation in addition to the following requirements:
The QSBS investor is not permitted to be a corporation. The shareholder can be, however, a pass-through entity such as a partnership or LLC.
What’s the Benefit for QSBS Under Section 1202?
If the QSBS holder holds the stock for at least five years, 100 percent of the federal income tax gain from the sale or transfer of the stock can be excluded (as long as the QSBS was purchased after Sept. 27, 2010 and the other requirements touched upon above are met). For those companies that can satisfy the Section 1202 requirements, this extremely favorable tax treatment can be very attractive to investors.
However, because of the potential difficulties in meeting the numerous requirements under Section 1202, companies are advised to carefully review the types of representations and warranties investors may ask them to provide with regard to Section 1202 treatment of their stock.
Holders of QSBS can realize potential tax benefits even if they do not hold the stock for five years. If QSBS is held for more than six months, the holder may be eligible to roll over the capital gains from the sale or transfer of the stock to another qualifying corporation’s QSBS if purchased within 60 days of the sale of the QSBS. This is statutorily established in Section 1045 of the IRC.
Conclusion
The slashing of corporate tax rates due to the Tax Cuts and Jobs Act of 2017 has resulted in a quasi-revival of interest in QSBS tax planning. Section 1202 can be useful in spurring investment in certain startups and smaller companies. However, the numerous requirements and limitations must be carefully considered to determine the feasibility of obtaining, and making any promises on achieving, QSBS tax treatment.
The attorneys at Linden Law Partners are well-equipped to negotiate and structure investments in a wide variety of startups. Contact us here to discuss your options and see how we can help navigate a win-win solution for your company.
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We are pleased to announce that Pat Linden received the Barrister’s Best award from Law Week Colorado (Law Week), an elite annual publication of the “best of the best” in the legal profession in Colorado. For 2020, Pat was selected as “Best M&A Lawyer”.
This isn’t Pat’s first time being recognized on the Barrister’s Best list. In 2019, he was selected as Colorado’s “Best Private Equity Lawyer”, and in he was also previously recognized as Colorado’s best M&A lawyer in 2018. Law Week described Pat as “an entrepreneur for entrepreneurs” who is “active with like-minded business people who are making moves.” Law Week also specifically noted Pat’s breadth of practice given his 2019 recognition for his work in private equity.
For nearly twenty years, Pat’s practice has concentrated on commercial transactions. He represents companies, investors and entrepreneurs across a broad variety of early stage, venture capital (VC), private equity (PE) and M&A deals. Pat has represented many of the leading companies, investors and senior executives in the Rocky Mountain region on virtually all aspects of their investment and M&A transactions, ranging from seed stage investments for hundreds of thousands of dollars to PE and M&A deals reaching $700 million.
The Barrister’s Best list is based on a poll of votes from Law Week readers and input from editorial staff in identifying and recognizing Colorado’s top lawyers by practice area. Law Week is Colorado’s only newspaper published specifically for lawyers, law firms, corporate counsel and the judiciary. It is written and edited by award-winning journalists and lawyers with long-standing credibility in the legal marketplace.
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