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 stock must have been purchased on original issuance (and not on the secondary market).
- The purchaser must have exchanged money, non-stock assets, or services for the QSBS.
- At least 80 percent of the corporation’s assets must be used in active conduct of a “qualified trade or business”. This must be the case during substantially the entire period in which the investor holds the QSBS stock.
- Certain trades and businesses, as well as most professional services business, are not qualified trades or businesses, including trades or businesses that operate in the financial, insurance, farming, mining, oil and gas, and hospitality industries, among others.
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.
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.
© 2020 Linden Law Partners, LLC. All rights reserved.