Section 1202 is cool again; how to harness a powerful tax break

By Kurt Piwko, Plante Moran

For many years after its introduction in the early 1990s, Section 1202 languished as a little loved, obscure capital gains tax break.

Even today, a surprising number of companies and investors are unfamiliar with how and when to use this break, known as the Qualified Small Business Stock (QSBS) gain exclusion.

But it’s becoming increasingly hard, and unwise, to ignore it. Venture capitalists, company founders and early employees, especially in the tech sector, are starting to see the powerful tax savings that have resulted from several changes to the law beginning in 2009. Business founders and early investors should all be thinking about how they can harness the QSBS tax break.

Section 1202 began life in 1993 as an attempt to incentivize investment in startups. It only applies to C corporation shareholders and initially could only be used to exclude up to 50 percent of gains on QSBS that had been held for five years.

The rewards can be huge

QSBS’s appeal really started to grow again a decade ago when the U.S. Congress raised the exclusion amount to 75 percent and then 100 percent, and later made it permanent. Congress also raised the capital gains tax rate and created the 3.8 percent net investment income tax, both of which make the QSBS gain exclusion more favorable. The alternative minimum tax preference has also been eliminated for some QSBS gain.

Piwko

To qualify for the 100 percent exclusion, the shares must have been issued after Sept. 27, 2010. Shares issued after Feb., 18, 2009, but before Sept. 27, 2010, can qualify for the 75 percent exclusion while all other shares issued after Aug. 11, 1993 can still qualify for the 50 percent exclusion. In order for stock to be QSBS, the C corporation must have had a tax basis of $50 million or less in gross assets at the time stock is issued.

The potential rewards are massive. A shareholder can exclude up to $10 million of gain on QSBS or 10 times the adjusted basis in the stock, whichever is greater. The exclusion can be further enhanced if QSBS sales are spread out over different tax years, because while the $10 million threshold is reduced by any prior gain recognized, the 10 times adjusted basis limit is not.

Tech and VCs could really benefit

Tech firms and investors have been the most high-profile beneficiaries of the Section 1202 renaissance. Silicon Valley is a venture-capital-rich environment and tech stocks have enjoyed strong gains in recent years.

But here are some common mistakes to avoid:

Disqualifying stock by contributing into a partnership. This will totally disqualify you from claiming the exclusion on that stock. It’s not a problem if the stock was originally in a partnership, or if you are taking it out of a partnership.

Redeeming stock. This is especially common in mid-stage funding rounds when founders and employees want to take some money off the table. It risks being a very costly mistake in terms of Section 1202, though, because it can result in a wide swath of stock being disqualified. Other mechanisms can often be used to get to the same point without sacrificing the QSBS benefit.

Qualifying assets. Companies need to ensure that 80 percent of their assets are being used in trades or businesses that qualify under the law. If investment assets start to build up, for example, there is a risk of breaching the 80 percent threshold and being disqualified.

Working capital. A certain amount of working capital counts as investment assets and can trip up the qualification for Section 1202 if not monitored carefully. The rules allow for a generous, but not an unlimited amount of working capital, generally 50 percent of the company’s assets. This can occasionally become problematic if a company has a large capital raise that will not be deployed immediately.

Although Section 1202 is now nearly 30 years old, its unpopularity for much of that time means there’s remarkably little IRS guidance on how to claim it, and no new rules likely to come down any time soon. That makes for a lot of ambiguity, and a fair degree of flexibility, presenting some valuable planning possibilities.

Action Item: For more info on Section 1202 from Plante Moran, visit Plante Moran’s website at https://bit.ly/2YesE6V.

Kurt Piwko is a partner at Plante Moran’s National Tax Office. He can be reached at Kurt.Piwko@plantemoran.com.