Tax Savings Opportunities with Qualified Small Business Stock
Section 1202 is one of the most generous—but often overlooked—sections of the tax code allowing startup founders and investors to potentially exclude up to 100 percent of their gains from the sale of qualified small business stock (QSBS).
QSBS Overview & Background
Over the last few years, C corporations have gained increased popularity as the entity of choice for startups and investors. A major reason for this change was the Tax Cuts and Jobs Act, which reduced the corporate tax rate from 35 percent to a flat 21 percent; however, structuring companies to qualify for the potential 100 percent gain exclusion under §1202 also has contributed to the rise in popularity.
The §1202 gain exclusion may become even more valuable, offering federal tax savings of up to 43.4 percent, if capital gains rates are doubled as proposed under President Biden’s tax plan.
The ability to exclude 100 percent of the gain on the sale of QSBS under §1202 is one of the most beneficial tax saving strategies available to founders and investors in the tax code. However, few investors and advisors are familiar with the rules. The reason for this is because prior to September 2010, the exclusion only provided minimal tax savings, given that it was limited to 50 percent or 75 percent of the qualified gain and the nonexcluded portion was subject to a higher 28 percent tax rate and considered an alternative minimum tax (AMT) preference item. In 2009, Congress temporarily increased the gain exclusion from 75 percent to 100 percent for QSBS acquired after September 27, 2010, and then made the 100 percent exclusion permanent in 2015. This change also eliminated the 28 percent tax rate and AMT effect, which increased the tax savings and popularity.
What Is §1202?
The §1202 provision allows for a noncorporate shareholder, including individuals and qualified pass-through entities, to exclude gains from the sale of QSBS that has been held by the shareholder for at least five years. The exclusion amounts range from 50 percent to 100 percent depending on the issuance date of the QSBS, and the amount of gain that can be excluded on a per-issuer basis is limited to the greater of:
- $10 million, reduced by the amount of gains excluded under §1202 in prior tax years for the same corporation
- 10 times the aggregate adjusted basis of the QSBS the taxpayer sold during the tax year
The $10 million limitation is cumulative, whereas the 10-times basis is an annual limitation. These gain exclusions are subject to per-taxpayer, per-issuer limitations, which means that each shareholder is entitled to a separate gain exclusion for each QSB they own. So, a taxpayer who holds QSBS in five different issuers has separate $10 million or 10-times basis exclusions for each issuer. In addition, each partner in a partnership or shareholder in an S corporation that holds QSBS will be treated as a separate taxpayer and is eligible for their own $10 million or 10-times basis gain exclusion.
For purposes of calculating the adjusted basis, when a taxpayer contributes property other than cash in exchange for QSBS, the tax basis under §1202 is deemed to be the fair market value of the property contributed.
Any gains in excess of the exclusion limitations are taxed at regular long-term capital gains rates and are subject to the net investment income tax (NIIT). However, later in this article we will explore some powerful tax planning opportunities that can defer and increase the gain exclusion beyond the $10 million and 10-times basis limitations.
In general, to be eligible for the gain exclusion under §1202, the following requirements must be met:
- The issuer must be a domestic C corp with aggregate gross assets that do not exceed $50 million at all times since its formation and immediately after the stock’s issuance. Aggregate gross assets are defined as the amount of cash and adjusted basis of property held by the corporation. The fair market value of contributed property is used for purposes of applying the aggregate gross asset test, so be careful to avoid contributing property with values exceeding $50 million. If the corporation is a QSB at the time of issuance, the issued stock continues to be eligible for the exclusion even if the corporation’s gross assets exceed $50 million in future years.
- A noncorporate taxpayer must acquire the stock at its original issuance in exchange for money or property or as compensation for services, and they must hold it for a minimum of five years. The holding period typically begins on the date of issuance, i.e., date of investment or contribution of property, but taxpayers who receive stock as compensation for services with vesting should consider making a §83(b) election so the holding period starts on the grant date instead of when shares vest.
- At least 80 percent of the value of the eligible corporation’s assets must be used in one or more qualified trades or businesses during “substantially all” of the taxpayer’s holding period. Excluded businesses include professional services (health, law, accounting, consulting, etc.), banking and insurance, leasing, investing, farming, mining and extraction, and lodging.
As a side note, it also is important for companies to avoid significant stock redemptions, as that could disqualify the entire corporation or the taxpayer’s shares from the §1202 gain exclusion. Inquiries about past or future redemptions should be part of every investor’s due diligence list when evaluating an investment in an existing or potential QSB.
While most taxpayers won’t exceed the $10 million gain exclusion, there are some taxpayers who have gains in excess of this limitation. However, with proper tax planning, taxpayers can generate significant tax savings by implementing the following strategies that allow them to increase their gain exclusions.
Section 1202 only determines the gain exclusion for a specific tax year, so with advanced planning, you can enhance the exclusions by selling shares over a multiple-year period. This benefits taxpayers who have more than $10 million in gains and have shares with both a high and low tax basis. For example, the taxpayer can sell their low-basis shares in year one, using the $10 million gain exclusion, and then take advantage of the 10-times basis exclusion in subsequent years by selling their high-basis shares. By combining both exclusions over a multiple-year period, the taxpayer is able to exclude more than the $10 million in gains.
Investing Through a Pass-Through Entity
When QSBS is held by a pass-through entity, such as a partnership or S corp, each partner or shareholder is treated as a direct investor in the QSB and can exclude their share of gains from the sale of QSBS—up to $10 million or 10-times basis—which significantly increases the total amount of gain excluded under §1202.
Incorporating a Partnership
Many startups initially operate as partnerships due to the ease of formation and ability to pass through losses, but as a startup’s valuation increases, it could make sense to convert to a C corp so its shareholders can qualify for the benefits of §1202. When a partnership converts to a C corp, for §1202 purposes, the partnership’s adjusted basis in its assets is deemed to be at its fair market value at the time of contribution. This means that as long as the fair market value of the contributed assets is less than $50 million upon contribution, then the 10-times basis exclusion could significantly increase each shareholder’s gain exclusion upon sale. Please note that the five-year holding period starts on the date of conversion and the difference between the tax basis and fair market value of the property does not qualify for the gain exclusion and is subject to long-term capital gains.
Gifting QSBS to Nongrantor Trusts
Startup founders and investors can significantly increase their gain exclusions if they structure the ownership of their QSBS to include their adult children, pass-through entities, and/or nongrantor trusts. Since the IRS defines a taxpayer as any person subject to income tax and gifting QSBS is allowed under §1202, you have a lot of flexibility and planning opportunities. One such opportunity is for founders to gift their QSBS to one or more nongrantor trusts for the benefit of their family while they still have a low value. This strategy not only allows the founder to remove the value of the shares from their estate but also creates additional QSBS exclusions for each trust. Instead of only excluding $10 million of gains, a founder could exclude $30 million by gifting QSBS to two nongrantor trusts and at the same time remove $20 million of assets from their estate. Although this can be a very useful strategy, it is highly scrutinized by the IRS, which has the ability to disallow or aggregate multiple trusts into one if they have identical beneficiaries or are formed solely for tax purposes.
Section 1045 Rollover
For taxpayers who sell their QSBS before meeting the five-year holding period or have gains in excess of the exclusions, §1045 allows them to defer the gains by rolling some or all of the sale proceeds into another QSBS within 60 days of the sale. The taxpayer must have owned the original QSBS for more than six months, and their basis, holding period, and QSBS exclusion percentage are carried over to the replacement QSBS. If the taxpayer’s replacement QSBS is sold after it has reached a combined five-year holding period, the gains can be excluded under §1202. In addition, taxpayers may be able to benefit from combining the §1045 and §1202 strategies. For example, if the gain on the sale of their QSBS exceeds $10 million, they can defer the excess gains by reinvesting the related proceeds into a replacement QSBS, therefore allowing them to exclude and defer all of the gains.
Another option is to reinvest the proceeds into more than one replacement QSB investment, which would give the taxpayer separate QSBS exclusions for each investment.
Although the §1202 requirements can be complex, proactive tax planning and evaluating structuring options with a tax advisor can result in substantial tax savings, and we expect this opportunity to become more valuable as tax rates increase in the future.
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