For many owners of closely held businesses, secession planning involves selling their business prior to retirement, investing the proceeds, and using them to provide lifetime income. With a strong possibility of tax rates increasing (perhaps significantly) in the very near future, this strategy could become increasingly difficult to use. A possible solution could be the use of IRC Section 1202, which could allow a significant amount of gain to be excluded from the sale of a small business. But, this is a very complex code section, and substantial planning must be done to ensure its use is maximized.
IRS Section 1202 Overview
Internal Revenue Code section 1202 was first enacted in 1993 as an incentive to invest in small businesses. The statute:
- Provides an exclusion from income tax for the sale of a Qualified Small Business Stock (QSBS).
- Allows exclusion of gain for a stock acquired after the effective date of the statute, and it must be held for at least 5 years.
- The amount of gain exclusion depends upon the date the QSBS was first issued. For stock issued prior to February 18, 2009, the exclusion is 50%; for stock issued between February 18, 2009, and September 27, 2010, the exclusion is 75%. For all stock issued after September 27, 2010, the exclusion is 100%.
- Note: The September 13, 2021 proposal by the House Ways and Means Committee would change the special 75% and 100% exclusion rates. The rates would not apply to taxpayers with AGI equal to or exceeding $400,000. The baseline 50% exclusion would remain available for all taxpayers.
QSBS only applies to C Corporations
Many small businesses have shied away from this benefit because QSBS only applied to C corporations. Unless the business owner intended to sell the stock from its inception, founders were hesitant to impose double taxation, especially since the C corporation rate had the highest marginal rate of 34% prior to the Tax Cut and Jobs Act (TCJB). With the reduction of the C corporation rate to 21% in 2017, many owners of small businesses who intended to sell their businesses as their exit strategy are now considering making a change to qualify for QSBS.
How does IRC 1202 work?
IRC 1202 allows certain taxpayers to exclude 100 % of their eligible gain realized from the sale or exchange of QSBS which was issued after September 27, 2010, and held for more than 5 years. The stock must be issued by a qualified small business and be acquired by the original taxpayer at issuance either in exchange for cash, property, or the performance of services. The statute limits the amount of per-issuer amount that can be excluded to only eligible gain to the greater of the following amounts: $10 M reduced by any amount that the taxpayer excluded from the sale or exchange of QSBS in the prior years, or 10 times the aggregated adjusted basis of QSBS issued by the corporation, disposed of during the taxable year. The basis is determined on the original issue date of the stock. Since the limitations are the higher of the two amounts, the potential for gain exclusion may substantially exceed $10 M. Since the corporation can have up to $50 M of assets at inception, the gain exclusion could reach as high as $500 M.
What is a qualified small business?
A qualified small business is a domestic C corporation that meets the following three requirements:
- the aggregate gross assets of the corporation including any predecessor corporation cannot exceed $50 M at any time after August 10, 1993
- the aggregate gross assets of the corporation immediately after issuance cannot exceed $50 M
- the corporation agrees to submit reports to the Treasury Department as required.
After these three requirements have been satisfied, an active business test must be met. To meet the active business test, at least 80% of the assets must be used in an active trade or business. In addition, the corporation must be a C corporation that is not a domestic international corporation, a Domestic International Sales Corporation (DISC), a regulated investment company, a real estate investment trust, and a real estate investment conduit, or cooperative. For purposes of meeting the 80% test, three types of assets will qualify: (1) assets used in startup activities, (2) assets used for working capital needs, and (3) assets used for investments which are expected to be used to finance research and development or working capital within two years.
What is a qualified trade or business?
A qualified trade or business is not specifically defined, but is rather defined by what it is not, namely:
- any trade or business involving the performance of services in the fields of health, law, engineering, architecture, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business in which the principle asset is the reputation or skill of one or more of its employees,
- any banking, insurance, financing, leasing, investing, or similar business,
- any farming business (including the business of raising or harvesting trees
- any business involving the production or extraction of products of a character with respect to which a deduction is allowable under sections 613 or 613A (oil and gas properties subject to depletion
- any business operating a hotel, motel, restaurant, or similar business. Other than this brief statutory exclusion, there is scant guidance. The basic reason for this is the obscurity of the statute.
There are two private letter rulings which focused on whether the customers were provided services, products, or expertise. In both rulings it was held that the primary benefit was other than services, so the businesses were held to be qualified trade or businesses for the purpose of QSBS.
Section 1202 permits taxpayers to hold QSBS in a Pass-Thru Entity
Section 1202 allows taxpayers to hold QSBS through a partnership, subchapter S corporation, or a common trust fund. However, if the original issued QSBS is transferred to a pass-thru entity, it will generally lose its QSBS status. Any QSBS held through a pass-thru entity will enjoy the same treatment as any QSBS held directly, providing the pass-thru meets all the requirements that otherwise apply to the original holder of the QSBS. For example, the pass-thru must hold the stock for 5 years, as well as meet all the asset and active business requirements.
Section 1202 allows transferees of QSBS
Section 1202 allows transferees of QSBS to retain their character in certain permitted transfers. A list of permitted transfers clearly illustrates tax policy blessing certain actions that receive carry-over basis treatment for other purposes. For example, taxable gifts, corporate reorganizations, 351 transactions, and contributions of assets in exchange for partnership interests all qualify as permitted transfers. One needs to be very careful if they want to retain their QSBS status. QSBS is not an elective statute; if owner’s business is one, their taxable income is determined by it. If QSBS is held that was under the 50% or75% tax regime, it is possible that the tax could be higher than that of the regular tax system. Consequently, when looking to sell a business, the shareholder should perform a proforma tax return, and if taxable income is higher under the QSBS system, then consider the use of a non-qualified transfer to remove the business from the QSBS system.
What to do if taxpayer has a substantial gain?
If a taxpayer has a gain significantly in excess of the excluded gain under the statute, it may be possible to gift stock to an irrevocable trust to multiply the statutory exclusion amounts. But beware of the multiple trust limitations of income tax regulation Section 1.643(f)-1. Under this regulation, two or more trusts will be aggregated if such trusts have substantially the same grantor and beneficiaries, and the purpose for creating such trusts is the avoidance of federal income tax. An example is necessary to show how to avoid this rule.
Steve Rodgers is considering selling stock in his closely-held C corporation, in which he would incure gain of $30 M. He is only entitled to exclude $10 M of gain under Section 1202. He has a son and a daughter, to whom he and his wife desire to make large taxable gifts to take advantage of the disappearing applicable exclusion amount. He can create two separate trusts (one for each child) and gift stock to each trust, and each will be able to exclude $10 M on the sale of the business. The multiple trust rule will not apply because the beneficiaries are not the same.
Section 1045 allows the taxpayer to rollover gain on a disposition of a QSBS into the QSBS of a different issuer, provided that the QSBS is held for more than 6 months prior to disposition and the rollover occurred within 60 days. If the taxpayer does not purchase replacement QSBS with a fair market value equal to or greater than the replacement QSBS, then the taxpayer will recognize boot in the form of capital gain like the treatment of a Section 1031 exchange. For example, Billie Business has a $200,000 adjusted basis and a 3-year holding period in Rex Corporation, which is a QSBS. She then sells Rex Corporation for $2 M, and purchases Lex Corporation for $1.5 M within 60 days. The $200,000 basis rolls over to Lex Corporation, but she recognizes $300,000 as capital gain. To avoid this $300,000 gain, she could have rolled over a second 1045 transfer into Nexus Corporation.Thus, if Billie was to make both these transfers, she would only need to hold the property for two more years to qualify for 100% exclusion.
Section 1202 Traps to Avoid
Although Section 1202 provides wonderful tax benefits to business owners who desire to sell their businesses, there are a couple of traps that will cause the best planning to go awry.
The first is the use of put options as dispute resolutions. Section 1202 (j) prohibits the exclusion of gain if the taxpayer holds an offsetting short position with respect to the QSBS. Although 1202 was clearly designed for taxpayers to seek strategies to mitigate their economic risk of loss for QSBS holdings, there exists no statutory or regulatory exception for the use as an offsetting short position, which would allow the shareholder to exit by either compelling a sale to another shareholder, or the corporation itself. Planners who are unaware of section 1202(j) could inadvertently trigger its application by attempting to set up a method for the corporation to prevent a crippling impasse between its principles.
The second trap deals with the failure to monitor the assets or spend working capital. Section 1202(e) measures the active business requirement by how the corporation uses its assets. Section 1202(e)(1)(A) requires the corporation to use 80% of its assets in the active conduct of a qualified trade or business. While section 1202(e) provides several exceptions, failure to meet the requirements of 1202(e) could result in a tax disaster. Corrective action may cure the problem, but any rescue attempt must be done quickly to meet the substantially all requirement of Section 1202 (c)(2)(A). Because there is no bright light standard for measuring the substantially all standard for QSBS, time is of the essence for taxpayers and their advisors to discover and remedy any circumstances causing less than 80% of the assets to be used in qualified trade or business.
Can you benefit from Section 1202?
Section 1202 did not receive much press from the tax and legal community, because of the relative unattractiveness of C corporations. But, with the passage of the TCJA, now is the ideal time for the professionals to review the inner workings of the statute. Despite ambiguity, taxpayers can obtain significant benefits from 1202, especially if they work with their advisors to avoid tax traps. In the current environment, the choice of a C corporation would be favored when QSBS applies. Although shareholders, accountants, and attorneys will need to work together to navigate section 1202, the reward is often well worth the complexity.
RINA has extensive experience working with clients, attorneys, and other trust and estate professionals on how to optimize Section 1202. Please reach out if you’d like to talk.
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This content does not constitute accounting, tax, or legal advice, nor is it intended to convey a thorough treatment of the subject matter.