Background
Section 1202 of the Internal Revenue Code offers a powerful tax incentive for investors in qualified small businesses: the potential to exclude up to $10 million — or 10 times their adjusted basis — from capital gains tax. Despite being on the books for over three decades, this provision is still underutilized, largely due to its complexity and lack of detailed IRS guidance.
Challenge
A New York-based advisor reached out to MGO for a second opinion. Their client, a company founder, had recently undergone a recapitalization transaction involving a conversion of common to preferred shares and a partial redemption. A tax attorney had advised the client to claim a $5.8 million gain exclusion.
The situation raised several key questions under Section 1202:
- How and when did the client acquire their shares?
- Does the company meet the definition of a "qualified small business"?
- Has anyone calculated the actual gain eligible for exclusion?
Approach
MGO conducted a deep-dive analysis of the transaction and the company's qualification status under Section 1202. The team verified the business met IRS criteria for a Qualified Small Business. We also walked the client through the full implications of the LLC-to-C corporation conversion and confirmed the funding event had triggered a significant step-up in basis. This meant that instead of being capped at $10 million, the client was eligible for a 10 times basis exclusion — resulting in a $100 million gain exclusion shared between the founder and his business partner.
Additionally, the team evaluated the structure of past and future share sales — including those involving preferred shares. As a result, the client was able to exclude all gains from the reported transactions and still retain $26 million in gain exclusion potential for future stock sales.
Value to Client
MGO transformed a narrowly scoped tax filing into a massive win:
- $100 million in total gain exclusion identified
- $0 in capital gains tax on current transactions
- $26 million in future tax exclusion potential preserved
By leveraging in-depth knowledge of Section 1202, MGO helped the client turn a limited exclusion into a far more advantageous result.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
