When evaluating the right business entity structure, the preferential tax treatment provided under Section 1202 should be given major consideration. Additionally, the impact of Section 1202 should be assessed when exiting a business structured as a C Corporation.
BENEFITS OF SECTION 1202
Under Section 1202, noncorporate shareholders are allowed to exclude the gain on the sale of qualified small business stock (QSBS) if the shareholder and corporation meet certain requirements, including a five-year holding period.
The amount of gain that is eligible for exclusion is the greater of $10 million or ten times the basis in the QSBS. The percent of this gain that is excluded depends on the date the QSBS was issued:
- For current issuances and any issuances after September 27, 2010, 100% of the gain would be eligible for exclusion;
- For issuance after February 17, 2009 and on or before September 27, 2010, 75% of the gain would be eligible for exclusion; and
- For issuance after August 10, 1993 and on or before February 17, 2009, 50% of the gain would be eligible for exclusion.
Additional benefit is provided to QSBS issued after September 27, 2010. These later issuances are not subject to the Alternative Minimum Tax (AMT) and all gains in excess of the excluded amount are subject to the capital gains rate. For issuances on or before September 27, 2010, these will be subject an AMT adjustment for 7% of the excluded amount, and the non-excluded gain would be taxed at a higher 28% tax rate.
Related Read: QSBS Offers Remarkable Tax Breaks
REQUIREMENTS OF SECTION 1202
Section 1202 places certain requirements on both the shareholder and the company that must be met initially and continued throughout the shareholder's holding period of the stock.
A shareholder must meet each of the following requirements, individually, to qualify for the exclusion under 1202:
- The shareholder must be a noncorporate shareholder, which includes individuals, trusts and estates;
- The shareholder must have a holding period of at least five years before the stock is eligible to be QSBS;
- The shareholder must receive the stock on original issuance from the corporation; and
- The shareholder must not have any offsetting short positions with respect to the stock.
For a company to have its stock qualify as QSBS, the following requirements must be satisfied:
- The corporation must be a domestic corporation other than a DISC, REMIC, REIT or S corporation;
- The corporation must be a "qualified small business." To meet this requirement, the corporation's gross assets must be less than $50 million at all times prior to the issuance of the stock and continue to be less than $50 million immediately after the stock issuance;
- The corporation must meet the "active business
requirement" for "substantially all" of the
shareholders five-year holding period. A corporation achieves this
test by using 80% (by value) of its assets in the active conduct of
one or more qualified business activities. A qualified business
includes any business other than the following activities:
- Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial services, brokerage services, or any trade or business where the principal asset of such trade or business 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 depletion deduction is allowable under Section 613 or Section 613A of the Internal Revenue Code; or
- Any business operating a hotel, motel, restaurant or similar business.
Section 1202 does place additional constraints on the use of the corporation's assets, including the following:
- After the first two years the corporation is in existence, no more than 50% of the corporation's assets may be used in research activities to meet the 80% test discussed above;
- Throughout substantially all of the holding period of the shareholder, the corporation may not hold more than 10% of the company's assets in portfolio stocks or securities;
- Throughout substantially all of the holding period of the shareholder, the corporation may not hold more than 10% of the company's assets in real estate holdings that are not used in the conduct of the corporations qualifying trade or business; and
- The stock must meet the original issuance requirement meaning that the stockholder acquired the stock directly from the company for money, property or services. The original issue requirement may be violated in instances when a company redeems shortly or after the issuance of stock.
Taxpayers should work with their tax advisors to weave through the requirements of Section 1202 and determine whether the corporate entity structure is the correct structure for their business.
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.