Many people (including some tax accountants) do not know, or forget, that there is a potential significant tax benefit for having invested in a startup business that is either a C Corporation or converts to a C Corporation from another structure such as a Partnership or LLC. This benefit comes by way of what is referred to as IRC 1202 Qualified Small Business Stock and can lead to having more than $10,000,000 (with proper planning) of gain excluded from tax.
In simple terms, IRC 1202 lets you exclude a portion, if not all, of your gain related to the sale of certain C Corporation stock. The amount of the exclusion depends on when the stock was purchased.
Benefits of 1202 Stock:
- Stock acquired after Sept 27, 2010 – 100% Gain Exclusion – Yes, All of the Gain is Tax Free!!
- Stock acquired after Feb 17, 2009 and before Sept 28, 2010 – 75% Gain Exclusion
- Stock Acquired before Feb 18, 2009 – 50% Gain Exclusion
The portion of the gain excluded is exempt from both capital gains tax (generally 15-20%) as well as the Net Investment Income Tax (3.8%). The reason many taxpayers and practitioners are not familiar with 1202 Stock is because when only the 50% gain exclusion applied, the tax rate on capital gains was 15% and remaining gain that was not excluded was subject to a 28% tax rate (IRS Rule on the rate for 1202 stock). That meant that at best there was a 1% tax benefit (15% capital gains tax rate on 100% of the gain vs 28% tax rate on 50% of the gain). However, fast forward to today and the capital gains tax rate is 20% plus the Net Investment Income tax of 3.8%. This means that even with only 50% excluded, the savings is now significantly more!
Now that you have a taste of some of the benefits of 1202 Stock, many are likely asking what stock qualifies as 1202 Stock. The answer to that is relatively straight forward:
Any Domestic (US) C Corporation stock which was originally issued after Aug 10, 1993 that meets the following qualifications:
- Any time after Aug 10, 1993 and prior to the stock issuance, the corporation’s gross assets did not exceed $50M as well as;
- The corporation’s gross assets immediately before and after the stock issuance did not exceed $50M
- The Corporation is in an active trade or business. (Think – does the entity have some sort or operations or are they essentially an investment vehicle)
- The stock had to be acquired with money or property (not other stock) or received as compensation of services provided to the corporation
- The stock had to have been acquired at original issuance from the corporation
Now that you have run through your mind of if stock qualifies, what other parameters are there to be able to exclude a portion of your gain? The basic parameters are outlined below:
- An individual must own the stock either directly or through a flow though entity such as a Partnership or S Corporation
- If the stock is owned in a pass-through, you must hold the pass-through interest when the stock was purchased as well as all of time afterwards up until the 1202 Stock was sold
- The stock must be held for at least 5 years until it is sold in order for the stock to receive 1202 treatment
For example, say you invested in stock or convertible debt on 1/1/2011 for which you have an original cost basis of $100,000. On 5/29/2016 the stock is worth $2,000,000 and you decide to sell it. Based on the date purchased and your holding period, you can exclude 100% of the $1,900,000 gain. Now consider if you had sold the stock six months earlier. You now no longer met the 5 year holding period and must pay tax of $452,200 (1.9M*3.8% – Net investment income tax+ 1.9M*20%-Capital Gains tax rates)!! That is a massive detriment for the unwary and for only 6 months of extra holding time.
Unfortunately the party does not go on forever but the news is not all bad. The maximum gain that can be excluded from the sale of stock of a single company is limited to the greater of $10,000,000 (lifetime for that stock) or 10x its basis. Therefore, you can take a $10 million exclusion in one year and if you plan which shares are sold, you can exclude a gain up to 10x your basis in the stock sold in each subsequent year. This means you could end up with significantly more gain excluded than $10,000,000 with the proper tax planning.
The above was just a quick overview of some of the benefits of selling 1202 but as you can tell the tax savings can be very significant. We always recommend that you run your plans by your CPA as there are many other nuances that need to be taken into consideration to make sure that you do not run afoul of the rules, as well as considerations with regards to convertible debt and other types of funding that may qualify for 1202.
Would you like to discuss this topic further? Contact us at firstname.lastname@example.org or 716-633-7022.