Using Section 1202 Qualified Small Business Stock

Summary

If you are a noncorporate taxpayer and hold stock in a domestic C corporation, there are opportunities to potentially eliminate or defer the capital gain on the sale of Section 1202 qualified small business stock (QSBS). Tax planning around QSBS is essential in light of President Biden’s tax proposals, which include a potential increase of the long-term capital gains rate from 20% to 39.6% for taxpayers with over $1 million of taxable income.

In Detail

Here’s a rundown of the tax benefits and eligibility requirements of QSBS and the actions a company and shareholders can take now.

Tax benefits

1. The owner of QSBS may exclude up to 100% of the gain from the sale of the stock if the stock was acquired on or after September 27, 2010. The exclusion is 50%-75% if the stock acquisition date is before this date. The eligible gain limit is the greater of $10M or 10 times the stock basis. This exclusion is available for non-C corporation shareholders. The taxpayer must have held the stock for more than five years.
2. If the holding period is more than six months but less than five years, the QSBS 100% gain exclusion provision is not available. However, the taxpayer may nonetheless be able to defer the gain by rolling it to another QSBS under Section 1045 within 60 days beginning on the date of sale.

Please note that Section 1202 QSBS is federal tax law. Each taxpayer should consult with their tax advisor for state conformity based on their state of residency. For example, California does not conform to Section 1202 QSBS and Section 1045.

There are five requirements that must be met in order for the stock to be considered Section 1202 QSBS.

1. The stock must be originally issued after August 10, 1993.
2. The corporation issuing the shares must be a “qualified small business” when the stock was issued.
3. The stock must be exchanged for (i) money or other property (not including stock) or (ii) compensation for services (other than services performed as an underwriter of the stock).
4. The corporation must satisfy the “active business” requirement for substantially all of the holder’s holding period.
5. The shares must not have been issued during a period of disqualification brought on by redemptions by the issuing corporation.

“Qualified small business” is defined under IRC 1202(d) as any domestic C corporation if the total gross assets do not exceed $50M at all times after 1993 and before and after the issuance of the stock. The assets of wholly owned subsidiaries are aggregated for this test.

To meet the “active business” test, at least 80% (by value) of the assets of the corporation must be used by the corporation in the active conduct of a qualified trade or business. The key word is value. This includes a detailed review of the 409A valuation reports and assets held by the company.

Special rules are available for early stage companies who needed cash to finance research expenses and had higher working capital needs for the first two years. The government does not want the balance sheet to hold excessive passive investments such as real estate, T-bills and idle cash beyond research and working capital needs.

Action Steps

The company and/or shareholders should conduct a 1202 study to make sure all the eligibility requirements listed above were satisfied since inception and will be satisfied prospectively as new rounds of stock are issued. There are a number of critical nuances to consider such as: will shares still qualify as QSBS after crossing the $50M threshold, or what happens if there is a redemption or series of redemptions, or if idle cash is invested in the short term?

Stock option holders, please note: Due to the five-year QSBS holding requirement, it may be prudent to review your stock option vesting schedule. Consider an exercise of your stock options, including an early exercise. The holding period clock only begins on the date of exercise when the stock is originally issued to you. It is worthwhile to prepare a tax projection on the exercise of stock options to go over key tax provisions such as alternative minimum tax and the $100,000 limit on incentive stock options.

If you have any questions or need assistance with a 1202 study, contact our experts.

February 18, 2021