For an entrepreneur, a liquidity event can be rewarding both financially and emotionally. However, when the tax bill associated with this emotional and financial high comes due, reality swiftly grounds you. For certain business owners anticipating a sale in the near future, we feel it is important for them to be aware of a special section of the tax code that can result in significant tax savings.
What is IRC § 1202?
This section is referred to as IRC § 1202. It allows capital gains resulting from the sale of qualified small business stock (QSBS) to be excluded from federal tax. This means all or a portion of what you receive from your liquidity event could be tax-free. The amount of gain is limited to $10 million in a year or 10 times the owner’s basis of the QSBS sold in a year. With capital gains rates at 20%, the implementation of this strategy could translate to $2 million in tax savings.
Reviewing the Benefits and Qualifications
As outlined in a recent New York Times article, many companies and employees are unaware of the benefits permitted under IRC § 1202, leaving significant capital at risk of loss through taxation. A paper by Frost Brown Todd dives deeper into the complicated process of qualifying for the exemption while describing how updated tax laws are driving more tax attorneys to advise their clients to consider organizing as a C corporation.
Of course, with such significant tax savings come specific qualifications in order to receive the benefit. The following includes some, but not all, of the requirements that must be met for § 1202:
- QSBS is defined as stock acquired by the taxpayer from the issuing domestic C corporation.
- QSBS must be held for at least five years.
- Aggregate gross assets of the corporation can’t be more than $50 million at the time of issuance.
The IRS does not make this qualification easy, which is to be expected when such significant tax savings are at stake. As Frost Brown Todd outlines, there are complex steps involved in planning for the ideal capitalization when issuing QSBS. This point is made not to deter business owners, but to emphasize the importance of working with qualified tax and finance professionals.
Evaluating the Risks
Unfortunately, many entrepreneurs consider the QSBS exemption at the time of sale when it may be too late. To avoid this issue, appropriate planning is necessary. Another pitfall, as explained in a Forbes article, is that many startups capitalize to stimulate stronger initial growth instead of focusing on tax optimization in the longer term. As companies and business owners come to understand the impact § 1202 may have on a future liquidity event, we may see more pre-liquidity planning implemented and more companies organizing and capitalizing with a long-term mindset.
If you’re interested in setting up an appointment with an advisor to learn more about IRC § 1202 and QSBS, send us an email at email@example.com.