Section 1202: The little-known tax rule that could save you big money when you sell your business.

A little-known tax provision dubbed Section 1202, which we’ve covered before, is getting a lot of attention these days thanks to the Tax Cuts and Jobs Act (TCJA) and the renewed promise that it could nearly wipe out your tax liability when you go to sell your company. Sound too good to be true? Perhaps. Here’s what you need to know.

First, know that the Section 1202 conversion is nothing new. In 1993, Congress enacted a tax loophole for qualified small business stock to spur investment in certain small businesses. This is the Section 1202 conversion, and it’s gone through several iterations over the course of its lifetime — though none quite as attention-grabbing as now. It was made permanent by the Protecting Americans from Tax Hikes Act (PATH), signed into law nearly two years before the TCJA.

The 1202 exclusion provides that if you contribute a qualified company to a C-corporation, and hold the company’s stock for five years or more, then the greater of $10 million or 10 times the initial value are not subject to capital gains when you sell. It’s a huge incentive.

What took everyone so long to pay attention to it?

It boils down to the corporate tax rate. To qualify for the Section 1202 exclusion, you have to create a new C-corp and “contribute” the equity from your existing company into the new entity. Until recently, the corporate tax rate was substantially higher (remember that the TCJA reduced it from the max 35% to 21%), so becoming a corporation (C-Corp) wasn’t an easy pill to swallow. The previous corporate tax rate was such a deterrent, in fact, that even a change 2010 to permit a 100% exclusion on capital gains on the sale of a company left many business owners refusing to incorporate.

Now, corporate tax rates have changed. Is it time to hurry up and incorporate and sell your business? Consider the following.

First, setting up a C-corporation isn’t as easy or automatically right as it may sound. The paperwork is relatively painless, but becoming a new entity with a new EIN will send you on a time-consuming journey of establishing new bank accounts, new accounting books, new payroll, new insurance, new everything. It’s time consuming to say the least.

Once the legal conversion is made, it’s advisable that you conduct a proper valuation of your initial company using a certified appraiser. That valuation could cost you dearly: If it’s too low, your “10 times” gain cap might be smaller than ideal. If it’s too high, you will pay additional tax on this basis when you sell down the road.

Next, you do need to wait 5 years after you create a new C-corp and “contribute” the equity from your existing company to the new entity. Anyone with immediate plans to sell isn’t right for this option.

Still, it could be the right decision, and a seriously advantageous one at that. After waiting a minimum of five years, you can exclude up to 10 times the base value from tax. Instead of paying the long-term capital gains tax on the total value of your sale, you might only pay long-term capital gains on the base value. In a growing company, this five-year-old basis could be a small fraction of the sales price.

Here’s an example: Say your company is valued today at $2 million, and you sell it five years later for $22 million. Using Section 1202, you would pay tax on the initial $2 million, and not a penny on the remaining $20 million. If tax rates stay roughly where they are today, your effective federal tax rate on the sale would drop from 20% down to just 2%. 

Of course, there is more than a little fine print:

Pursuant to Section 1202, conversions provide benefit only if your company performs a sale of equity. Asset sales do not benefit from this tax treatment. In addition, to qualify as Qualified Small Business Stock (QSBS), several requirements must be met:

  • QSBS must be stock in a domestic C corporation that was originally issued after August 10, 1993. 
  • QSBS must be acquired by the taxpayer at its original issue. 
  • The QSB must have total gross assets of $50 million or less at all times on or after August 10, 1993 and immediately after the stock is issued (if your company has $50 million or more in assets during any period of the five years, it will not qualify).
  • During the time the taxpayer holds the QSBS, at least 80 percent of the value of the corporation’s assets must be used in the active conduct of a qualified trade or business.

Businesses that don’t qualify are those where people are the primary assets, including businesses involved in: 

  • services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services, or any business where the principal asset of such business is the reputation or skill of one or more employees, 
  • banking, insurance, financing, leasing, investing, or similar business,
  • farming,
  • the production or extraction of certain natural resources eligible for a depletion allowance, and
  • the operation of a hotel, motel, restaurant or similar businesses. 

Another key point to note is that QSBS held within a partnership falls within the purview of Section 1202 and, therefore, noncorporate partners may also benefit from this exclusion. Accordingly, a taxpayer’s allocable share of gain attributable to a sale of QSBS by a partnership may potentially qualify as gain eligible for the Section 1202 exclusion subject to the following provisions: 

  • The stock must meet all the requirements to be QSBS and must be held by the partnership for more than five years. The taxpayer’s share of such gain must be attributable to an interest in the partnership held by such taxpayer on the date on which the partnership acquired the QSBS stock and always thereafter until the disposition of QSBS by the partnership.
  • Increases in the taxpayer’s interest in the partnership after the date on which the partnership acquired the QSBS are ignored in determining the amount of gain eligible for exclusion in the hands of the taxpayer. 

Bottom line: There is a potentially huge tax upside to converting now and electing the 1202 conversion as part of your exit strategy. Corporate tax rates could change again, making the burden of operating within a C-Corp more expensive. Congress could also change the exclusion.

However, tax savings alone should never be the reason you quickly decide to jump ship from your business. Succession planning is a deeply complicated and personal thing, and it involves more than “just numbers”. Proper exit planning takes so much more than  taxes into consideration.

Consider this new development in your exit planning strategy, and please reach out to begin (or, better yet, continue) the discussion on your transition from your company — whenever that planned day may be.

 

 

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