• Connor Abene

Sell your Business Tax Free: Section Code 1202

Section Code 1202 is a mostly unheard of tax advantage for the sale of a small business. Section 1202 has evolved over time from a 50% deduction to now a full 100% deduction due to Barack Obama’s passing of the Protecting Americans from Tax Hikes Act (PATH) in 2015. Section 1202, also called the Small Business Stock Gains Exclusion, is a portion of the Internal Revenue Code (IRC) that allows capital gains from select small business stock to be excluded from federal tax.

There are several requirements to ensure that you can maximize your deduction. Most of these requirements pertain to how the business is organized and two easy tests are available to determine if you meet the qualification for the qualified small business (“QSBS”).

The first test is the Gross Assets Test. The business must have less than $50 million in gross assets at all times between its formation and immediately after stock issuance. What constitutes gross assets? Cash and the fair market value of any assets the corporation received in exchange for stock at the time of the contribution. If the corporation owns more than 50% of a subsidiary company, all the subsidiary’s assets are included for this litmus test, too. Importantly, the gross asset requirement is not based on the fair market value of the business at the time of issuance. Stock issued that satisfies the asset test will continue to be treated as QSBS even if the corporation’s gross assets eventually exceed $50 million.

The second test is the Active Business Test. Size and structure represent important criteria, but it doesn’t end there. The business must use at least 80% in a qualified trade or business, and cannot be a trade or business that is explicitly disqualified. What types of businesses fall into the latter category? A “qualified trade or business” (QTB) is defined in section 1202(e)(3). This includes businesses involving finance or investment management, accounting, law, farming, mining, or the operation of a hotel, motel, or restaurant.

The organizational requirements exclude any S-Corp or LLC type businesses. Any businesses hoping to use the 1202 tax advantage are required to be a Corporation. However, this does apply to investors and employees of the business as long as they were issued shares for services or as an investment in the business. The shares must have been purchased directly from the business and not through any intermediary or even purchased from another shareholder.

If you are currently anything but a C-corporation you can transition and still be eligible for the tax advantage. However, there are still a few stipulations that apply to this. You must transfer all the assets, bank accounts, by-laws and employees from the current entity into the new C-corp. Secondly, you must hold the equity in the new entity for 5 years prior to the tax advantage.

To maximize the 100% deduction there are a few rules that must be followed. Firstly, you must have held the shares for a minimum of 5 years from date of issue. Secondly, your maximum deduction is $10mm or 10x the price of the shares issued. The capital gains that are exempt from tax under this section are also exempt from the 3.8% net investment income (NII) tax applied to most investment income.

Below, you will see a relevant example that leverages this particular tax advantage.

Consider a taxpayer who is single and has $410,000 in ordinary taxable income. This income places them in the highest tax bracket. They sell qualified small business stock acquired on Sept. 30, 2010, and have a realized profit of $50,000. The taxpayer may exclude 100% of their capital gains, meaning the federal tax due on the gains is $0.

As the example shows, applying these tests to a specific company or stockholder’s stock is often more complex than it appears. Given the powerful tax incentives on the table, consider engaging qualified tax and legal professionals sooner rather than later.