Section 1202 stock
Selling your company tax free?
Mike Drexler, CPA and Phillip R. McCollum, Jr., CPA, JD
UPDATE: With the enactment of the Tax Cuts and Jobs Act (TCJA) in 2018, Congress reduced the corporate tax rate from a high of 35% to a flat 21%. This change has led to more discussions that C corporations, may be an appropriate choice of entity to operate a business and then being in a position to qualify for Section 1202 stock treatment.
Are you thinking of selling your business? Maybe you’re looking for the next opportunity. Or do you want to recapitalize to get more liquidity in your company? If you hold stock that was issued to you directly by the company, there are ways you can exclude the first $10 million in gain from income tax using the section 1202 stock exclusion. This exclusion is commonly known as the qualified small business stock exclusion.
Who is eligible?
Section 1202 allows founders and other holders of stock issued directly to them by a C (taxable) corporation that has at least 80% of its value in assets in the active conduct of a trade or business to exclude the first $10 million in gain on the sale of that stock from income taxes. The stock must be issued to the holder by the company, the stock must be held for at least five years, and the company cannot exceed $50 million in assets.
Each stockholder can potentially exclude $10 million in gain from their stock when they sell it, so if your company has multiple founders, each can qualify for the exclusion. The exclusion is now a permanent part of the tax law, and it is not subject to alternative minimum tax (AMT) limitations.
Another interesting aspect of this exclusion is that the stock can actually be owned by a pass-through entity. For example, stock held by a partnership or an S corporation is eligible for the exclusion if all other conditions are met.
You also have the option of rolling over your gain. Let’s say you have a transaction with a gain. You can roll it over into another active trade or business. You may elect to roll over capital gains from the sale of qualified small business stock held for more than six months if other small business stock is purchased during the 60-day period beginning on the date of sale. Gain is only recognized to the extent that the amount realized on the sale exceeds the cost of replacement qualified small business stock during the 60-day period. To the extent that capital gain is not recognized, that amount will be applied to reduce the basis of the replacement small business stock. Keep in mind that it must be an active trade or business. You can’t just invest in stocks or mutual funds.
What about the buy side?
If you are looking to buy a company, understanding the seller’s tax situation may allow you to structure a deal that benefits both parties. If a selling company has five shareholders who qualify for the exclusion, their potential savings in tax exceeds $10 million. By structuring the deal to meet the section 1202 rules, you may be able to offer less for the company but put more after-tax money into the sellers’ pockets.
Planning to save
Because qualified small business stock must be held for five years, and the company cannot exceed $50 million in assets, owners should plan sales transactions accordingly. For instance, if you sell stock that you have held for four years and 11 months, the transaction would be fully taxable. But, if you hold on to it for one more month, a portion of the gain can be tax free. Likewise, selling your stock directly to a buyer versus having a buyer investing in the company and redeeming your stock could have vastly different tax consequences. Finally, if M&A is part of your business strategy, the $50 million threshold can be reached very quickly.
If you are thinking of selling or recapitalizing your business, contact your Henry+Horne tax advisor to see if you can take advantage of this small business tax saving opportunity.
Phillip R. McCollum, Jr., CPA, JD, Partner, specializes in tax planning, consulting and compliance work for privately held businesses and their owners. He can be reached at (480) 839-4900 or PhilMc@hhcpa.com.