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The recent signing of the Tax Cuts and Jobs Act (TCJA) permanently reduced the corporate income tax rate from a maximum rate of 35 percent to a flat rate of 21 percent. This, as expected, resulted in a renewed interest in C corporations by company founders and investors. In addition, the reduction in the corporate tax rate is refocusing attention on another powerful provision – Section 1202, which was made permanent by the Protecting Americans from Tax Hikes Act (PATH), signed into law almost exactly two years prior to the signing of the TCJA. In their current, and now-permanent form, these two provisions should be reviewed together with a fresh eye and a new perspective as they can provide taxpayers with potentially powerful tax planning opportunities.
Summary of provision
The benefits afforded by Section 1202 to owners of qualified small business stock (QSBS) have been in existence since 1993, when Congress sought to spur investment in certain small businesses. Over the years, Section 1202 has gone through several iterations, but the benefits have never been more powerful than they are today.
Section 1202 generally permits noncorporate taxpayers to potentially exclude up to 100 percent of the gain realized from the sale or exchange of QSBS held for more than five years (provided the stock acquisition date is September 28, 2010 or later). The exclusion is applicable for both regular and alternative minimum tax purposes. The gain eligible for exclusion is limited to the greater of $10 million or 10 times the taxpayer’s cost basis in the stock of the issuer sold or exchanged during the year.
Consider the following example: A qualified small business (QSB) is capitalized and a significant portion of the capital is used to acquire tangible property for its trade or business. Five-or-more years down the road, the owners sell the stock of their QSB. The potential benefits are three-fold:
- Accelerated depreciation: Eligible tangible property can be immediately expensed due to the rules of bonus depreciation (which is currently 100 percent). The recurring investment in tangible property will serve to reduce or eliminate taxable income. (Note: Under the TCJA bonus depreciation gradually phases out after Dec. 31, 2022).
- Reduced tax rate: To the extent a highly profitable business cannot shield its entire taxable income with the depreciation benefit listed above, residual taxable income will be taxed at a 21% tax rate, as opposed to the prior 35% maximum tax rate.
- Section 1202 eligible stock sale: If all the qualifications set forth in Section 1202 are satisfied (discussed below), not only will the corporation benefit due to reduced taxable income and reduced tax rate, perhaps most importantly, the shareholders will be able to exclude up to a minimum of $10 million from taxable income.
Requirements
Pursuant to Section 1202, several requirements must be satisfied to qualify as QSBS, as follows:
- 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
- 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
A qualified trade or business is defined as any trade or business other than businesses:
- Involving 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,
- Involved in banking, insurance, financing, leasing, investing, or similar business,
- Involved in farming,
- Involved in the production or extraction of certain natural resources eligible for a depletion allowance, and
- Involved in 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.
What you need to know
- Investments structured as pass-through entities will not qualify. Accordingly, existing pass-through entities that would otherwise qualify under Section 1202 should consider converting to a C corporation. In most cases, this can be accomplished in a tax-free transaction. While any appreciation that has occurred prior to conversion will not qualify for the exclusion, post conversion appreciation will qualify. Shareholders will need to hold the stock in the company for five years after the conversion.
- The form of investment should be analyzed when considering investments and raising capital, as common structures such as convertible debt, options and warrants will not qualify for the benefits under Section 1202 until either conversion or exercise; and the issuing corporation’s gross assets will be measured at the time of conversion or exercise.
- The exit strategy or form of disposition of the investment should be carefully considered. Investments may be disposed of as either a sale of assets or a sale of stock. Note that only those transactions structured as a stock sale can benefit from the Section 1202 exclusion.
What does CohnReznick think?
The reduction of the corporate income tax rate to 21 percent coupled with the unique benefits of Section 1202 present the potential for a supercharged tax planning opportunity for both qualified investors and company founders of early-stage companies. Taxpayers should ensure that they are familiar with Section 1202 as they structure their personal, business, and estate tax affairs.Subject matter expertise
Joel Boff
CPA, CGMA, Partner
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Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.