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Section 1202: Opportunity for Tax Savings upon the Sale of Small Business Stock

Hinckley Allen Tax Alert

By: Avi M. Lev

Small business owners often shun C Corporation status because of its various tax drawbacks, perhaps most significantly, the dreaded double tax.  However, in recent years, Congress has enacted tax provisions designed to incentivize new investment in small C Corporations.  Specifically, Congress has expanded the benefits of Section 1202, which now affords taxpayers significant potential tax savings when realizing gains upon the sale of their small business stock.  There are several limitations (discussed below), but this provision offers an excellent opportunity for taxpayers who are thinking about converting their partnerships and certain LLCs to C Corporations, or who are considering starting a new business in the coming months.  To qualify for this beneficial tax treatment, taxpayers must obtain their C Corporation stock before January 1, 2014, so time is of the essence.

How does it work?

Taxpayers who during September 27, 2010 to December 31, 2013 acquired “original issue” stock in qualified small businesses are permitted by Section 1202 of the Internal Revenue Code to exclude from income the full amount of any gains realized upon the ultimate sale of that stock, provided that the taxpayer holds the stock for at least five years before selling it and that certain other requirements are met.  Additionally, any gains that are realized upon the sale of stock will not be subject to the Alternative Minimum Tax (AMT).

Illustration: Dave has decided to start a company to develop a new smartphone application.  On November 1, 2013, Dave forms a C Corporation and receives 100 shares of the corporation’s stock in exchange for an investment of $10,000, which will cover initial operating costs. Over the next five years, Dave’s application becomes wildly popular, and eventually a major social networking website offers to purchase Dave’s application.  On November 2, 2018, Dave sells all of the stock in his C Corporation to the social networking website for $5,000,000 and realizes a gain of $4,990,000.  Because Dave received his original issue stock in the C Corporation during 2013, he will not be required to pay any capital gains or alternative minimum tax related to the sale of the company.

This provision will sunset at the end of 2013, meaning that for companies formed after 2013, taxpayers will be able to exclude only 50% of the gain (as opposed to the current 100%) when they sell their qualified small business stock in the future.  Additionally, the AMT will apply once again to gains realized upon the sale of qualified small business stock in companies formed after 2013, as will the new 3.8% net investment income tax.  Therefore, there are significant tax advantages to starting or investing in new corporations before the end of 2013 rather than waiting until next year.

Illustration: Returning to the case of Dave, the following illustrates the difference in his tax liability upon the sale of his business had he waited to form his C Corporation until 2014, rather than forming it in 2013:

Formation in 2013 Formation
in 2014
Holding Period 11/1/2013-11/2/2018 1/1/2014-1/2/2019
Capital Gains Rate 0% 28%

on 50% of the gain, for a 14% effective rate
Tax Liability on Capital Gain $0 $698,600
Alternative Minimum Tax None Dave may be required

to pay AMT, although the amount of his AMT liability depends on other factors.
Net Investment Income Tax $0 Depending on Dave’s Adjusted Gross

Income, the extent of his participation in the business, and other factors,

he may also owe net investment income tax of up to $189,620.

Amount Dave Saved by Forming His C Corporation in 2013 Rather than 2014: Over $888,220

Does my business qualify?

Section 1202 benefits extend only to original issue stock that is issued by a C Corporation during September 27, 2010 to December 31, 2013.  This includes any stock that is issued by a new C Corporation formed during that period, as well as stock issued by a company that during that period converts from being an entity taxed as a partnership (which includes some LLCs) to being a C Corporation.  Therefore, if you currently own an entity that is taxed as a partnership, you may be eligible to convert to C Corporation status to take advantage of this tax benefit.

To qualify for this favorable tax treatment, several requirements must be met:|

  • The stock must be issued by a domestic C Corporation with no more than $50 million in gross assets at the time of issuance.
  • The Corporation must use at least 80% of its assets in an active trade or business.
  • The stock must be issued during September 27, 2010 to December 31, 2013.
  • The stock must be held by a taxpayer that is not a corporation.
  • The stock must have been acquired by the taxpayer on original issuance.  This includes stock acquired by converting into a C Corporation an entity that is taxed as a partnership.
  • The stock must be held for at least five years from the date of issuance.
  • The Corporation may NOT be one of the following:
    • A trade or business where the principal asset is the reputation or skill of one or more of the employees, such as a law firm, healthcare provider, accounting firm, financial services firm, or consulting firm (among others);
    • A banking, insurance, financing, leasing, investing, or similar business;
    • A farming business; or
    • A business operating a hotel, motel, restaurant, or similar business.

Other Limitations

There is an upper limit to the amount of gain that a taxpayer will be permitted exclude for capital gains and AMT purposes.  Additionally, there are other restrictions that may apply to certain types of businesses. Finally, taxpayers who do not hold their qualified small business stock for at least five years will not be able to take advantage of the exclusion.

Conclusion

Section 1202 can provide significant tax benefits to many taxpayers who are thinking about starting a business in the near future and are able to incorporate that business before the end of 2013, or who already own a business that is taxed as a partnership and want to convert it to a C Corporation.  If you fall into one of these categories, please contact us as soon as possible so that we may assist you in determining whether you can take advantage of Section 1202’s benefits.

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