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How to Save Money When Selling Your Business: Section 1202

February 18, 2020
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Under the signing of the Tax Cuts and Jobs Act (TCJA), the corporate income tax rate for C Corporations was lowered from a maximum rate of 35% to a flat rate of 21%. With this more attractive rate for C Corporations, a lot of business owners have refocused on the potential benefits of converting to a C Corporation. One very powerful provision in the tax code that has become much more attractive as a result of this change falls under Internal Revenue Code Section 1202, also known as the Small Business Stock Gains Exclusion.

Section 1202 was enacted in 1993 but made permanent two years prior to the TCJA under the Protecting Americans from Tax Hikes Act (PATH). Section 1202 generally permits non-corporate taxpayers to exclude up to 100% of the gain realized from the sale or exchange of qualified small business stock (QSBS) that is held for more than five years. The gain eligible to be limited is the greater of $10 million or 10 times the taxpayer’s cost basis in the stock of the issuer that was sold or exchanged.

PHASES OF GAIN EXCLUSION

There are three phases of exclusion that lead up to the maximum of 100% gain exclusion, as follows:

  • For qualifying QSBS acquired from August 9, 1993 to February 17, 2009, there is an opportunity to exclude up to 50% of the gain.
  • the 50% exclusion percentage was increased to 75% for stock acquired from Feb. 18, 2009, to Sept. 27, 2010.
  • For stock acquired after September 28, 2010, there is a potential exclusion of 100% of the gain. The 100% exclusion, unlike many other tax breaks, is permanent.

REQUIREMENTS

In order for your QSBS to qualify, there are several requirements:

  • There must be stock in a domestic C Corporation issued after August 10, 1993.
  • The stock must be acquired by the taxpayer at its original issuance in exchange for cash, property, or as compensation for services provided to the corporation.
  • The C Corporation must have $50 million or less in total assets for the entire period from August 10, 1993 through the day after the date of issuance, including any assets the corporation received as a result of the issuance.
  • At least 80% of the corporation's assets need to be active in the conduct of a qualified trade or business. Assets held for “reasonably required working capital needs” are used for the corporation's assets under this test. This is defined as a sufficient level of working capital to cover operating costs for a corporation's single operating cycle.

Manufacturing and distribution companies are eligible to qualify as trades or businesses under Section 1202, therefore, it is a significant opportunity for tax planning. The ability to exclude up to 100% of the gain on the sale of stock — stock sold for cash, moreover — is one of the most impactful benefits in the IRS tax code. Despite the incredible potential, many advisors are still not using this tool to help drive ultimate value to their clients upon a sale. We believe that the lower income tax rate for C Corporations of 21%, coupled with the attractive benefits of Section 1202, allow for significant tax planning opportunities for existing business owners, qualified investors, and founders of early-stage companies. Contact your Citrin Cooperman advisor to learn more.