Scott Dolson | TaxConnections

Maximizing Section 1202’s Gain Exclusion

The combination of the 21% corporate federal income tax rate and the possibility of qualifying for Section 1202’s gain exclusion has made operating a business through a C corporation an attractive choice.[1] This article is one of a series of articles and blogs authored by Scott Dolson addressing planning issues relating to Sections 1202 and 1045. Additional information regarding qualified small business stock (QSBS) planning and the firm’s tax planning group can be found here and in our QSBS Library and Guidebook.

Section 1202 allows a taxpayer to claim a gain exclusion when QSBS is sold, so long as the taxpayer meets all of Section 1202’s eligibility requirements. Section 1202 places limits on the amount of gain exclusion that can be claimed by a taxpayer with respect to a corporation’s QSBS. This article explains how the gain exclusion caps work and provides planning suggestions for increasing the amount of available gain exclusion.

Gain exclusion cap basics (including the standard $10 million per-taxpayer per-issuer cap)

Section 1202(b) provides that, for a specific taxable year, a taxpayer’s aggregate per-issuing corporation gain exclusion is generally limited to the greater of (a) $10 million, minus the aggregate prior Section 1202 gain excluded with respect to such issuer (the “10 Million Cap”), or (b) 10 times the taxpayer’s original adjusted tax basis in the issuer’s QSBS sold during the taxable year (the “10X Basis Cap”).[2]

For purposes of the 10X Basis Cap, a taxpayer’s original adjusted tax basis equals the aggregate cash and fair market value of property exchanged for the shares of QSBS sold during the applicable tax year. If shares of QSBS sold were originally issued in exchange for services, the original adjusted tax basis would be the value of those shares for Section 83 purposes.[3] Capital contributions with respect to already issued QSBS are ignored for purposes of calculating the 10X Basis Cap. Therefore, capital contributions without the issuance of additional QSBS should be avoided; instead, additional QSBS should be issued in exchange for each money or property contribution, assuming the issuer is still eligible to issue QSBS.[4]

Several key aspects of Section 1202’s gain exclusion cap are as follows:

Written by Scott Dolson | Posted in Section 1202’s Gain Exclusion

Can Stockholders of Employee Leasing Companies Claim Section 1202’s Gain Exclusion?

Stockholders must satisfy several eligibility requirements before they can claim Section 1202’s generous gain exclusion.[i] One of the more significant issuing-corporation level eligibility requirements is the 80% Test. In order to satisfy the 80% Test, a corporation must continuously use at least 80% of its assets (by value) in the pursuit of one or more qualified business activities. “Leasing” is included in Section 1202’s list of excluded activities. This article explores whether Professional Employer Organizations (PEOs), staffing firms, employer of record companies (EORs) and employee leasing companies (referred to in this article as “Co-Employers”) are engaged in excluded “leasing” activities for purposes of Section 1202.

The primary purpose of this article is to illustrate how a particular category of business activities can be analyzed for purposes of Section 1202. If an actual project involves issuing an opinion letter, seeing a private letter ruling or defending a taxpayer, the process necessarily involves first identifying all of the pertinent facts associated with the proposed or ongoing business activities, which are then considered within an analytical framework which could be similar to the one outlined below.

This is one in a series of articles and blogs addressing planning issues relating to qualified small business stock (QSBS) and the workings of Sections 1202 and 1045. During the past several years, there has been an increase in the use of C corporations as the start-up entity of choice. Much of this interest can be attributed to the reduction in the federal corporate income rate from 35% to 21%, but savvy founders and investors have also focused on qualifying for Section 1202’s generous gain exclusion. Legislation proposed during 2021 sought to curb Section 1202’s benefits, but that legislation has stalled in Congress.

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Written by Scott Dolson | Posted in TaxConnections

06 Oct 2023

Determining The Applicable Section 1202 Exclusion Percentage When Selling Qualified Small Business Stock

When Section 1202 was enacted in 1993, a 50% gain exclusion applicable to the sale of qualified small business stock (QSBS), with the remaining 50% of the gain taxed at a 28% rate.[1] Not surprisingly, operating as business through a C corporation for the purpose of qualifying for Section 1202’s gain exclusion was not particularly attractive for most businesses. After Congress increased the gain exclusion to 75% for QSBS issued after February 17, 2009, and then 100% for QSBS issued after September 27, 2010, qualifying for Section 1202’s gain exclusion became a viable planning goal. In most cases, determining the applicable exclusion percentage is a straightforward exercise. But as discussed below, there are a couple of factors that can complicate this determination.

This is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045. During the past several years, there has been an increase in the use of C corporations as the start-up entity of choice. Much of this interest can be attributed to the reduction in the federal corporate income rate from 35% to 21%, but savvy founders and investors have also focused on qualifying for Section 1202’s generous gain exclusion.  Legislation proposed during 2021 sought to curb Section 1202’s benefits, but that legislation, along with the balance of President Biden’s Build Back Better bill, has stalled in Congress, perhaps permanently. More background information regarding qualified small business stock (QSBS) and the workings of Sections 1202 and 1045 of the Internal Revenue Code is available on our website.
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Written by Scott Dolson | Posted in TaxConnections

21 Sep 2023

The Intersection Between Equity Compensation Planning And Section 1202

There are numerous tax and business issues associated with equity compensation planning for employees and other service providers.[i] Numerous tax professionals focus on structuring compensation arrangements and many articles address the key planning issues. But at the same time, very little attention has been focused on structuring equity compensation arrangements for corporations that have issued qualified small business stock (QSBS) to founders and venture capitalists. This article focuses on the intersection between Section 1202’s unique requirements and traditional equity compensation planning.[ii]

This article is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045. During the past several years, there has been an increase in the use of C corporations as the entity of choice for start-ups. Much of this interest can be attributed to the reduction in the federal corporate income tax rate from 35% to 21%, but savvy founders and venture capitalists have also focused on qualifying for Section 1202’s gain exclusion.  Legislation proposed during 2021 sought to curb Section 1202’s benefits, but that legislation stalled along with the balance of the Build Back Better Act. Finally, during August, 2022, Congress passed the Inflation Reduction Act, but that legislation did not amend Section 1202.
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Written by Scott Dolson | Posted in Equity Compensation Planning • Section 1202

19 Sep 2023

A Section 1202 Walkthrough: The Qualified Small Business Stock Gain Exclusion

Section 1202 allows stockholders to claim a minimum $10 million federal income tax gain exclusion in connection with their sale of qualified small business stock (QSBS) held for more than five years.[i] Assuming a 23.8% federal income tax rate, stockholders selling $10 million worth of QSBS qualify for a $2,380,000 gain exclusion.[ii] Needless to say, Section 1202’s gain exclusion is the most attractive tax benefits available to founders and venture capitalists. The failure of the Build Back Better Act and the Inflation Reduction Acts to reduce Section 1202’s benefits has dramatically improved the prospect that QSBS issued today will qualify for Section 1202’s 100% gain exclusion during 2027 and beyond.

This article is intended to serve as a resource for founders and venture capitalists exploring whether to position their business activities and investments to qualify for Section 1202’s gain exclusion. Along the way, the article bookmarks past in-depth articles and blogs addressing various QSBS planning issues.

This article is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045. During the past several years, there has been an increase in the use of C corporations as the entity of choice for start-ups. Much of this interest can be attributed to the reduction in the federal corporate income tax rate from 35% to 21%, but savvy founders and venture capitalists have also focused on qualifying for Section 1202’s gain exclusion.  Legislation proposed during 2021 sought to curb Section 1202’s benefits, but that legislation stalled and then died, along with the balance of the Build Back Better Act. Congress finally passed the Inflation Reduction Act in August, 2022, but that legislation did not adopt the proposed amendments to Section 1202.

What It Takes To Qualify for Section 1202’s Gain Exclusion.
Section 1202 has a number of issuing corporation-level and stockholder-level eligibility requirements, all of which must be satisfied in order to claim Section 1202’s gain exclusion. These eligibility requirements are discussed below.
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Written by Scott Dolson | Posted in Qualified Small Business Stock Gain Exclusion

14 Sep 2023

Navigating Section 1202’s Redemption (Anti-Churning) Rules

Section 1202 provides for a substantial exclusion of gain from federal income taxes when stockholders sell qualified small business stock (QSBS).[1] But a number of requirements, including avoidance of Section 1202(c)(3)’s anti-churning rules, must be satisfied in order to be eligible to claim Section 1202’s gain exclusion. This article focuses on the potential forfeiture of QSBS status that can be triggered by poorly-timed issuances and redemptions of stock.

If Section 1202’s anti-churning rules are triggered, the affected stock will forfeit its QSBS status. Presumably, Section 1202(c)(3) was enacted as an effort to block the strategy of exchanging non-QSBS for QSBS. The potential application of these rules should be considered before stock is redeemed or QSBS issued. Also, understanding how these rules work is important when vetting whether stock is QSBS.

Stock redemptions are not common occurrences for early-stage companies. But companies do occasionally redeem stock from exiting founders and early-stage employees. Later-stage companies also occasionally rely on stock redemptions as a source of liquidity for founders or investors. Understanding whether the anti-churning rules would be triggered by a redemption is a necessary part of the planning process.

This article is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045. During the past five years, the C corporation has gained favor as the entity of choice for many start-ups. Much of this interest can be attributed to the reduction in the federal corporate income tax rate from 35% to 21%, but savvy founders and venture capitalists have also focused on qualifying for Section 1202’s gain exclusion.  Efforts by Congress to reduce Section 1202’s benefits over the past several years have failed. Additional information regarding the eligibility requirements for Sections 1202 and 1045 can be found in our QSBS library.

What qualifies as a stock redemption?
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Written by Scott Dolson | Posted in Section 1202’s Redemption (Anti-Churning) Rules

12 Sep 2023

Transfers “At Death” Of Qualified Small Business Stock

This article addresses the consequences of “transfers at death” of qualified small business stock (“QSBS”) under Section 1202.

Generally, in order to qualify for Section 1202’s gain exclusion, the stockholder who sells QSBS must be the same stockholder who was issued the QSBS by the qualified small business corporation. There are several exceptions to this requirement, including Section 1202(h)(2)(B), which provides that when there is a transfer “at death,” the transferee is treated as the original stockholder for Section 1202 purposes and is treated as having held the transferred QSBS for the original stockholder’s holding period.

This is one in a series of articles and blogs addressing planning issues relating to qualified small business stock (QSBS) and the workings of Sections 1202 and 1045 of the Internal Revenue Code.[i] During the past several years, there has been an increase in the use of C corporations as the start-up entity of choice. Much of this interest can be attributed to the reduction in the corporate rate from 35% to 21%, but savvy founders and investors have also focused on qualifying for Section 1202’s generous gain exclusion. Any future increases in capital gains rates may result in QSBS eligible investments being even more attractive by comparison.[ii]

What does transferred at death mean?
“At death” is not defined for Section 1202 purposes or in any other tax authority expressly interpreting Section 1202.
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Written by Scott Dolson | Posted in TaxConnections

07 Sep 2023

Advanced Section 1202 (QSBS) Planning For S Corporations

Section 1202 provides for a substantial exclusion of gain from federal income taxes when stockholders sell qualified small business stock (QSBS).[1] A number of requirements must be satisfied before a stockholder is eligible to claim Section 1202’s gain exclusion. Those requirements have been addressed in a series of articles on Frost Brown Todd’s website. This article focuses on the planning challenges posed by S corporations for business owners interested in pursuing the benefits of Section 1202’s gain exclusion.

This article is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045. The C corporation has gained favor in recent years as the entity of choice because of the 21% corporate tax rate and the potential for benefiting from Section 1202’s gain exclusion. Additional information regarding the eligibility requirements for Sections 1202 and 1045 can be found in our QSBS library.

The following Section 1202 eligibility requirements show why S corporations and QSBS are incompatible:
Only C corporations can issue QSBS (stock issued by an S corporation can never qualify as QSBS) — Section 1202(d)(1).[2]
A corporation issuing QSBS must remain a C corporation during “substantially all” of a stockholder’s holding period for the QSBS (i.e., after QSBS is issued, conversion by the issuing corporation to an S corporation will usually terminate QSBS status) — Section 1202(c)(2)(A)
A corporation issuing QSBS must remain a C corporation when the QSBS is sold — Section 1202(c)(1).

S corporations are corporations for federal income tax purposes that have made an election to be taxed under the S corporation regime. S corporation stockholders share in the corporation’s income and loss which is passed through on Schedule K-1s. There is nothing inherently wrong with operating a business through an S corporation, but business owners who seek Section 1202’s gain exclusion should avoid S corporations. This article suggests several approaches for addressing the situation where a business has strayed into the grasp of the S corporation.
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Written by Scott Dolson | Posted in Section 1202 (QSBS) Planning For S Corporations