A guide to Section 1202 tax benefits for entrepreneurs

UPDATE – In the Omnibus appropriations bill of 2015, Congress made this provision permanent and retroactive to the beginning of 2015.

I’m writing this post because in my nine years of being in the startup world, I have never met an entrepreneur who had ever heard of section 1202 or section 1045 (upcoming post). The topic hardly ever comes up in conversation, and when it does I just get quizzical looks.

It’s amazing to me that there’s hardly anything besides an 83b election that can have a bigger effect on the amount entrepreneurs take home during an exit. So, what follows is a brain dump of everything that I’ve learned about this incredibly complex, yet useful section of the tax code.

First, a few disclaimers: I am not a lawyer or an accountant, and while I have no idea what the rules are regarding giving advice, you should assume that I’m not doing that. If you want to take advantage of these sections, you should find a lawyer or an accountant. Having said that, I will warn you that the vast majority of lawyers and accountants have no idea how these acts work (I’ve been through several), so you should probably look for somebody who practices specifically in startup law. Also, most of this will be oversimplified to address the specific case of startups. If, for example, you are running a “specialized small business investment company”, then you’ll need to just talk to your lawyer.

Section 1202

Section 1202 allows for a partial exclusion of gain on certain small business stock. In English, it allows you to cut your capital gains tax bill by 50%, 75%, or 100% based on when your company was (is) founded. These days, with the top capital gains rate at 23.8%, selling stock that qualifies for section 1202 could make your effective tax rate roughly 16%, 9%, or 0%.

In order to get this deal, you have to receive stock in a C corporation that qualifies as a “Qualified Small Business”.

A Qualified Small Business is a C corporation, including parents and subsidiaries, that has never had gross assets of over $50 million and will not have gross assets of over 50 million immediately after your stock is issued. (Meaning of “immediately” discussed in footnote 1)

Once you receive this stock, if you hold the stock for at least five years and the company meets the “active business requirement” (active business requirement discussed in footnote 2)for at least 80% of that time, then your stock qualifies as Qualified Small Business Stock (QSBS) and gets you the big discounts. Whether you get the 50% discount, of the 75% discount, or the 100% discount depends on when your stock was issued.

  • 50% exclusion: a holder of qualifying stock acquired after August 10, 1993 and on or before February 17, 2009 may be eligible for a 50% exclusion from Federal capital gains tax.
  • 75% exclusion: a holder of qualifying stock acquired after February 17, 2009 and on or before September 27, 2010 may be eligible for a 75% exclusion from Federal capital gains tax.
  • 100% exclusion: a holder of qualifying stock acquired after September 27, 2010 may be eligible for a 100% exclusion from Federal capital gains tax.

As long as you make sure that you check all the boxes above, the only thing you have to do is claim the QSBS exemption on your taxes at the end of the year that you sell your stock. It’s actually pretty easy if you are using TurboTax.

The Numbers

How do we get the effective tax rates?

The Rate. Because of the weird way the law is written, it works off of the old small business capital gains tax rate of 28%. If you qualify, say, for the 50% exemption, then you get an exemption of 50% of your gains from taxation. The rest is taxed at 28%, yielding an effective tax rate of 14%. 7% if you qualify for the 75% exemption. (That’s one reason why nobody really cared much about section 1202 until the Obama administration raised the capital gains tax rate to 20% and added on the 3.8% net investment tax)

The AMT. That’s not all, though. If you qualify for the 50% exemption, then you’re going to get hit with the Alternative Minimum Tax (AMT). 7% of the gain excluded on the sale of QSBS for regular tax purposes is a preference that must be added back to income in determining AMTI. At one point I understood how this works, but for now suffice it to say that the AMT adds about 1% to your effective tax rate.

Net Investment Tax. You don’t have to pay the net investment tax on the amount that you exclude, but you have to pay it on the rest. So, again, if you qualify for the 50% percent exclusion, the net investment tax adds 1.7% (50% of 3.8).

For the 50% exclusion, your effective tax rate for your capital gains will be, roughly, 14% + 1% + 1.7% = 16.7%

State Taxes

In addition to getting the discount at the federal level, there are two kinds of states: states that conform to section 1202 and states that do not. I’m afraid I only know something about California and New York. If you happen to be in any other state when you sell your stock, you’ll have to check with your accountant.

In short, California is a nonconforming state. That means that your state taxes will be based on the full amount of your capital gains, as much as 13.3% if you make enough.

New York is a conforming state. Because it is a conforming state, the exemption flows down to the state level. Your effective state tax rate will be half as much as it would otherwise be. For example, if you hit the top tax bracket, at 8.3%, your effective tax rate would be 4.15%.

If you happen to be in a conforming state, there’s nothing special you have to do on your tax return. The reduced amount of capital gains will flow through to your state return.

The fine print

  • The stock has to be received “at original issue”, which basically means directly from the company. You can’t buy them from someone else
  • For options, original issue means when you exercise your options, not when they were granted.
  • The exclusion phases out when you have either $10 million in capital gains before the exclusion or 10 times your basis, whichever is greater. This limitation is per company, so if you’ve invested in multiple companies or done a section 1045 rollover, your good for up to $10 million per company.

Footnotes

  1. According to this mergers and acquisitions book (page 2-390) neither the statute nor the legislative history defines the term “immediately after”. In the absence of specific authority, taxpayers may be able to take the position that the term should be interpreted literally to refer to the state of affairs at the instant immediately following the issuance of stock, disregarding all subsequent events.

    In interpreting other code provisions, however, IRS and the courts, applying the step transaction doctrine has interpreted the term “immediately after” to include preplanned future events. The phrase “immediately after the exchange” does not necessarily require simultaneous exchanges by two or more persons, but comprehends a situation where the rights of the parties have been previously defined in the execution of the agreement proceeds with an expedition consistent with orderly procedure.

  2. To put it bluntly, nobody knows what “active business” in the active business requirement actually means. After talking to several accountants, they all just claim it’s facts and circumstances. However, I have managed to gather some data points that may help set some boundaries.

    The active business requirement seems to be measured by how the assets are used. Clearly, there are many possible active businesses: There are those that that don’t require very much work to take in substantial revenues and others that never make any revenue despite teams of people working around the clock. The best advice I’ve been able to get is just a treat it like a real business: work on it yourself, hire people, attempt to get customers, etc. Though, there are two fairly clear groups of carveouts:

    • There are carveouts that specifically state that startup activities, research and development, and in-house research all pass the active business test.
    • There is a carveout for working capital. If the assets are held as part of reasonably required working capital for the business or are held for investment that could reasonably be expected to be used to finance research and experimentation within two years…it passes the active business test.

Further Reading

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s