Tax minimization is something we all seek. In the good years the tax bill seems entirely too much and in the bad years the tax bill highlights what we made and didn’t get to keep.
I’ve written about Section 1202 before and how it allows investors and entrepreneurs to escape taxation on the first $10 million of gain on qualified small business stock (click here for earlier article on Section 1202).
There is another provision in the tax code where you can elect to defer your gain in a qualified small business stock – it’s referred to as Section 1045.
Many of you are probably familiar with 1031 or 2035 exchanges. These allow you to defer paying taxes when you sell real estate for ‘like kind’ real estate (1031) or allows you to move money from one insurance/annuity contract to another without paying taxes (1035).
Section 1045 is similar but it applies to Qualified Small Business Stock (QSBS).
What qualifies as QSBS?
The same guidelines apply for Section 1045 as in Section 1202. The company must to meet the following specifications:
1) It must be a C Corporation.
2) The stock in the C Corporation must have been issued after August 10, 1993 and the gross value of the assets of the issuing corporation must have been less than $50 million at the time the stock was issued and immediately after.
3) At least 80% of the assets of the corporation have been used in the active conduct of one or more qualified trades or businesses.
4) The stock must have been acquired at ‘original issue’.
5) The taxpayer/stockholder must have owned the assets for at least 5 years.
What’s the benefit?
If a company meets the conditions set forth above and you have owned the stock for at least 6 months when you sells your shares in the company you can ‘rollover’ the gain to another qualified small business stock within 60 days.
Pretty simple. Own QSBS for at least 6 months. Sell QSBS and buy new QSBS within 60 days and you don’t have to pay income taxes on ANY of the gain. Of course, the gain and subsequent deferral election has to be recorded properly on your tax return.
The initial law as passed referred specifically to taxpayers. However, it was amended one year later to a ‘taxpayer other than a corporation’ – meaning it applies to partnerships, trusts, LLCs, and more. The pass through nature of Section 1045, therefore, seems to apply directly to angel funds and their members.
What’s the catch?
There’s no catch. It’s a pretty straight forward and SHORTLY worded law (read it here if you choose – https://www.law.cornell.edu/uscode/text/26/1045).
With that being said, there is no reason to believe this is always the best thing to do. Remember, Section 1202 allows you to realize the gains and not pay capital gains taxes on gains up to $10 million (the % of the exclusion is either 50%, 75% or 100% – depending on when you acquired the shares).
And Section 1045 simply allows you to DEFER paying capital gains. In essence, your basis in the first company carries over with you and serves as the cost basis in the shares of the second company.
For example, let’s assume you invest $100,000 into a QSBS in 2012 and in 2016 it sold and your share was $1,000,000. If you were able to identify a new QSBS and invest in that company within 60 days of the sale of the previous shares, your basis in Company 2 would still be $100,000, not $1,000,000. At some point in the future, when you sell the shares in the new company you will have to pay taxes with a basis of $100,000 (though you may still be able to claim an exclusion under Section 1202 as long as the shares are held for at least 5 years).
So why defer when you can claim the gain and not pay?
There doesn’t seem to be any discouragement from combining Section 1202 with Section 1045 – or vice versa.
What if you sold your stock in a company and the gain was $15 million? You could exclude up to 100% of the gain (depending on the year the company was founded) of up to $10 million. However, the remainder of the gain ($5 million) would still be taxed. If you properly planned and had another investment opportunity lined up you could invest up to $5 million and still not pay capital gains.
You may also have invested in a company in 2007 when the exclusion was ‘only’ 50% of the gain up to $10 million. As such, you may not want to pay taxes on the other 50%, or some portion of it.
If that’s the case, you could ‘rollover’ the gain from one QSBS to another QSBS and defer the gain. By all measures, it would also allow you to qualify the gain within THIS QSBS.
1) Let’s assume Peter bought shares of Company X (a QSBS) in 2013 for $100,000. On April 1, 2016 the company sold and Peter’s shares were worth $1,000,000. This is a situation where the gain does NOT qualify for Section 1202 because the stock was not held for 5 years. As such, Peter has a gain of $900,000 – by all indications, the gain will be taxed at 23.9%. If he is able to identify a new QSBS to invest in prior to May 30, 2016, then he can defer all or part of the gain (depending on how much he invests in the new QSBS).
2) Let’s assume Mary bought shares of XYZ Corporation (a QSBS) in 2007 for $50,000. On June 1, 2016 the company is sold and her shares are now worth $750,000. Only 50% of her gain of $700,000 is excludable. If she finds a new QSBS stock to invest in, then she can reduce her capital gain for this year.
However, her cost basis in XYZ Corporation would carry her forward to the new company. If she holds the stock for 5 years though, all indications are that she can exclude 100% of the gain up to $10 million since she acquired the new QSBS in 2016.
Clearly, either one of these Sections of the Internal Revenue Code helps minimize taxes in any given year. However, the combination of the two can be pretty powerful. Unfortunately, taking proceeds from one successful QSBS and moving it directly into another successful QSBS is a lot easier to write about than to execute. If it was that easy to find winners all the time, we’d all be a lot happier – even come tax time these days.
William Bissett is an Investment Advisor Representative with Secrest Blakey & Associates, a Registered Investment Adviser. Opinions expressed on this program do not necessarily reflect those of Secrest Blakey & Associates. The topics discussed and opinions given are not intended to address the specific needs of any listener.
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