Less taxes for owners – Small Business Stock Capital Gains Exclusion.
What if the Federal government provided an opportunity for entrepreneurs to pay less capital gains taxes when they sell their successful business?
Would that be a terrible thing? After all, the business has created jobs for employees, paid payroll taxes, paid federal and state taxes and has likely supported the community in so many other ways.
What is Section 1202?
Section 1202 was originally passed by Congress back in 1993. The benefits afforded under Section 1202 have changed periodically over the years but the intent is the same.
Section 1202 provides a capital gains exclusion for owners of qualified small business stock (QSBS).
So what are the requirements for a company to qualify as a qualified small business stock?
1) It must be a C Corporation (startups take note as you can convert from an LLC to a C Corp and still qualify).
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’. In essence, you must acquire the stock from the company not from another shareholder (THIS IS IMPORTANT).
5) The taxpayer/stockholder must have owned the assets for at least 5 years.
The first and last points are certainly the bigger hurdles. Not all – or maybe even most – startups are C Corporations and LLCs do NOT qualify. Additionally, you have to have held the stock for at least 5 years. If a business is 4 years and 6 months old and about to sell, it may very well be worth it to hold it for another 6 months to qualify. On the other hand, if it’s only a year old – or if you’ve only owned the stock for a year – it doesn’t really matter much.
What does original issue mean? It means the shares were purchased from the company not from another person. Given the nature of angel investing, this is almost always the case so most people do not need to worry too much about points 2, 3, and 4.
What is the exclusion?
The gain eligible for exclusion depends on the year the stock was acquired (see below) but it may not exceed the greater of: (a) $10 million less the aggregate gain excluded in previous years or (b) 10 times a shareholders aggregate basis in the company.
· For stock acquired between August 10, 1993 and February 17, 2009 – the gain exclusion is limited to 50% (up to the greater of $10 million or 10 times the basis – see above).
· For stock acquired between February 18, 2009 and September 27, 2010 – the exclusion is limited to 75% of the gain (up to the greater of $10 million or 10 times the basis – see above).
· For stock acquired after September 28, 2010 – the exclusion is 100% of the gain (up to the greater of $10 million or 10 times the basis – see above).
As you can quickly see, Section 1202 applies to two groups of people: investors and entrepreneurs.
Quick example
After years of working in the corporate world, Bill stepped away to start his own software business in 2004 – East Coast Software, a C Corporation.
After gaining a little traction, he felt he needed to raise capital to take advantage of the opportunity ahead of him. He talked to a number of local investors and found someone willing to invest $100,000 at a pre-money valuation of $1.0 million – 10% of the value of the business. Fortunately for Bill and his investor, no more money was needed.
In 2009, Bill sold the company for $10,000,000. Bill’s share of the company was $9,000,000 (with a basis of effectively $0) while the investor cashed out at $1,000,000 with a basis of $100,000.
On his 2009 tax return, Bill reported a total gain of $9,000,000 but was able to exclude ½ of the gain, up to $10,000,000.
Entrepreneurs
For entrepreneurs this adds yet another wrinkle to the age old question, what is the best business structure – an LLC or C Corporation. Since this favorable tax treatment is only available to C Corporations it would seem to tilt the scales at least a little to the C Corporation.
The LLC taxed as a partnership has been a favorite of many startups in the past because it allows for flow through of losses to the shareholders during the lean years.
It may still be an LLC is for you. However, it’s certainly worth considering the tax benefits afforded by Section 1202 for you, future employees, and investors. However, C corporations do typically have a higher ongoing tax burden than an LLC taxed as a partnership.
For purposes of 1202, stock options are not considered ownership – they must be exercised before the 5-year clock starts. We’ve discussed Section 83(b) elections for employees before and why it can be beneficial to exercise the stock options as soon as they are granted. Starting the clock early of ownership is just another reason to consider making an 83(b) election on shares.
Investors
An immediate question is does this apply if you own the stock through an LLC – such as an angel fund or through an LLC you use personally for angel investments? The short answer is yes.
However, the following conditions must be met:
· All eligibility requirements of the company being a qualified small business stock have to have been met.
· The entity (e.g., LLC) has to have held the stock for more than 5 years.
· The ‘end taxpayer’ had to have had an interest in the pass through entity at the time the QSBS was purchased.
If those conditions are met investors are also allowed to exclude the gains as taxable income in the year the stock is sold. In other words, as investors you should be encouraged and pleased when you see a C corporation present.
I’m not sure how many administrators of angel funds are familiar with 1202 exclusions. It’s certainly something they should become more familiar with over time, but there is no guarantee they are aware of it. As a result, it’s on you to ask them whether or not a company qualifies – especially when the stock sale shows up as capital gains on your K-1.
One important point to make is convertible debt does NOT count as stock, preferred stock does. As such, if you own a convertible note on a startup and convert the note to stock at some point in the future the 5-year clock starts at the point of conversion – not the point of original purchase of the note.
Another interesting note is the combination of section 1045 which allows the rollover of gain from one qualified small business stock to another – as long as the new entity is also a QSBS and the rollover happens within 60 days. If those conditions are met, there are no taxes on the gain – to the extent not all the money is rolled over there would be taxable gain. This provision functions much like the more familiar 1031 exchange allowing real estate investors to defer capital gains as long as they ‘exchange’ real estate for real estate – a like kind exchange.
Why hasn’t this been discussed much before?
Historically, the benefit of Section 1202 was limited due to the way it was structured in 1993. There were two factors limiting its attractiveness: (1) there was a 50% capital gains exclusion but the rest of the capital gain was taxed at 28% and (2) the capital gain was an AMT preference item.
Essentially, both of these factors limited the effectiveness of the legislation.
In late 2015, Congress passed the Protecting Americans from Tax Hikes (PATH) legislation. The legislation afforded taxpayers the ability to shelter 100% of capital gains (up to $10 million per taxpayer) which lowers the effective tax rate for most and Congress also lifted the AMT preference treatment of Section 1202.
Quick example continued
Starting the business in January 2004 and selling it in December 2009 was a little unfortunate. By selling the business in 2009, Bill was able to exclude up to $10,000,000 of the capital gains but the other 50% was taxed at a 28% tax rate.
Under Section 1202, $4.5 million was taxed at 28% – creating a tax of $1,260,000 – and the remaining $4.5 million was not taxed at all. The effective tax rate was 14% – not that much better than the traditional tax rate of 15% (though we now have a 20% capital gains rate as well).
If Bill had started the business after September 28, 2010, he would have paid no capital gains taxes since he would have been able to exclude 100% of the gain up to $10 million.
His investor would have been better off too. Assuming he held the stock for the full five years, the investor would have paid $126,000 of taxes if the business was sold in 2009 (gain of $900,000 taxed at 28%) – at an effective tax rate of 14% too.
Had Bill and the investor started the business in December 2010 and sold it any time after December 2015, the investor also would not have paid any taxes and would have kept his full $1 million.
The situation can get much more complicated. What if the business sold for $50,000,000? What if Bill had children and he gifted some shares prior to selling the business? What if there were other investors? How about if instead of 1 investor, it was a local angel fund with several add-on investments? What would happen if Bill opted to ‘roll-over’ some portion of his gains into another qualified business opportunity?
Obviously, there are all kinds of planning opportunities to consider to further maximize what’s available in the tax code.
Conclusion
Clearly, it’s beneficial to understand Section 1202. For entrepreneurs, it may be a factor in determining the business structure you want for your new venture. For investors, you may realize you’ve been paying unnecessary taxes in the past.
Sometimes your accountant may not know the nature of your investments. As such, it could very well be up to you to notify them about the businesses you are investing in and whether it qualifies as a QSBS.
For those founders out there, it sure would be nice to know in advance whether or not you are a qualified business. If nothing else, find out before you sell the business and notify your investors if you are – a little extra benefit is always welcomed news.
Either way, Congress put these provisions into the tax code to spur investment in growing businesses. Investing in local startups clearly matches the intent. Utilize it if you can and lower your tax bill at the same time.
William Bissett is the owner of and an Investment Advisor Representative of Portus Wealth Advisors, a Registered Investment Adviser. Registration does not imply a certain level of skill or training. Opinions expressed on this program do not necessarily reflect those of Portus Wealth Advisors. The topics discussed and opinions given are not intended to address the specific needs of any listener.
Portus Wealth Advisors does not offer legal or tax advice, listeners are encouraged to discuss their financial needs with the appropriate professional regarding your individual circumstance.
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