Consider Section 1202 in the sale of your business.

Business foundersConsider Section 1202 in the sale of your business

April 22, 2022

Key things to know

  • When preparing to sell your business, it’s important to account for the impact taxes can have on the net proceeds from the sale.

  • If you own a business with significant value and meet the qualification requirements, completing a sale under Section 1202 may provide you the opportunity to reduce your tax bill.

When making plans to transition out of your business, it’s critical to start the process well in advance to help meet your most important objectives. Key among those objectives is achieving a satisfactory financial result from the sale of the business. It’s especially important to account for the impact that taxes could have on the net proceeds from the sale, as taxes can significantly reduce the final amount you receive.

What is Section 1202?

One tax planning strategy to consider taking advantage of is a law known as the Small Business Stock Gains Exclusion. It’s also referred to as Section 1202, reflecting the specific section of the Internal Revenue Code in which the Exclusion language resides. This law allows shareholders who sell their position to exclude all or at least a portion of capital gains from federal tax. In many cases, the tax exemption will also apply to capital gains from state tax (varies by state).

The benefits of Section 1202 apply to shareholders of qualifying stock, which can include investors and employees who are U.S. residents, as well as trusts and estates. In the case of most closely held businesses, the owners are often family members or trusts of the family.

“The savings for a business owner who is preparing to sell can be substantial,” says Karen Jonas, senior vice president, managing director of CFO Services at Ascent Private Capital Management of U.S. Bank. “It includes the capital gains tax rate of up to 20%, plus the 3.8% Net Investment Income Tax (NIIT) for federal tax purposes alone, possibly more depending on the state of residence.”

Benefits of Section 1202 vary depending on the date of issuance

The Small Business Stock Gains Exclusion was established in 1993 to encourage investment in small businesses by offering a tax incentive to individuals. While the primary aim is to promote investment in small businesses, the qualification requirements allow the benefits of Section 1202 tax treatment to extend to owners of businesses with significant value.

The applicable tax exclusion amount under Section 1202 has changed over the years. The benefits vary depending on when stock was initially issued:

  • Qualifying stock issued between Aug. 11, 1993 and Feb. 18, 2009 is eligible for a 50% exclusion from capital gains taxes and NIIT. Note that if this provision is utilized, the applicable capital gains tax rate would be 28% (rather than 20%). Therefore, the effective tax rate on this transaction would be 15.9%. Note that Alternative Minimum Tax (AMT) may also apply to the excluded gain.
  • Qualifying stock issued between Feb. 19, 2009 and Sep. 27, 2010 is eligible for a 75% exclusion, again using 28% as the base capital gains tax rate plus NIIT. That would result in an effective tax rate of 7.95%. AMT may also apply to the excluded gain.
  • Qualifying stock issued from Sep. 28, 2010 forward offers the best opportunity, with a 100% exclusion from capital gains and NIIT. In this case, AMT does not apply.

Primary Section 1202 qualification requirements

A number of specific qualifications must be met in order to claim Section 1202 treatment when a stock sale occurs. It’s important to review the requirements in advance with financial and tax professionals. Section 1202 rules will not apply to every situation where an individual sells an ownership position in a company. Here are some of the basic requirements that must be met.

Requirements of the issuing corporation

  • The stock currently held must have been issued by a domestic C Corporation, but not all C Corporation businesses will qualify. “The exclusion will primarily apply to manufacturing, retail, wholesale, technology, equipment sales firms and auto dealerships,” says Jonas.
  • The original issue of stock had to occur after Aug. 10, 1993, and the issuing corporation must have had assets (on the date of issue and immediately after) valued at $50 million or less.
  • There are other stipulations in the law designed to disqualify a stock for special capital gains tax treatment if after the shareholder obtained the stock, the company used proceeds to fund redemptions for other shareholders.
  • The company must use at least 80% of the fair market value of its assets on the active conduct of a qualified trade or business. It is expected that this standard will be consistent throughout your holding period.

This provides only a broad overview of the applicable requirements. A tax professional can help you understand the requirements of the issuing corporation as you make plans to sell stock in the company.

Requirements of the shareholder/business owner

  • The shareholder must be non-corporate, meaning that individuals, trusts or estates meet the qualifications.
  • In certain cases, the shareholder can be a partnership or S Corporation, but other requirements must be met in those circumstances. The owners of these pass-through entities are, in fact, non-corporate shareholders, but you’ll need to check to make sure you conform with all IRS rules to meet the qualification standard.
  • A critical qualification standard is the holding period. Once qualifying stock is purchased, the shareholder must retain it for more than five years before the sale can occur. The date of issuance is considered the start date of the holding period.
  • The stock must have been obtained by the shareholder on the date of initial issuance, and it must have occurred after Aug. 10, 1993. There are exceptions to this. For example, the stock could have been obtained as a gift or inheritance from another individual who acquired the stock at initial issuance.
  • It can also be stock that was received as compensation for services provided to the corporation.
  • Note that the initial issuance date does not have to be the date on which the company was originally incorporated.

This is a broad overview of the key requirements for individuals to qualify under Section 1202. Professional expertise will be critical to help you assess whether your ownership position meets all requirements.

The difference the Section 1202 tax benefit can make

Assuming qualification requirements of Section 1202 are met, you have the opportunity to reduce your tax bill when selling shares of the company. You can exclude a maximum of the greater of $10 million or 10 times the adjusted basis of the stock.

“The savings for a business owner who is preparing to sell can be substantial. It includes the capital gains tax rate of up to 20%, plus the 3.8% Net Investment Income Tax for federal tax purposes alone, possibly more depending on the state of residence.”

- Karen Jonas, senior vice president, managing director of CFO Services at Ascent Private Capital Management of U.S. Bank.

Here’s an example of how the exclusion works under the most favorable terms of Section 1202, when stock was initially issued after Sep. 27, 2010. If you invested $3 million when company stock was first issued on January 2, 2017 and planned to sell the stock in mid-2022, the five-year holding period requirement would be met. The stock will be sold for $25 million, resulting in a $22 million capital gain. If it’s determined that the stock meets the Section 1202 requirements, the full amount of the capital gain would be excludable from capital gains taxes and the NIIT (the gain is less than ten times the adjusted basis of the stock of $3 million). By avoiding 23.8% in taxes, you as the seller would retain the full $25 million in proceeds from the sale with no tax consequences. That represents a savings of $5,236,000 in taxes.

“If you qualify for this provision of the law when you sell company stock, it’s a real opportunity for notable tax savings,” says Jonas. She also points out that if your company stock was issued as “S Corp” stock initially, you can switch the corporate structure to a C Corporation to meet the qualifications as a stock issuer. If you switch the corporate structure, the original date of issuance still holds, so the five-year holding period requirement is not affected.

“If you’re considering completing a sale under Section 1202, you’ll want to work with your tax advisor to do a projection on what the ultimate result would be,” says Jonas. “Look at the sale price and what the gain would be versus a standard stock sale or asset sale, or other form of business transition such as gifting stock.” She notes that for some clients, completing a corporate reorganization and a stock-for-stock exchange would be a consideration.

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