By Christopher L. McLean, ESOPs, Benefits & Compensation

Overview
Business owners considering exit options from their businesses often can be blinded by purchase price figures and proceeds, often “accepting” that paying capital gains tax is part of the deal. The ability to avoid or defer capital gains taxes makes a substantial difference in the ultimate “take home” amount for the selling business owner. As business succession advisors, we have long championed the use of the Internal Revenue Code (Code) Section 1042 election to roll over capital gains taxes for C-Corp shareholders selling to an Employee Stock Ownership Plan and Trust (ESOP). In recent years, however, we’ve been able to help advise and assist an increasing amount of clients in capitalizing on another—even more favorable—tax election: Code Section 1202 – Qualified Small Business Stock Gain Exclusion.

What is Code Section 1202?
Code Section 1202 was enacted in the early 1990s to allow individuals to avoid paying taxes on up to 100% of the taxable gain recognized on the sale of qualified C-corporation small business stock (QSBS). Even though its original intent was as an incentive for investment in small businesses, a company can be quite large and still qualify as a “small business.”

The gain exclusion is available for stock issued after August 10, 1993, and the amount of gain that can be excluded from income for federal tax purposes is the greater of $10 million or 10 times the aggregate adjusted basis of the stock at the time of the stock’s issuance. Code Section 1202 can create an effective tax rate savings for federal income tax purposes under current law, and any future tax law changes that may increase the federal long-term capital gains tax rate will result in a corresponding increase in the tax benefit of Code Section 1202. The amount of the gain excludible by shareholders depends on the date of investment in the company. Many states also follow the federal treatment, resulting in even more substantial savings as the gains may be excluded from state income taxes as well.

Quite simply, a qualifying business owner selling stock in a qualifying business may exclude from recognition on his taxes the earnings from the sale of stock—currently a savings benefit of 23.8% for federal income tax purposes.

Recent Case Study
We recently had the opportunity to advise shareholders of an aerospace manufacturing firm on the sale of 100% of their stock to an ESOP Trust. In addition to our normal ESOP feasibility work exploring the sale structure’s impact on both the company and the shareholders, including Code Section 1042 analysis, we undertook an additional Code Section 1202 analysis for each of the almost two dozen shareholders.

While all of the shareholders satisfied the requirements for election of long-term capital gains rollover under Code Section 1042, not all of the shareholders were eligible for an election under Code Section 1202 for the exclusion of long-term capital gains due to the numerous, and often complex, requirements discussed further below. However, a handful of the shareholders were able to qualify and elect for long-term capital gains exclusion under Code Section 1202, and here’s one example:

Shareholder A was issued stock in the Company in February of 2012, in exchange for $200,000 in cash. In 2023, Shareholder A was one of many shareholders who sold shares to the Company’s ESOP Trust. Shareholder A sold his stock for $7.2 million, realizing a $7 million gain ($7.2M – $200,000 basis = $7M gain). Upon thorough analysis, Shareholder A satisfied the shareholder-level requirements and the Company satisfied the corporate-level requirements for Code Section 1202. Accordingly, Shareholder A elected under Code Section 1202 to exclude 100% of his $7 million gain, as the limit for exclusion under Code Section 1202 is the greater of $10 million or 10 times his initial basis of $200,000 ($2 million).

Since Shareholder A’s entire $7 million of gain realized would be excluded from income, Shareholder A paid $0 tax on the sale of stock. Without Code Section 1202, Shareholder A would have paid 23.8% on his entire gain, resulting in a tax liability of $1.7 million. Additionally, since Shareholder A resides in a state without income or long-term capital gains taxes on the state level, Shareholder A also paid no state taxes. By using Section 1202, Shareholder A saved almost $2 million in tax on a $7.2 million stock sale.

Like many valuable tax incentives, the requirements to qualify for Code Section 1202 are complex with numerous traps for the unwary and, combined with very little guidance from the IRS, Code Section 1202 creates challenges for taxpayers navigating the rules.

What are the requirements to qualify for Code Section 1202 gain exclusion?
There are several complex requirements for Code Section 1202 and, while some are straightforward, they all can become complex when undertaking a case-by-case analysis. Below is a high-level breakdown of the eight requirements, which can be divided into two categories: Shareholder Requirements and Company Requirements.

Shareholder Requirements for Code Section 1202

1. Eligible Shareholder

The underlying stock subject to sale must be held, directly or indirectly, by an eligible shareholder. In general, eligible shareholders are non-corporate shareholders, such as individuals, trusts, and estates.

In the event that a shareholder is a partnership or S corporation, the gain may still qualify, but additional requirements must be met in order for the non-corporate owners of the pass-through entity to claim the benefits of Code Section 1202. In particular, partnerships tend to create additional challenges that may reduce the ultimate benefit to the partners unless the partnership is designed intentionally to preserve the Code Section 1202 qualification.

2. Holding Period

The stock must be held for more than five years before it is disposed of in a sale transaction. Generally, the holding period of the stock begins on the date the stock was issued to the shareholder.

If the stock was issued in exchange for non-cash property, then the Code Section 1202 holding period would begin on the date of exchange even if the shareholder’s holding period for general tax purposes carries over from the time owning the non-cash property.

When the underlying stock was issued from the conversion of debt or the exercise of stock options or warrants, the holding period would begin upon the conversion or exercise—not the time of original issuance of the debt instrument or award.

In determining whether a shareholder has met the five-year requirement, a shareholder may be able to “tack on” previous holding periods if the stock was received from inheritance, as a gift, in a distribution from a partnership, or in certain stock conversions or exchanges.

3. Original Stock Issuance

The taxpayer must have acquired the stock in an original issuance from the subject company after August 10, 1993[i]. In other words, the stock must be acquired directly from the company, rather than another shareholder. However, the stock does not have to be issued in connection with the initial incorporation of the company.

Stock received as compensation for services provided to the company will meet this requirement. Furthermore, stock that is received in exchange for other stock can sometimes still qualify, although it is subject to additional requirements which will need to be thoroughly vetted.

A taxpayer may receive the stock through a gift or as an inheritance from another individual who acquired the stock in an original issuance from the company.

Company Requirements for Code Section 1202

4. Eligible Company

The company must be an eligible corporation when the stock is issued and during substantially all of the taxpayer’s holding period. An eligible corporation is generally any domestic C-Corp other than certain limited exceptions[ii]. S-Corporations are not eligible. However, a limited liability company (LLC) that has elected to be taxed as a C-Corp is eligible. Furthermore, while the company must be domiciled in the US, the activity of the company or its subsidiaries can be domestic or international.

5. Limit of $50 Million Tax Basis in Gross Assets

The company must not have had more than $50 million of tax basis in its assets at any time from August 11, 1993 (or the company’s incorporation if incorporated after August 11, 1993), through the moment immediately after the issuance of the underlying stock. This test is evaluated at the time of each stock issuance. Once the asset test is met for the underlying stock, this test will not be reevaluated at a later date for that stock. Therefore, stock issued when the company has less than $50 million in tax basis in its assets will continue to qualify, even if the company’s assets later exceed $50 million.

Since this test is measured on tax basis, other opportunities arise. As long as the company has low tax basis in its assets, a company can be worth significantly more than $50 million while continuing to be able to issue qualified small business stock. Meanwhile, a company with a low equity value might not be able to issue qualified small business stock if the company has a substantial amount of tax basis in its assets that are encumbered by substantial liabilities. Nonetheless, assets contributed to a company in exchange for stock are measured by their fair market value at the time the company received the property.

6. Redemption Transactions

When considering this requirement, it is important to remember that Congress intended Code Section 1202 to encourage investment in small businesses. Accordingly, Congress wanted to prevent situations where capital invested for Code Section 1202 was used to fund redemptions of other shareholders (where the capital is never paid into the company). To prevent this, Congress drafted text that cast a wide net in disqualifying stock that is issued shortly before or after a redemption of stock. This is one of the most common traps for taxpayers and results in inadvertently disqualifying stock that met all of the other requirements (including most of the shareholders in the transaction underpinning the case study above).

Any “significant” redemptions in the one-year period preceding or following a stock issuance will disqualify the stock from Code Section 1202. For instance, even a redemption as small as 5% of the company’s equity can be considered “significant.” When related parties are involved, the threshold is reduced to 2%, and the testing period is extended to two years before or after the stock issuance (talk about a wide net). There are some exceptions that may apply in determining whether the amount of stock redeemed is large enough to trigger disqualification, as well as permitting redemptions of any size in limited circumstances, such as death, disability, or termination of services.

7. Qualified Trade or Business Requirement

The company must be engaged in (or performing activities to start up) a “qualified” trade or business, which generally includes any trade or business except personal services[iii], financial[iv], farming[v], oil/gas mining[vi], hospitality[vii], and real estate[viii].

Unfortunately, the IRS has provided very limited guidance on exactly what most of these terms mean or how broadly they should be interpreted, leaving room for interpretation by both taxpayers and the IRS.

8. Active Business Requirement

The company must use at least 80% of the fair market value of its assets in the active conduct of a qualified trade or business. This requirement must be satisfied during substantially all of the taxpayer’s holding period of the stock. Therefore, a company can have activities related to some of the prohibited businesses listed above as long as the value of the assets used in that prohibited business are under 20% of all assets. Further, only up to 50% of the company’s assets can be made up of working capital held to support reasonable needs of the business or to support research.

For purposes of this requirement, a company will automatically fail to meet this test if:

• 10% or more of the company’s net assets consist of stock or securities in other companies in which the company does not own over 50%; or
• 10% or more of the company’s gross assets consist of real property not being used in the active conduct of a qualified business.

How is Code Section 1202 different from Code Section 1042?
While elections under Code Sections 1202 and 1042 appear similar, each is fundamentally different in application and function. For instance, even though Code Section 1202 contains complex rules for qualification, it does not contain any limitation with respect to any certain type of purchaser in the stock sale. Conversely, the election under Code Section 1042 is only available to C-Corp shareholders that are selling to an ESOP Trust in a transaction that meets the requirements set forth in Code Section 1042.

Additionally, both have fundamentally different tax implications under the Code and produce different tax outcomes for the electing taxpayer. Code Section 1202 provides an election for the taxpayer to exclude the gains from recognition as income for tax purposes, meaning that the selling shareholder takes home sale proceeds that are “tax-free” and can then do as it pleases with those funds.

Meanwhile, Code Section 1042 is an election to roll over or defer long-term capital gains taxes at the time of sale—it does not make those proceeds “tax free.” Although this means that the taxpayer does not recognize the earnings as income at the time of sale, it requires that the taxpayer reinvest the proceeds into qualifying securities, which then carry the same tax basis as the stock sold in the 1042 transaction. If the qualifying securities are ever sold, then the taxpayer recognizes the full amount of gain at that point of disposal. The way that an election under Code Section 1042 can avoid long-term capital gains taxes down the road is if the taxpayer making the election passes away before disposing of the qualifying securities, at which time the qualifying securities will have a stepped-up tax basis to the fair market value of such securities at the time of the taxpayer’s death. Then, those securities could be sold, and no (or very little) long-term capital gains tax would be paid.
 
Questions?
Code Section 1202 contains numerous complex requirements that present many potential traps for the unwary, which necessitate the guidance of experienced advisors to navigate. If you have any questions about Code Sections 1202 and 1042, ESOPs, or business succession in general, feel free to contact Christopher L. McLean at clmclean@kaufcan.com or any member of Kaufman & Canoles’ ESOPs, Benefits & Compensation Group.

The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2024.