One of the most powerful and often overlooked provisions of the Internal Revenue Code is section 1202. However, when asked about this total or partial exclusion for capital gains of stock, most need clarification on whether their accounting team has considered this. There are specific requirements that must be met. Still, it is undoubtedly worth the time and effort in having the conversation since the exclusion would exclude from gross income capital gain in an amount equal to the greater of (i) 10 million or (ii) an annual exclusion of 10 times their basis in the stock (for an exclusion amount up to $500 million).
Yes, you read that correctly.
If you are wondering why you have never heard of it, it is likely because, like most things, there are caveats and levels of requirements.
Here are some of the requirements on the issuer side:
- The company must be a domestic C-Corporation at ISSUANCE of the stock AND upon the shareholder’s sale
- The company must be engaged in a “QTB” or qualified trade or business. This excludes interactions involving services rendered for health, law, accounting, actuarial science, performing arts, financial services, brokerage services, or any trade or business where the company’s principal asset is the reputation of skill one or more of its employees. Several other classes of industries, including farming, banking, hotels, restaurants, and such, do not qualify
For the most part, tech companies usually qualify as a trade or business unless the main component of their business is service related. The devil is in the details, and a review of your business structure, including the revenue streams, is usually required to make a complete determination.
- The company must use at least 80% of the value of its assets in the active conduct of the QTB
- The company’s gross assets at all times before issuance and “immediately after” must not exceed $50 million
- The company must not have engaged in certain redemption transactions for its shareholders
There are also requirements on the shareholder side, which include but are not limited to the following:
- The shareholders must not be another C Corporation. It can be an individual, trust, partnership, S corporation, mutual fund, or common trust fund
- Must buy the stock from the company and not from another shareholder in the original issuance. There are exceptions, including gifting, distributions from partnerships, and tax-free reorganizations where stock is exchanged for other stock
- Most importantly, the stock must be held for more than five years, and the said shareholder must avoid certain hedging transactions
There are planning opportunities for 1202 that include conversing with your accountants about the company’s structure and how you can maximize the gain exclusion. Some of these planning opportunities include the exceptions for how the stock changes hands throughout the company’s life, which involve gifting, “stacking,” and “packing.” Withum is here to answer any questions regarding 1202 and has helped many companies secure this favorable exclusion.