No one told you You can’t have your cake and eat it too, should have called their accountants and lawyers first.
These professionals receive inquiries from founders, equity investment firms and venture capitalists about ways to save or avoid capital gains taxes on future business sales. Both attorneys and accountants encourage clients to investigate the tax savings offered by forming a Qualified Small Business (QSB) C-Corporation during the early stages of business formation. Using a QSB eliminates capital gains tax on future business sales if the company is incorporated and shares are issued pursuant to Internal Revenue Code No. 1202.
Many startups simply avoid using S-corporations, partnerships, and LLCs with robotics, but savvy tech founders should consider the long-term tax savings provided by IRS Code Section 1202.
This article provides an overview of the major requirements and tax savings offered by establishing an entity under IRC 1202 to maximize the capital gains tax exclusion.
IRC 1202 excludes capital gains tax on the sale of quality small business stock (QSBS) by non-corporate taxpayers if the stock has been held for more than five years. A QSBS is stock in a C-Corporation formed after August 10, 1993 and acquired by the taxpayer as compensation for cash, property, or services. At the time the stock is issued, the corporation may not have a fair market value of more than $50 million.
The IRC 1202 gain exclusion allows shareholders, founders, private equity and venture capitalists to claim a federal income tax exclusion of at least $10 million for the capital gain on the sale of a QSBS.
Prior to 2010, capital gains on QSBS were excluded from taxable income under Section 1202, and the excluded portion was a tax-preferred item subject to an alternative lower tax rate. This rule changed for stock acquired after September 27, 2010 and before January 1, 2015, the gain on such stock was fully excluded and any gain was not a tax preference item. This change was signed into law on December 18, 2015 and made permanent by the Protecting Americans from Tax Hikes Act of 2015.
Changes to IRC 1202 constitute a significant tax savings benefit for entrepreneurs and small business investors. However, the effect of the exclusion ultimately depends on the time the shares are held, the time a trade or business is carried on, and various other factors.
Qualifying for the Section 1202 capital gains tax exclusion requires careful planning
A critical plan that must be determined at the outset is the future sale of the stock, which must be structured as a QSBS sale for federal income tax purposes in order to obtain the capital gains tax exclusion. This can be challenging, as buyers typically opt for an asset purchase that allows for a goodwill offset process in the future.
In many business sales today, buyers expect shareholders to divest a portion of their equity, or receive stock or membership interests in a new entity as part of the transaction. An improper plan can cause QSB shareholders to lose the QSBS capital gains exclusion and pay taxes on the sale. This can happen if there is an impermissible transfer of equity to the LP or receipt of equity of the LLC.
