One of the most unnoticed tax benefits of sellers of eligible C corporations is IRC Section 1202. However, qualified small business stock exclusion is a straightforward strategy for tax planning. Let’s learn about all its basics so that your qualifying firm avails of all its benefits.
Many taxpayers were not aware of the tax benefits for C firms until now. Still, since the recent tax laws in the market, businesses have used it as a tax planning strategy to get massive benefits for shareholders.
Prospective benefits for tax rates on capital gains make these benefits even more critical. For tax planning, firms should know the tax benefits of IRC 1202 gain exclusion and shareholders’ needs.
What Comes Under The Section 1202 Or Qualified Small Business Stock Exclusion?
The IRC Section 1202 came out in 1993 to inspire small business investments. It lets business owners get huge tax exemptions on their qualified small business stock (QSBS sales.) And even though it is framed like a small business tax incentive, firms can be large while still being termed “small businesses.”
Gain exclusion from IRC Section 1202 is for issued stock post 10th Aug 1993 and applies to greater than $10 million or is ten times aggregate based on the stock issue time. With section 1202 benefits, firms can make savings on tax rates of more than 23.8% for income tax purposes under the law. Future changes increasing long-term federal capital gain tax rates bring a corresponding increase in the IRC Section 1202 tax benefits.
The shareholder excluded gain depends on corporation investment. Central states also follow a federal treatment based on more savings.
Which Firms Are Eligible For Section 1202?
The stock should meet the below-mentioned criteria. While all these have a few nuances that you can’t take at face value, we’ve gathered an overview for the same. Some depend on the shareholder, while others are based on the activities and facts of the firm.
Let’s know about the things that qualify shareholders for IRC Section 1202 exclusion.
You can hold the stock indirectly or directly. Eligible shareholders are non-corporate ones like estates, trusts, and individuals. If a shareholder is an S Corp or partnership, then the gain qualifies, but it should also meet other needs for the owners to pass through the entity and claim the IRC Section 1202 benefits.
Partnerships often make further changes that reduce benefits for the partners unless the partnership intentionally preserves the qualification of the IRC Section 1202.
Firms should hold the stock for up to five years before disposing of it. Mostly, the stock’s holding period starts on the date of issue. Let’s suppose the company issued the stock for non-cash property exchange. In this case, the holding period for the IRC Section 1202 brings on an exchange date even when the holding is carried over.
When the stock issue is from debt conversion or exercise of warrants or stock options, the stock holding period doesn’t start until the exercise or conversion. Moreover, some hedging transactions disqualify the IRC Section 1202 stock treatment.
To determine whether the shareholder meets the five-year need, the shareholder “tack on” holding periods when you get stock from inheritance as a gift, in partnership distribution, on the stock exchange, or conversions.
Original Stock Issuance
A taxpayer should have the issued stock after 10th Aug 1993 to qualify for the IRC Section 1202. Instead of getting it from the shareholder, they should buy stock from the source company. The stock shouldn’t be issued as a part of the initial incorporation. Stock compensation for services offered to the corporation meets the need. However, the stock in exchange for other stock qualifies.
Taxpayers should get the stock through inheritance and gifts from other individuals who got the issued stock.
Corporation Level Eligibility
Firms should qualify the essential criteria to be eligible for the IRC Section 1202 benefits.
The firm should be eligible at the time of stock issue and during all of the taxpayer’s holding period. We mean any domestic C corp by an eligible corporation with some exceptions (like former DSIC, IC-DISC, REIT, REMIC, RIC, or cooperative).
An S-corp is not an eligible corp for the IRC Section 1202, but the LLC with elected taxes as a C corp is eligible. Furthermore, while the corp is domiciled in the U.S., the firm’s and its subsidiary works can be domestic or global.
Limitation Of $50 Million Gross Assets
The firm shouldn’t have had up to $50 million tax based on its assets at any provided time during 11th Aug 1993, through the moment right after the stock issue. The test is evaluate at the time of each stock issue. After qualifying the asset test, it is not reevaluated later at the stock date. Therefore, stock issued with the firm being less than $50 million in tax basis on its assets continues qualifying, even when its assets cross $50 million.
The test is measured on a tax basis and opens other avenues. With a low tax basis on the assets, a corporation can significantly be up to $50 million while being able to issue small business stock. However, a low equity value firm might not qualify as IRC Section 1202 to issue small business stock with substantial tax amounts based on the assets encumbered with substantial liabilities. However, the assets to the corporation in the stock exchange are measured through fair market value when the corporation gets the property.
As congress encouraged investors to invest in small business firms, it wanted to avoid scenarios where the invested IRC Section 1202 capital was for funding redemptions of shareholders. Congress cast a wide net to disqualify stock shortly issued before or after stock redemption to prevent the unwanted element. It is among the typical taxpayer’s traps, and it results in inadvertently disqualifying stocks to meet all other needs.
Significant redemptions in the preceding year following stock issuance disqualify stock from the IRC Section 1202. Even redemption of as little as 5% is substantial. The threshold becomes less than 2% with two years more testing time when any related parties are there.
Qualified Business Or Trade
The firm should work as a “qualified” business or trade. It includes firms other than the ones in the below-listed business. Unfortunately, only limited guidance is available on the meaning of most of these terms and how to interrupt them, leaving room for both the IRS and taxpayers.
Active Business Need
The firm should use a minimum of 80% of the fair market value of the assets in the qualified trade or active business conduct. They should satisfy the requirement at the substantial holding period of a taxpayer. So the corporation has activities for prohibited businesses listed as long as the asset value in the business is under 20%. Furthermore, only 50% of the assets corporation are made through working capital held to help with business needs or research.
For this need, the firm automatically fails for the IRC Section 1202 to meet it if:
- 10% or more of the net assets of the stock have securities in other corporations where the firms don’t own up to 50%; or
- 10% or more of the firm’s gross assets are real properties not used in qualified business processes.
For firms that just started, are thinking of exit transactions, or you’ve already sold stock, it is vital to get all the information to get IRC Section 1202 exclusion. Industry-leading CPAs and tax professionals from Business Tax Benefits have extensive knowledge about Section 1202 and the best ways to get its benefits. Regardless of your firm’s size, we’ve acquired cutting-edge tax-saving solutions to focus on business work. Contact our expert team to know more about the IRC Sec 1202.