A Roadmap for Obtaining (and not Losing) the Benefits of Section 1202 Stock
IRC § 1202 has been around for years, but has not received a lot of attention. This inattention has resulted in large part from IRC § 1202's complicated qualification rules, not to mention the planning uncertainties associated with a required five-year holding period.
In two recent articles, we discussed the benefits of qualified small business stock (QSBS). Under IRC § 1202, 100% of gain on the sale of QSBS acquired after September 27, 2010, is generally excluded from tax. Also, gain on the sale of QSBS is no longer included as an alternative minimum tax preference item. We also discussed the impact of the reduction of corporate rate from a maximum of 35% to a flat 21% and the elimination of the corporate alternative minimum tax. We predicted that while these benefits will not in most cases tip the scales in favor of the C corporation over a pass-through entity, there will certainly be increased interest in C corporations.
IRC § 1202 has been around for years, but has not received a lot of attention. This inattention has resulted in large part from IRC § 1202's complicated qualification rules, not to mention the planning uncertainties associated with a required five-year holding period. These problems continue to apply, but if C corporations are being considered on their own merits, understanding how to qualify for the additional benefits of QSBS are an important part of choice of entity planning.
If stock acquired after September 27, 2010, qualifies as QSBS and the five-year holding period is satisfied, then the holder can sell the stock and exclude 100% of the gain up to the greater of (i) $10 million in the aggregate for all sales of such issuer's QSBS by the holder, or (ii) 10 times the aggregate adjusted tax basis of the QSBS of such issuer and disposed of by the holder during the tax year. IRC § 1202 has rules regarding the allocation of the $10 million per-issuer limit between spouses. A sale for IRC § 1202 purposes might be a direct sale by the holder, the redemption of QSBS by the issuing corporation, or a liquidating distribution by the issuing corporation (usually following the sale of its assets).
The amount of gain excluded by IRC § 1202 is not subject to the 3.8% Medicare tax and is not subject to the alternative minimum tax (for QSBS issued after September 28, 2010). The gain may also be excluded from state and local taxes if the taxing jurisdiction follows federal income tax laws.
The following discussion works through both the general eligibility requirements and pitfalls associated with obtaining and keeping QSBS status and obtaining the benefits of IRC § 1202, and the IRC § 1045 rules relating to the rollover of Section 1202 gain
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Attorneys at Frost Brown Todd have developed substantial experience assisting business clients with their entity tax planning and governance issues, and in particular working with founders organizing closely-held businesses. If you need assistance or would like additional information, contact Scott Dolson, Ben Hager, Nelson Rodes or any other member of the Tax Law Practice Group for Tax Law Defined™.
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Alison M. Stemler is FBT’s Employee Benefits Team leader. She advises on executive compensation and employee benefits plans, including equity-based and deferred compensation arrangements, and assists with compliance issues for retirement and welfare plans and HIPAA.