M&A Tax Planning – Qualified Small Business Stock – Potential for Large Gain Exclusion on Sale

By April 13, 2018 July 8th, 2019 April Tax Newsletter, Mergers & Acquisitions

Section 1202 was passed to encourage economic activity, employment, and investment in new ventures and small businesses. Under section 1202, a non-corporate taxpayer is able to exclude gain from the sale or exchange of qualified small business stock (“QSBS”) held more than five years from their taxable gross income. The recent passage of the Tax Cuts and Jobs Act of 2017 did not alter the QSBS benefit, however, the reduction of the corporate tax rate for C corporations to 21% has brought section 1202 to the forefront of small business tax planning. The combination of the new lower corporate tax rate and the section 1202 gain exclusion (discussed below) on the sale of stock should entice corporate executives to work with their tax advisors to understand if they can satisfy the 1202 requirements.

Depending on when the stock was issued, different percentages of gain can be excluded.  For example, if the stock of a qualifying U.S. corporation was acquired after September 27, 2010 then there is a 100% gain exclusion up to the limit. The maximum amount that can be excluded from taxable income is the greater of (i) $10 million per issuing corporation reduced by the eligible gain on the issuer’s stock excluded by the taxpayer in prior years or (ii) 10 times the taxpayer’s aggregate adjusted basis of the QSBS disposed during the tax year. Furthermore, the QSBS gain excluded from income is also excluded from the Net Investment Income Tax (“NIIT”).  In order to receive the benefits of QSBS the following requirements must be met: (i) must be stock of a C corporation; (ii) shareholder must hold their stock for a minimum of five years before a disposition; (iii) stock must be acquired at original issuance; corporation must have less than $50m in assets before and immediately after the date the stock is issued; and the corporation’s business must not be a “service” business.[1] Because certain entities can convert to C corporations and have the C corporation stock still qualify as QSBS, timing is of the essence if a near to mid-term exit strategy is being considered.

How to Qualify?

The analysis required to determine if C corporation stock satisfies the QSBS requirements is detailed and complex. Please reach out to Joshua Siegel, M&A Tax Senior Manager at 310.826.4474 to discuss how you can take advantage of section 1202.

[1]   This list is non-exhaustive and complex analysis must be undertaken to determine whether stock issued can qualify as QSBS.