TAKING ADVANTAGE OF THE SECTION 1202 GAIN EXCLUSION BY HANNAH FISCHER FREY, JESSE D. SITZ & CARRIE SCHWAB, BAIRD HOLM LLP WHILE THE SALE OF A BUSINESS CAN RESULT IN A HEALTHY lump sum for successful founders and their shareholders, the sale often results in recognition of gain, which is subject to taxation. The potential tax liability on gain recognition is where Section 1202 steps in as a beneficial tax planning tool. Section 1202 allows eligible, non-corporate taxpayers who own qualified small business stock (QSBS) for more than five years to exclude up to 100% of the taxable gain recognized by the sale of QSBS. Section 1202 was enacted in 1993 to incentivize small business growth. However, in its initial iteration, the statute only allowed for 50% of QSBS gain exclusion, and the non-excludable portion of gain was taxed at 28%, resulting in a similar tax rate as the standard long-term capital gain rate. The Small Business Jobs Act amended Section 1202 in 2010 to allow for the 100% exclusion of gain, which led to increased interest from business owners and private equity groups. With that said, Section 1202 is often overlooked and plays a significant role in negotiating the sale of any business that qualifies. Certain qualifications must be met to take advantage of Section 1202 gain exclusion. This article details what qualifies as small business stock and how business owners and investors can best take advantage of Section 1202. A. QSBS Requirements Stock qualifies as QSBS where (1) as of the date of issuance, the corporation was a “qualified small business”; (2) the stock was acquired by the taxpayer at its original issue in exchange for money, property, or services; and (3) during substantially all of the taxpayer’s holding period of such stock, the corporation meets the “active business” requirements and is a C corporation. 1. Qualified Small Business A “qualified small business” for the purposes of Section 1202 means a domestic C corporation for which: a.The gross assets donot exceed (andhavenever exceeded) $50MM on the date of the stock issue; b. Immediately after the issuance, the gross assets do not exceed $50MM; and c.The corporation agrees to submit reports to the IRS and its shareholders, as may be required by the IRS. The requirement that a C corporation is the issuer of QSBS results in tricky issues for existing S corporations and partnerships. However, mechanisms are available under Sections 368 and 351 that allow an S corporation to convert into a C corporation or to contribute assets to a newly formed C corporation. I S S U E 6 , 2 0 2 2 12 nebraska cpas
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