Are you a founder, a C-level or senior executive recruit, or angel investor of a startup life sciences company, a startup tech company, or a startup e-commerce or other high growth company?
If so, did you know that if your startup is properly structured and you hold onto your stock for five years, there may be ZERO Federal tax on the gain when you choose to sell it?
What’s more, even if you sell within five years, you might still achieve zero Federal taxation if you roll-over the proceeds from the sale into one or more similarly qualified small corporations.
Welcome to IRC Section 1202. This is the provision of the Federal tax code that allows you to sell “qualified small business stock” (QSBS) tax-free. Section 1202 can translate into a zero percent federal income taxation rate on your stock sales profits, within certain limits, if you understand how this tax law works.
Talk about a win-win. Keep reading to find out more about this exclusion and whether it could apply to your equity holdings or equity you seek to obtain in your next executive job offer or investment.
What is an IRC 1202 gain? Understanding QSBS Stock and Taxation
If you think the QSBS tax exclusion sounds too good to be true, think again. It was enacted in 1993 to provide an incentive for taxpayers to start and invest in specific types of small businesses. At that time, the law provided a 50% exclusion of limited utility. But with the Great Recession of 2008-2009, the law got a big boost to a 100% exclusion. Originally, it was year to year but then made permanent. Thus, all QSCS acquired after September 27, 2010 are eligible for the 100% exclusion.
Today, the statute continues to provide an exclusion from profits made on any exchange or sale of QSBS stock. The 100% exclusion from Federal taxation applies to all Federal taxation on capital gains, and also includes exclusions from the Alternative Minimum Tax (AMT) and the Net Investment Income tax (NII).
However, restrictions do apply. For example, you must own the stock for five years to take advantage of this fantastic opportunity. But IRC Section 1045 does allow you to roll-over of QSBS to shares of another qualified small business, if the new shares are purchased within 60 days of sale of your prior shares – so you can then continue your holding period to try to reach five years. Remember, too, that not all shares qualify.
How do you know if a business qualifies as a QSBS? For all intents and purposes, garden-variety C corporations and QSBSs are one and the same when it comes to tax and legal purposes. That’s why specific restrictions have been stipulated.
Which businesses and stock qualify for Section 1202?
To be eligible for a tax exclusion, the stock you purchase must meet the following requirements:
- It must be acquired through inheritance, gift, or upon original issuance
- At the date of stock issuance, the corporation must be a QSBS
- It must be a QSBS during substantially all the period you hold it
- You must acquire it in exchange for other property (not including stock), money, or services
At this point, you may be wondering what rules a corporation must meet to be considered a QSBS. They include being a domestic C corporation. The corporation must also be deemed an active business. To fulfill this requirement, at least 80 percent (by value) of its assets must get utilized in its active conduct and not ownership of real estate or passive investments.
Businesses Excluded from Section 1202
Besides meeting the restrictions described above, certain businesses are excluded from QSBS standing. They include companies involved in:
- Banking, insurance, financing, leasing, investing activities
- Agriculture and farming
- Operation of a motel, hotel, restaurant, health clubs, entertainment
- Production or extraction of natural gas, oil, or other natural resources
- Performance of services in the fields of health, law, architecture, engineering, athletics, and general consulting.
The list above is by no means comprehensive. So, make sure that you consult with an experienced startup tax attorney before making any significant decisions.
Despite these exclusions, most companies engaged in production in the high growth innovation areas economy are going to qualify – life science, tech, e-commerce, etc.
Besides the nature of the business, there is a size limitation as well to be a qualified small business corporation. To qualify, the C corporation cannot possess gross assets over $50 million before and immediately after issuance of the stock to you.
Limitations on Excludable IRC 1202 Gains
Other limitations to your tax-free capital gains also exist. For example, tax limits on your eligible gain exclusion must not exceed the greater of:
- $10 million reduced by the number of eligible gains already accounted for in prior tax years from the sale of other QSBS stock (or, $5 million for those who are married but filing separately)
- Ten times the aggregate adjusted basis in the QSBS shares sold
Effect of Built-in Gain with LLC Units Converted to QSBS
An exception is allowed to the C corporation requirement. If the entity was a partnership or LLC when you acquired your interest and there is a later conversion to C corporation status, and your interest converts to C corporation shares in a tax-free exchange, then your shares would be eligible as QSCS, with the holding period and tax basis in your stock starting on the date of conversion.
There is further exception to the exclusion limits in the case of LLC or partnership units converted to C corporation stock that can qualify as QSBS. If your startup equity was originally held in an LLC or partnership, then at the time of conversion to C corporation, a determination is made as to fair market value of your equity position, and from that value the determination is made as to limits on excluded 1202 gain.
This rule can work in your favor or against you depending on the company’s success. For example, your tax basis is $100,000 but at the time of LLC conversion to a C corporation, the fair market value of your stock is $10 million, and then you sell six years later. If your sale price is $15 million, only $5 million would be excluded from your $14,900,000 gain, with the remaining $9,900,000 taxable because it was built in gain attributable to appreciation while held in the LLC. However, if instead, you sold your shares for $80 million, then the same $9,900,000 would taxable because it was built in gain attributable to the LLC, but now the $70 million gains above $10 million would be excluded from taxation because you are permitted to exclude up to 10 x the fair market value of shares at the time of conversion.
Planning your Executive Equity Package to use QSBS to your benefit
As a CEO or other C-level executive considering a job offer with a startup or other qualified small business corporation, it is wise to consider the following planning features in connection with your move.
- Obtain stock not options – only actual stock issued will qualify as QSBS and start your holding period to qualify for tax free treatment
- IRC Section 83(b) election – Make the 83(b) tax election over unvested shares: to the extent you hold options or no such tax election is made, you will be taxed at ordinary income rates until shares vest or non-qualified options are exercised.
- Assure business is qualified – If you receive LLC units, be sure that the conversion occurs when the business is still under $50 million in gross assets or otherwise still a qualified small business corporation at the time of conversion when shares are issued to you.
- Plan your roll-over if needed – If your company is in play and the sale likely to occur within the 5-year holding period, then, so long as you have held your QSBC stock more than 6 months, plan to diversify, using the proceeds to invest in other QSBS, where if such purchases are made within 60 days of sale, you can then tack your holding period, and later achieve tax free treatment when you sell those shares after the 5-year combined holding period.
How to Achieve Zero Taxation on the Sale of Your Company Stock
In this article, we’ve discussed many of the critical rules to help you better understand the opportunities offered by QSBS despite the different restrictions and limitations. We’ve discussed QSBS in terms of timeframes and business types. We’ve also examined stock eligibility and finance restrictions that apply.
Tips have also been offered in structuring your executive equity compensation as a CEO, C-level or senior executive joining a qualified small business corporation. If this sounds like an opportunity that may benefit you, it is wise to discuss this further an experienced executive employment and tax attorney for additional assistance.