Section 1202 Stock: Potentially Huge Tax Savings for Startup Companies

When starting a new business, many people ask which type of legal entity they should setup the company as. Currently, most professionals in the field say startup businesses should be setup using a Limited Liability Company (LLC). While in many cases this is a great choice, there are some instances where other entity options could potentially be more beneficial. To determine this, the company must decide their overall plan with the company.

What is your startup’s end goal?

Many people start companies because they have a great idea for a solution, but they do not think much about their end goal for the company. If their plan is to scale, grow, and then sell their company at a gain, these businesses should consider setting their company up as a C-Corporation in order to take advantage of 1202 Stock.  They might ultimately start as an LLC, but C-Corporation should at least be in the discussion.

Is 1202 Stock right for your startup?

Qualified Small Business Stock (QSBS), also known as 1202 Stock, gets its name from Section 1202 of the tax code. This section of the tax code allows for partial or full exclusion of gain from the sale of qualified stock. In order for the stock to be Qualified, it has to meet the following requirements:

  1. The stock must be issued by a corporation that is a small business corporation, a domestic C corporation with cash and other assets totaling $50M or less.
  2. The shareholder must acquire the stock in its original issue in exchange for money, property, or as composition. It cannot be purchased from a secondary market.
  3. The stock is issued by a C-Corporation that has at least 80% of the value of the corporation’s assets are used in a qualified trade or business and the corporation.
  4. The stock must be held for a minimum of five years.

There are a few industries that the tax code specifically states do not qualify as 1202 stock. Review these with your advisory team before making your entity decision.

What is the exclusion amount for 1202 Stock?

The amount of the exclusion can be quite significant for most taxpayers.  Under current law, the gain eligible for exclusion is the greater of $10 million, reduced by any prior gains excluded for the stock being sold, or 10 times the taxpayer’s basis in the stock that is sold.  For taxpayer’s with a large basis in their stock, they could end up being able to exclude over $10 million in gains.

The acquisition date is also taken into consideration when determining the exclusion amount the taxpayer is receiving.

  • If stock is acquired on or before February 17, 2009, the taxpayer may receive a 50%
  • If stock is acquired on February 18, 2009 and before September 28, 2010, the taxpayer may receive a 75%
  • If stock is acquired on or after September 28, 2010 the taxpayer may exclude 100% of the gain from gross income.

Please keep in mind, the five year holding period still applies regardless of when the stock was acquired.  Additionally, depending on when the stock was acquired, there could be Alternative Minimum Tax adjustments required for the excluded gain.

1202 Stock Example

Facts:

  1. The company is a C-Corporation that was founded on January 1, 2011, and the founder currently has a basis of $100 in her shares.
  2. On February 1, 2018, the founder sold her shares for $10,000,100.
  3. The total gain on the sale of her shares is $10,000,000.

Assuming this C-Corporation meets all of the qualifications for section 1202 Stock, this $10,000,000 gain would be completely excluded from income and result in $0 tax. This would be $2,000,000 in tax savings by structuring the entity as a C-Corporation instead of another entity type. 

As can be seen from this example, proper planning for the entity type when the company is founded can lead to huge tax savings down the road.

While the tax savings are potentially powerful as a C-Corporation, there are other factors that should be considered before making the decision to become a C-Corporation or an LLC.  Additionally, LLCs that convert to C-Corporation may also be eligible for this benefit.  Please contact an Anders advisor for guidance on which entity would be best for the future of the company.