Selling Your Business? Find Out About Section 1202 to Avoid Taxes on Your Capital Gain

Investing in emerging fields like tech and software can have enormous tax advantages. When entrepreneurs sell their businesses, they may be able to exclude up to 100% of capital gain under Section 1202—up to $10 million or 10 times their investment, whichever is more. Both founders and their investors qualify for the exclusion after they have owned the company for five or more years.

If you want to position yourself for the Section 1202 gain exclusion when you sell your business, you may need to change the structure of your business to make an easy sale.  

Requirements for Claiming a Section 1202 Gain Exclusion

When selling a business or stock, having the wrong structure can be incredibly costly. For example, selling a business after changing the organizational structure from a C Corporation to a trust disqualifies the seller from the Section 1202 gain exclusion.

To qualify for the exclusion, a small business must meet the following requirements:

1. Its aggregate gross assets did not exceed $50 million at any time on or after August 10,1993, and before the issuance.
2. Its aggregate gross assets do not exceed $50 million after the issuance.
3. It is a U.S. C Corporation and will continue to be so when its stock transfers to a buyer.
4. The owner bought its stock with cash, property, or services.
5. Its stock must be stock as defined in the federal income tax code. Non-vested stock, stock options, and warrants are not Q.S.B.S.

While corporate stockholders are ineligible for Section 1202’s gain exclusion, stockholders of other business entities may qualify for the gain exclusion. This includes individuals, trusts, and pass-through entities.

Which Business Investments Qualify for Capital Gain Exclusions?

The capital gain exclusions in Section 1202 were designed to stimulate the economy. Thus, qualified trades or businesses are those creating jobs and/or knowledge including manufacturing, technology, research and development, and software.

Investments in service industries are not qualifying stock purchases. Section 1202 lists the following fields as not qualified for the capital gain exclusions:

A. Accounting, actuarial science, athletics, brokerage services, consulting, engineering, financial services, health, law, performing arts, or any other profession in which the main asset is the reputation or skill of employees.

B. Banking, financing, insurance, investing, or other financial services.

C. Farming.

D.  Oil and gas production covered under Section 613 or 613A.

E. Operation of hotels, motels, restaurants, or similar businesses.

In addition, property management is not a qualified business (Section 1202(e)(7)).

When you are structuring a business for easy sale and positioning yourself for capital gain exclusions, stay focused on its qualifying mission. You need to invest at least 80% of the corporation’s assets (by value) in qualified business activities to receive the Section 1202 exclusion.

How the Section 1202 Exclusion Became So Lucrative

The federal government sweetened the deal for investors following the Great Recession. Before 2009, Section 1202 allowed certain small businesses and start-ups to exclude 50% of capital gain in their gross income. The 2009 Recovery Act increased the exclusion to 75% of the capital gain of the sale of qualified small business stock (Q.S.B.S.) purchased between February 18, 2009, and September 27, 2010. The exclusion expanded to 100% of capital gain after September 27, 2010. Today, those selling a qualifying business receive:

• 100% exclusion from U.S. federal capital gain tax. (Sometimes the exclusion is a lower percentage. See below.) 
• 100% exclusion from the alternative minimum tax 
• Exclusion from the 3.8% net investment income tax

When you sell a business that does not qualify for Section 1202 exclusions, you probably will be responsible for paying the taxes on gains related to selling small business stock at the maximum rate of 28.7%.

Section 1202 Considerations for the Easy Sale of a Business

When you are ready to cash out on the successful launch of your business, pay close attention to whether your business is structured for easy sale AND for keeping you eligible for Section 1202 gain exclusions. To qualify for the exclusions, you must sell stock, not assets (deemed or actual). However, most buyers want to buy your company’s assets, not your stock. When you offer stock, and the other party is buying most of the shares, they will likely demand a discount. In this scenario, you may benefit from rolling over 20% to 30% of your equity as part of a structured deal. You will be allowed to defer gain, and be positioned to claim a Section 1202 gain exclusion, when the buyer eventually sells the rollover equity.

Many other ways to structure a business for easy sale are buried in the tax code. Here at Swiecicki & Muskett, we are experts at uncovering the opportunities lying just under the surface of the mountains of rules enforced by the I.R.S. and the court system.

Moves for When You Don’t Qualify for Section 1202 (Yet)

Suppose you want to take advantage of the Section 1202 exclusions but can’t because you have the wrong business structure. If you expect significant appreciation of your company’s stock and plan to sell your business or stock, changing your structure from an S corporation to a C corporation is a wise move. Capital gain after the conversion will qualify for exclusion on Section 1202.

The corporate tax team at Swiecicki & Muskett has many other solutions for structuring your business for an easy and lucrative sale. Based in St. Louis County, Christopher Swiecicki and his team serve growing businesses of all structures and sizes. Contact him at 636-778-0209 or email [email protected].