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:
   • The gross assets do not exceed (and have never exceeded)
     $50MM on the date of the stock issue;
   • Immediately after the issuance, the gross assets do not exceed $50MM; and
   • 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.

While a pass-through entity itself cannot take advantage of Section 1202, the shareholders of the pass-through entity may take advantage of the exclusion upon the disposition of QSBS owned by the entity, if the pass-through entity meets certain requirements. The exclusion is only available to the gain attributable to the interest that the taxpayer owned in the pass-through entity on the date the QSBS was acquired. Therefore, if Owner A has a 25% interest in ABC partnership on Jan. 1, 2015, when ABC partnership purchases QSBS for $1MM, then Owner A would only be entitled to 25% of that $1MM, even if ABC partnership purchases more QSBS after Jan. 1, 2015.

2. Original Issuance
   A corporation must have issued the stock after Aug. 10, 1993, and in exchange for money, property, or services but not in exchange for stock. The prohibition against acquiring QSBS through the exchange of stock is an issue when a corporation engages in a recapitalization or reorganization. However, Section 1202 allows for the preservation of QSBS status through certain Section 368 or Section 351 transactions.

Likewise, the holding period for QSBS received upon a transfer by gift, at death, or from a partnership to a partner will be tacked onto the newly acquired QSBS. A similar result occurs upon the exercise of convertible stock.

3. Active Business
   The active business requirement specifies that the corporation must (i) have been a C corporation during substantially all of the taxpayer’s holding period of the stock for which the taxpayer is claiming the exclusion; (ii) use at least 80% of its assets, measured by value, in the active conduct of one or more qualified trades or businesses; and (iii) be an eligible corporation.A qualified trade or business does not include:

• • A business involving the performance of certain professional services;
  • Any banking, insurance, financing, leasing, investing, or similar business;
  • Any farming business;
  • Any business involving the production or extraction of products like oil and gas; or
  • Any business operating a hotel, motel, restaurant, or similar business.

An eligible corporation does not include:

1. A domestic international sales corporation (DISC) or former DISC;
2. A regulated investment company, real estate investment trust, or real estate mortgage investment conduit (REMIC);
3. A cooperative;
4. A corporation where more than 10% of the value of its assets consist of stock or securities in other corporations which are not subsidiaries; or
5. A corporation where more than 10% of the total value of assets consist of real property.

B. Maximizing the Gain Exclusion

The available gain exclusion for QSBS depends on the date of issuance and whether the gain exceeds the dollar limitation that applies to each taxpayer individually.

1. Percentage Limitation
   The maximum gain exclusion percentages, ranging from 50% to 100%, depend on the date of issuance. For example, stock that qualifies as QSBS acquired on July 1, 2001, will only be eligible for 50% gain exclusion upon disposition, whereas stock acquired on July 1, 2011, will be eligible for 100% gain exclusion. Accordingly, any analysis must closely track the date of issuance and incorporate the applicable exclusion percentage.
2. Dollar Limitation
   In addition to the percentage limitations, Section 1202 also provides for a dollar limitation on the amount of gain that may be excluded. Gain excluded in a year by a taxpayer from the sale of QSBS cannot exceed the greater of:

• • $10MM reduced by the aggregate amount of eligible gain taken into account by the taxpayer. This limitation is a lifetime, per-taxpayer, per-QSBS limitation. This limitation is also a per-issuer limitation; or
  • 10 times the aggregate adjusted bases of QSBS issued by such corporation and disposed of by the taxpayer during the taxable year.

C. Potential Disqualification Missteps

There are several easy-to-overlook missteps that may result in the disqualification of QSBS treatment, including (1) disqualifying redemptions by the issuing corporation; (2) inadvertently exceeding the gross asset cap of the issuing corporation; and (3) failing to continually meet the active business requirement. Each of these rules should be closely examined as part of the deal analysis to ensure compliance both during negotiations and until the deal has closed.

D. Rollover Equity Transactions and Section 1202

Rollover equity transactions became increasingly popular during the COVID-19 pandemic as a way for private equity firms to reduce their initial equity investment during uncertain economic times. Rollover equity acts as seller financing, and rollover equity helps ensure that interests are aligned between rollover participants and the target’s buyers. Structuring a rollover equity transaction involves interesting tax planning hurdles where QSBS is involved.

In a typical rollover equity transaction, structuring the transaction to ensure equity rolls over on a tax-free or deferred basis is essential. The initial tax on the rollover equity is deferred until the target company resells. Tax is avoided in these situations by not triggering a sale. However, where QSBS is involved, structuring the rollover as a sale instead of a tax-free transaction results in two benefits: (1) QSBS holders cashing out can avoid tax on gain resulting from the sale, and (2) rollover participants can claim the gain exclusion and receive a step up in basis on the replacement equity. To defer the gain exclusion in a rollover equity transaction, rollover participants must make a timely Section 1045 election.

There are three ways to trigger a taxable rollover: (1) a sale, (2) redemption for cash (that satisfies the redemption requirements above), or (3) a taxable exchange of QSBS for buyer equity. The transaction must also be structured in a manner that does not inadvertently qualify for tax-free treatment, such as under Section 351 or Section 368.

E. Choice of Entity Considerations

In 2018, the Tax Cuts and Jobs Act (TCJA) reduced the corporate tax rate to 21% and eliminated the corporate alternative minimum tax (AMT). The TCJA changes and the growing interest in Section 1202 have resulted in a newfound popularity for C corporations; therefore, a growing number of taxpayers are looking to take advantage of Section 1202 benefits.

Whether advising a startup or venture capitalist, Section 1202 is a helpful tool for practitioners and is growing in use. Keeping an eye out for potential missteps and following the requirements above will assist in achieving compliance with Section 1202.