Q&A: Why to consider Section 1202 in acquisitions

Section 1202 allows only noncorporate taxpayers (individuals, trusts, and eligible partners in a partnership) to potentially exclude up to 100% of the gain from the sale of qualified small-business stock (QSBS) held for more than five years. Under Section 1202(a)(4), 100% of gain from the sale or exchange of QSBS acquired on or after Sept. 27, 2010, may be excluded up to the greater of either:

• $10 million reduced by the aggregate amount of eligible gain taken into account for prior taxable years and attributable to dispositions of stock issued by such corporation
• 10 times the aggregate adjusted basis of QSBS issued by such corporation and disposed of by the taxpayer during the taxable year

The IRS and the U.S. Department of the Treasury have issued limited guidance related to Section 1202. Section 1202 has not attracted the interest of private equity or business founders until recently because the 100% gain exclusion started to apply after Sept. 27, 2015. The reduction of the corporate income tax rate from 35% to 21% in 2018 also made a C-corporation structure more attractive.

What are the IRC Section 1202 requirements?

For stock to be considered QSBS under Section 1202, it must meet the following requirements:

• Original issuance. Domestic C-corporation stock must be acquired directly from the issuing corporation in exchange for money or other property (not including stock) or as compensation for services provided to the corporation.
• Gross assets. The aggregate gross asset basis of the corporation must not have exceeded $50 million at any time on or after Aug. 10, 1993, until immediately after the shareholder acquires the stock.
• Active business. During substantially all of the shareholder’s holding period, at least 80% of the corporation’s assets must have been used in the active conduct of a qualified trade or business.
• Qualified trade or business. Section 1202(e)(3) defines “qualified trade or business” as any trade or business other than an enumerated list in the code.

What is considered a qualified trade or business?

A qualified trade or business for Section 1202 does not include the following:

• Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees
• Any banking, insurance, financing, leasing, investing, or similar business
• Any farming business (including the business of raising or harvesting trees)
• Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A
• Any business of operating a hotel, motel, restaurant, or similar business¹

Limited guidance is available on exactly what most of these terms mean and how broadly they should be interpreted. For example, while services performed by doctors are in the field of health, what about in-home personal care that does not provide nursing services or a health club? 

What is a potential Section 1202 benefit for private equity?

Assume 10 individual partners in a private equity fund each invest $2 million into a partnership that purchases QSBS stock for $20 million. If the partnership sells the QSBS after five years for $220 million, all the partners would be able to exclude all of their individual gain (because each partner has a $2 million basis and would be eligible to exclude gain equal to 10 times their basis).

Being able to determine the gain exclusion at the partner level instead of at the partnership level can be extremely attractive to private equity investors.

What are some of the challenges associated with Section 1202?

• Regularly monitoring to ensure Section 1202 requirements are met
  • For example, a change in business or new nonqualified trade or business lines might impact the active business requirement resulting in negating the QSBS status
• Structuring bolt-on acquisitions to maintain QSBS status
• Calculating the $50 million gross asset test could be complex
  • For example, testing multiple investor rounds and the impact of roll-over equity transactions
• Stock redemptions causing stock to be ineligible for QSBS treatment
• Offsetting the potential benefits of gain exclusion during the holding period by potential incremental income tax due to operating the business as a C corporation rather than a flow-through entity (for instance, a partnership)

While conceptually simple, the application of Section 1202 warrants careful, qualified, professional tax assistance when initially considering an investment as well as during the hold period of the investment.

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¹ ”26 USC 1202: Partial exclusion for gain from certain small business stock,” Internal Revenue Code, https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section1202&num=0&edition=prelim