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The Magical Section 1202 Provision – Where a 0% Capital Gain Tax Rate Becomes a Reality

Industries: Technology

Services: Tax

One of the things I love about the Triangle is the entrepreneurial spirit that lives and breathes in the area. When I joined Hughes Pittman & Gupton (“HPG”) 15 years ago, I remember thinking that the Firm fit right into this spirit, in how it operates and thinks on behalf of its clients.

That said, I came from the land of family-owned tool and die manufacturing in Pennsylvania, where the exit plan for most companies was a pass-down to the next generation. I knew nothing of this magical Section 1202 provision, until I entered the start-up scene in NC.

Founders and early investors in companies can exclude 100% of the capital gain associated with selling their stock. I remember thinking “Can this be real?,” then researching intently to understand, “It is real!”  Of course, this is all subject to the set of rules that come with Section 1202, but with thoughtful planning, these rules are not difficult to meet and can dramatically change an entrepreneur or investor’s take-home cash after an exit.

The exclusion isn’t always 100% - it can be 50%, 75% or 100% depending on when the stock was issued. The 100% exclusion was made permanent for stock issued after September 27, 2010. The maximum amount of gain eligible for the exclusion is the greater of $10M or ten times the amount of the investor’s basis in the stock acquired. To qualify, the investor must be an individual, must hold the stock for at least five years, and meet the other rules under Section 1202.

So, what are the other rules? Like any rules put forth by the IRS, there are quirks and things you must understand about them; but generally speaking, aside from the ones above, there are four:

  1. The corporation issuing the stock is a C Corporation,
  2. The stock satisfies the original issuance requirement,
  3. The corporation issuing the stock satisfies the “qualified small business” requirement, and
  4. The corporation issuing the stock satisfies the active trade or business requirement.

Section 1202 is designed to encourage new investment in small corporations so there are also rules regarding redemptions intended to prevent circumventing the original issuance requirement.

It takes some experience to know who should qualify (for example, rule 4 above requires that the business not be on a list of excluded types of businesses to start with); but the tax benefit if the company does qualify is pretty magical.

It’s difficult to always get entrepreneurs focused on this because many believe in the “jinx-factor” of thinking too soon about an exit. As a tax professional who advises on exits, I often cringe when we get to an exit and the company unknowingly did something to taint all or part of its stock. Many investors aren’t familiar with the exclusion, so if they aren’t working with a tax professional who is, they may miss it altogether. Since the exclusion is claimed on the individual’s return, it is up to that person to determine if the stock qualifies. My best advice is to consult a tax advisor who is familiar with 1202 so you don’t miss out on this magical tax benefit.