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Use IRS Code Section 1202 to sell your multimillion-dollar startup tax-free

Whoever said you can’t have your cake and eat it too should have called their accountants and lawyers first.

These professionals often receive inquiries from founders, equity investment firms and venture capitalists looking for ways to save on or avoid capital gains taxes on future business sales. Both lawyers and accountants encourage clients to examine the tax savings offered by setting up a Qualified Small Business (QSB) C-Corporation at the initial business formation stage. Using a QSB can eliminate capital gains tax due on the future business sale if the company is established and stock issued pursuant to Internal Revenue Code Section 1202.

Many startups often simply default to a robotic use of S-Corporations, partnerships, and LLCs, but savvy tech founders should consider the excellent long-term tax savings afforded by IRS Code Section 1202.

This article provides a general overview concerning the major requirements and tax savings provided by forming a startup entity structured to maximize the capital gains tax exclusion in IRC 1202.

IRC 1202 excludes capital gains tax realized on the sale of qualified small business stock (QSBS) of non-corporate taxpayers if the stock has been held for more than five years. QSBS is stock in a C-Corporation originally issued after August 10, 1993, and acquired by the taxpayer in exchange for money, property or as compensation for services. The corporation may not have gross assets in excess of $50 million in fair market value at the time the stock is issued.

The IRC 1202 gain exclusion allows stockholders, founders, private equity and venture capitalists to claim a minimum $10 million federal income tax exclusion on capital gains for the sale of QSBS.

Prior to 2010, only part of the capital gain on QSBS was excluded from taxable gain under section 1202 and the portion excluded from gain was an item of tax preference subject to alternative minimum tax. This rule was changed for stock acquired after September 27, 2010, and before January 1, 2015, such that the gain on such stock was fully excluded and no portion of the gain was an item of tax preference. This change was made permanent by the Protecting Americans from Tax Hikes Act of 2015, signed into law on December 18, 2015.

Given the changes to IRC 1202, it constitutes a significant tax savings benefit for entrepreneurs and small business investors. However, the effect of the exclusion ultimately depends on when the stock was acquired, the trade or business being operated, and various other factors.

Qualifying for Section 1202’s capital gains tax exclusion takes careful planning

The critical plan to be determined at the outset is the future stock sale, which must be structured as a sale of QSBS for federal income tax purposes to achieve capital gains tax exclusion. This can be a challenge, as buyers typically prefer asset acquisitions permitting a step-up in basis and future goodwill amortization.

In many business sales today, buyers expect stockholders to roll over a portion of their equity, or receive stock or membership interests in a new entity as part of the transaction. Imprecise planning will cause the QSB stockholders to forfeit the QSBS gain exclusion and owe tax on the sale. This can happen if there is an impermissible equity rollover to an LP, or receipt of LLC equity.

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