Expertise Beyond the Numbers

Investing Insights Part 1: Are You Utilizing Valuable Tax Planning Opportunities?

As an investor it is important to not overlook important tax incentives. Thoughtful investment planning requires working with a tax advisor to review how you can be managing your portfolio. Taking the time to fully understand the tax consequences through investments in specific funds will help you produce efficient tax results. The following is a deep dive into the potential advantages you can obtain for your investment funds through Section 1202.

What is Section 1202 and How Does Someone Qualify?

Section 1202 allows non-corporate taxpayers to exclude all or part of a gain when qualified small business stock is sold. The potential savings here are significant so it’s important to give this consideration when structuring transactions.

To qualify as Qualified Small Business Stock (QSBS) under §1202, all of the following must apply:

  • The stock must be in a domestic C Corporation.
  • The stock must be acquired by the taxpayer at original issue in exchange for money, other property (not including stock), or as compensation for services provided to the corporation.
  • The corporation must have gross assets under $50 million as of the date the stock was issued and immediately after. These assets are valued at original cost instead of fair market value, with the exception of contributed property.
  • The corporation must conduct an “active business” rather than be an investment company during the entire holding period of the taxpayer’s stock. At least 80% of the assets must be used in the active business.

What are the Tax Benefits?

If you have held stock that meet the qualifications above for at least five years, you may be able to exclude a portion or all of your gain for federal tax purposes. The remaining capital gain is taxed at 28% (assuming you are in the 15% or 20% brackets for regular long-term capital gains). The gain exclusion is limited to $10 million or ten times the adjusted basis in the stock*.

(*Note – The $10 million exclusion is one-time only. A taxpayer cannot exclude $10 million in year 1 for selling part of the stock and then exclude an additional $10 million in year 2 for an additional sale of stock in the same QSBS.)

Depending on when you first acquired the QSBS, the exclusion percentages vary. As time has passed, the exclusion percentage has increased because Congress wanted to encourage investment in small businesses. With the passage of the PATH Act in 2015, the 100% exclusion window was made permanent which is great news for those investing in small businesses. The table below shows the federal exclusions for regular and AMT purposes.

Federal Exclusion of Gain:

Acquisition Period Percent Exclusion
(Regular Tax)
AMT
Add-back %
Before 2/18/2009* 50 7
2/18/2009 – 9/27/2010 75 7
9/28/2010 and Later 100 0

 

*If the acquisition occurred before January 1, 2000, AMT add back is 42%.

Please note that some states follow the federal tax treatment for sale of QSBS while others have different rules. This is often overlooked when structuring transactions. The net investment income tax does not apply to the gain excluded from capital gains tax under §1202.

Planning Considerations:

If you have stock that qualifies as QSBS, make sure you keep good records so that you can claim your QSBS benefits. If you think you are buying stock that may eventually qualify for QSBS treatment, ask the company to certify that it meets those qualifications now.

Make sure you know when your investment reaches the five-year holding period. You don’t want to sell too early and miss out on potential benefits.

If you plan to invest in small businesses, contact your tax advisor to make sure you are taking advantage of any potential tax saving opportunities.

 

Robin Boyd and Ashley Caudle co-authored this piece.  They are both members of the SC&H Group Investment Funds Tax Team.