When qualifications are met, Section 1202 of the Internal Revenue Code of 1986 (the Code) can provide a fantastic tax benefit for acquirers: capital gains are excluded from federal income taxation up to the greater of (A) $10 million and (B) ten times the taxpayer’s aggregate adjusted basis of qualified small business stock (QSBS) issued by the corporation.

For example, assume Jalen Brunson Fund 1A, LP forms a C corporation newco buyer entity which purchases Ice In His Veins, LLC for $20 million on June 13, 2018. If in an exit that closes on June 14, 2023, Jalen Brunson Fund 1A sells the stock of the C corporation buyer for $100 million, assuming the 1202 requirements are met, Jalen Brunson Fund 1A’s investors would be able to exclude the full $80 million in gain (the greater of $10 million or ten times Jalen Brunson Fund 1A’s adjusted tax basis in the stock) from their income on an exit. Section 1202 would result in a federal tax savings of $19,040,000.00!

In this article, we discuss the requirements to qualify for a Section 1202 exclusion and other points to consider.

Please make sure to consult with a tax professional to ensure compliance with these requirements, to determine what amount of gain can be excluded under Section 1202, and to understand any future changes in the Code.

Key Requirements for a Section 1202 Qualified Small Business Stock Gain Exclusion

There are several requirements for stock to qualify for Section 1202 benefits. While each requirement is subtly complex, below are a few high-level requirements that may influence decision making:

1. The stock must be in a domestic C corporation acquired from the corporation at its original issuance (and not from another stockholder) in exchange for money, property (other than stock), or services. In the context of an M&A transaction, the newco buyer entity would need to be a C corporation, and that corporation’s stock would be the qualified small business stock.
    
2. The stock must be held for five years prior to its disposition.
    
3. The aggregate gross assets of the corporation (measured by adjusted basis) must not exceed $50 million immediately after the original issuance and must not have exceeded $50 million at any time prior to the original issuance. The adjusted basis of any property contributed to the corporation is equal to its fair market value as of the time of such contribution.
    
   1. In the context of an M&A transaction, critically, the gross asset test is as of the original issuance date. So, if a newco buyer that qualifies as QSBS acquires a business, the adjusted gross assets of the buyer corporation can grow to be worth more than $50 million, and the stock would not be disqualified from 1202 treatment.
       
4. At least 80 percent of the corporation’s assets must be used in the active conduct of a qualified trade or business.
    
   1. Excluded businesses include professional services (health, legal, engineering, architecture, accounting, actuarial, performing arts, consulting, athletics, financial (including banking and insurance), or any trade or business for which the principal asset is the reputation or skill of its employees), agriculture businesses, businesses involving mining, drilling, or extraction activities, and hospitality businesses.
   2. In addition, for any subsidiary corporation in which the parent owns more than 50 percent, the parent corporation is deemed to own its ratable share of the subsidiary’s assets, and to conduct its ratable share of the subsidiary’s activities.
   3. Any corporation would be disqualified if it holds more than 10 percent of its assets in real estate not actively used in its business or more than 10 percent of its net assets in stock in an entity in which the corporation owns 50 percent or less of the entity.
       
5. The stock must be held by a taxpayer other than a C corporation. Eligible stockholders generally include pass-through entities such as partnerships, limited liability companies, and S corporations, as well as individuals and trusts.
    
   1. Individual owners of a pass-through entity would need to meet certain additional requirements to qualify for Section 1202 benefits: (i) the gain must be attributable to the pass-through entity’s disposition of QSBS and (ii) the gain is attributable to the individual’s ownership of the pass-through entity on the date the pass-through entity acquired the stock and at all times between acquisition and the disposition.
       
6. Reorganizations, stock conversions, and stock buybacks can jeopardize QSBS status. Specifically, stock buybacks jeopardize QSBS qualifying status (i) for all shareholders when redemptions greater than 5 percent of the stock value occur during the two-year period starting one year prior to the original stock issuance (i.e., until one year after the stock issuance), and (ii) for a particular shareholder if the corporation repurchases more than 2 percent of its stock owned by such shareholder or a related party stockholder during the four-year period starting two years prior the original stock issuance (i.e., until two years after the stock issuance).

Other Considerations

As with any C corporation, income will be subject to corporate taxation and dividends to shareholders will also generally be subject to U.S. federal income taxation. In addition, purchasers generally prefer to acquire assets for U.S. federal income tax purposes to achieve a step-up in basis for future depreciation. For the seller in an exit to benefit from the Section 1202 exclusion, a future purchaser would be required to acquire the relevant corporate shares, which likely negates the step-up and would be a negotiation with the potential purchaser.

Future tax law changes could have a significant effect on Section 1202 federal income tax savings. For example, the benefits could be heightened if capital gains tax rates increase. On the other hand, while no legal reform has yet passed to specifically limit the benefits of Section 1202, future legislation could do so. In addition, while Section 1202 structuring is becoming more common, there is limited IRS guidance and case law on Section 1202, and open questions on the topic remain.

Conclusion

The tax benefit that Section 1202 offers can be extraordinarily valuable, including in the context of M&A transactions. Please consult with a tax professional to determine if your transaction may qualify for Section 1202 treatment.

Gabrielle Celia provided additional key support for this article.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.