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Code Section 1202: Big Benefits for Small Business

Written by: Kolbie R. Deamon & Amy E. Drake

Published in the Portsmouth Herald (1/12/2020)

Since the 1990s, small business owners have gravitated to the pass-through taxation afforded by partnerships and S corporations. Nevertheless, forming a business as a C corporation has some unique advantages that should not be overlooked.

One significant, albeit lesser-known, advantage of a C corporation is the ability to potentially sell C corporation stock completely tax-free under Section 1202 of the Internal Revenue Code (“Code”). Section 1202, which was designed to encourage investment in small businesses, creates a powerful incentive to elect C corporation status, particularly given the current low corporate income tax rate.

In brief, a shareholder may exclude all or part of the gain from the sale of stock in a C corporation under Section 1202 where the corporation is a “qualifying small business” that meets certain “active business” requirements. To qualify, the stock must have been “originally issued” to the shareholder in exchange for cash or property or as compensation for services and must have been held by the selling shareholder for at least five years.

Qualifying small business

Special treatment under Section 1202 is generally available for “qualifying small businesses.”

In order to be considered a “qualifying small business,” your business does not have to be as small as you might expect.

Under the Code, a “qualifying small business” is any domestic C corporation whose aggregate gross assets did not exceed $50 million at any time before or immediately after the issuance of the stock for which Section 1202 treatment is sought.

The determination that the corporation was a “qualifying small business” must be separately made for each shareholder seeking to exclude income from the later sale of stock in the corporation under Section 1202.

Active business requirement

In order to meet the active business requirement, at least 80% of a corporation’s assets must be used in the conduct of one or more “qualified trades or businesses.” Generally, a “qualified trade or business” is any business other than 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.” In addition, businesses engaged in banking, insurance, financing, leasing, investing, farming, or hospitality (hotel or restaurant) services are also excluded. Holdings of portfolio securities or of real estate in excess of 10% of the corporation’s assets (by value) will also disqualify the stock in the corporation for Section 1202 treatment.

Original issue requirement

As noted above, in order to qualify under section 1202, the stock must have been originally issued to the shareholder seeking Section 1202 treatment either (1) in exchange for cash or property or (2) as compensation for services. In other words, the shareholder may not have purchased the stock from another shareholder. Importantly, however, a shareholder can have acquired the stock in the form of a gift or bequest provided the stock was “originally issued” to the prior shareholder.

Amount of gain exclusion

The amount of gain exclusion under section 1202 varies depending on when the qualifying stock was acquired by the shareholder. For stock acquired after September 28, 2010, 100% of the gain from the sale of such stock may be excluded under Section 1202.

By contrast, only 50% of gain from the sale of qualifying stock acquired prior to February 17, 2009 and 75% of gain from the sale of qualifying stock acquired between Feb. 17, 2009, and Sept. 28, 2010, may be excluded from income under Section 1202. The gain on the sale of stock that not excluded under Section 1202 is subject to a special 28% tax rate rather than the normal capital gains rates.

Finally, with respect to the stock of any single corporation, the aggregate amount of gain from dispositions of stock issued by such corporation which may be excluded under Section 1202(a) cannot not exceed the greater of $10 million 10 times the taxpayer’s aggregate adjusted basis in the stock. Any gain in excess of this cap is subject to normal capital gains rates.

Section 1202 can provide significant benefits to small business owners and passive investors in qualifying C corporations, provided the complex requirements of section 1202 are met. When considering the structure of your next business or target of your next investment, talk with your tax advisors about the possibility of investment in a C corporation so as to take advantage of the unique benefits of Section 1202.

Kolbie Deamon and Amy Drake are attorneys in the Tax Department of McLane Middleton, Professional Association. They can be reached respectively at [email protected] and [email protected].

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