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Gambling with New Corporations: 100% Gain Exclusion on the Sale of Qualified Small Business Stock

August 2011

As published in The Daily Journal of Commerce

As if you didn't have enough choices to make as a budding entrepreneur, the choice of entity decision has taken on the gravity of an offer you can't refuse.

To encourage investment in new "small" business ventures, Section 1202 of the Internal Revenue Code (the "IRC") rewards individual investors on the sale of their small business stock acquired after September 27, 2010, and before January 1, 2012, and held for at least five years.  The sale will be tax free – 100 percent exclusion of the capital gain.  A big pot will be yours to take home if you are willing to gamble.

The small print starts here.

A Brief History

Under the original Section 1202, created by the federal legislature in 1993, only 50 percent of the capital gain could be excluded on the sale of qualified small business stock ("QSBS").  In order to stimulate the economy, the exclusion percentage was raised to 75 percent in 2009 and then to 100 percent in 2010.  Most recently, the 2010 Tax Relief Act extended the 100 percent gain exclusion to apply to QSBS acquired before January 1, 2012.

The Rules

In addition to the qualifications discussed above, the issuing corporation must meet several qualifications in order for the issued stock to be considered qualified.  The issuing corporation must be a C corporation.  The C corporation must invest at least 80 percent of its assets in the active conduct of a "qualified trade or business."  While many businesses will meet the "qualified trade or business" requirement, certain businesses are excluded, including, but not limited to, those businesses involving banking, insurance, financing, leasing, investing, farming, hospitality, and most services professions.  In addition, the C corporation must have assets of no more than $50,000,000 at the time the QSBS is issued. 

Further, the 100 percent capital gain exclusion is limited to the greater of $10,000,000 or 10 times the investor's basis in the stock.  The limitations are applied on a shareholder-by-shareholder basis, so this "limitation" could potentially lead to a massive amount of capital gain exclusion if the qualifying small business corporation experiences incredible growth.

There are a number of other requirements, and potential investors should consult with a tax professional.

The Gamble

Two requirements of the Section 1202 gain exclusion especially make planning for this scenario a risk: (1) the qualified small business must be a C corporation and (2) the QSBS must be held for five years or more. 

C corporations have fallen out of favor because of several tax disadvantages as compared to other entity types.  The primary disadvantage is "double taxation."  The C corporation is taxed at the corporate rate on corporate earnings, and shareholders are taxed at the dividend rate when those corporate earnings are distributed.  Comparatively, S corporations, limited liability companies, and partnerships generally do not suffer from double taxation.

Fortunately, in a start-up company's first years, the double taxation may not have much of an impact.  Start-ups typically do not generate a great deal of earnings.  For those that do, earnings can be paid out in reasonable salaries to shareholders that actually work for the C corporation – effectively minimizing the amount of earnings on which the company is taxed – and excess earnings can be distributed to shareholders while dividends enjoy a very low federal dividend tax rate of 15 percent (although the federal dividend rate is scheduled to revert back to higher personal marginal federal rates as high as 39.6 percent after December 31, 2012).

Actively managing earnings to minimize annual tax liability may be worth the effort for investors focused on the large prize of 100 percent capital gain exclusion.  And start-up investors are not often complaining when there are excess earnings.

However, the start-up gloss can wear off quickly, and investors must wait at least five years before selling.  A successful company, the very sort of business that would be a target for acquisition, may find its earnings increasingly difficult to manage, and investors may find C corporation taxation more difficult to swallow.

Further, it is important to assess the nature of the business when considering the QSBS gamble.  Businesses with appreciating assets will have a more difficult exit strategy if the business is not sold.  When corporations distribute appreciated property to shareholders, it triggers a tax on the appreciation (once again, a double tax for the C corporation shareholder).  If that same property had appreciated in a limited liability company or a partnership, it may be distributed without triggering any tax at all.

If shareholders cannot sell their QSBS, the shareholders may be stuck with appreciated property in a C corporation – a poor tax result.  If the shareholders are willing to give up the opportunity to exclude capital gain under IRC 1202, they can at least limit taxation by converting the C corporation to an S corporation.  Appreciation from the date of conversion forward would not be subject to double taxation and, after ten years, the prior appreciation would be relieved of its "double tax" stain.  Once again, there are mitigation strategies, but there is no easy way out for the QSBS investor who can't sell or no longer wants to sell.

An investor can realize tremendous tax savings from the 100 percent gain exclusion under IRC section 1202.  In order to take advantage of Section 1202, investors are forced to operate as a tax-disadvantaged C corporation for at least five years.  The risk of the gamble depends on the success of the business and a willing buyer's ability to buy the QSBS at the right time, at the right price.

While many investors will walk away from the table, others will go "all in" in hopes of reaping the financial reward of risk.

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