Section 1202 Exclusion — What Investors, Founders + Employees Should Know

Internal Revenue Code Section 1202 is among the most valuable tax provisions for investors, founders and employees of early-stage startups. It often impacts choice of entity and investment decisions.

The provision allows investors, founders and employees of startup companies to exclude up to 100% of their capital gains from the sale of qualifying stock that is held for more than five years. Section 1202 excludes from income the 20% capital gains rate (highest bracket) and the 3.8% net investment income tax that affects the highest earners. A taxpayer's tax liability on the gain of a sale of qualifying stock could go from 23.8% to 0% if all the requirements of Section 1202 are met.

Qualified Small Business Stock

Section 1202 provides tax benefits to investors and others who hold Qualified Small Business Stock (“QSBS”). QSBS means any stock in a Qualified Small Business that the taxpayer acquires at its original issue in exchange for money or other property (not including stock) or as compensation for services provided to such corporation.

Qualified Small Business

To be a Qualified Small Business, the business must be a C Corporation with aggregate gross assets of less than $50 million, including after the issuance of stock. The Qualified Small Business must use at least 80% of the corporation's assets (by value) to actively conduct qualified trades or businesses. The company must agree to submit reports to the IRS to ensure they are complying with Section 1202.

A Qualified Small Business must be engaged in a qualified trade or business. A qualified trade or business does not include service industries such as health, law, engineering, architecture, accounting, actuarial science or any trade or business where the principal asset is the reputation or skill of its employees. Further, a qualified trade or business does not include banking, insurance, financing, leasing, investing, farming or operating a restaurant or hotel. Regulated investment companies and REITs also do not qualify.

Exclusion

QSBS held by a taxpayer for more than five years would be eligible for favorable treatment under Section 1202 upon the sale of the QSBS. If the QSBS was acquired before February 18, 2009, a 50% exclusion is available. If the QSBS was acquired between February 18, 2009, and September 28, 2010, a 75% exclusion is available. If the QSBS was acquired after September 27, 2010, a 100% exclusion is available. In addition, Section 1202 gain is excluded from the net investment income tax of 3.8%.

Examples

Let's say an early-stage investor based in Greater Des Moines (DSM) is excited about a company's prospects. The company, based in Ames, is seeking outside investment to help grow the business. Assume the company meets all the statutory requirements. In August of Year 1, the investor purchased a 25% interest in the company for $1 million. As of August of Year 1, the company would have a value of $4 million. The business grows significantly to a valuation of $20 million by October of Year Five. The stockholders, including the investor, decide to sell the company to a private equity firm for $20 million. The investor’s portion would be worth $5 million. The investor would take the gain of $5 million less the basis of $1 million for a net income of $4 million. At the highest tax bracket, this would be taxed at 23.8%. However, using Section 1202, the income is excluded reducing the investor’s tax liability from $952,000 to $0.

Here's another example, considering an early employee. In exchange for services, in Year One, the employee receives a salary of $50,000 and restricted stock (that vests in three years) worth $25,000. If the employee makes the 83(b) election, they will report an income of $75,000 in Year One. This will begin the employee’s holding period for QSBS purposes. In Year Seven, a strategic buyer purchases the company for four times the valuation of Year One. The employee would sell his stock to the purchaser for $100,000. The employee would have $75,000 of gain, but that gain would be excluded under Section 1202. The tax liability for the employee would go from $17,850 to $0.

Section 1202 Limitations

At first, Section 1202 seems too good to be true. However, it has extensive requirements and limitations that require expertise to navigate. Corporate stockholders are not eligible for the gain exclusion under Section 1202; rather, only individuals, partnerships, trusts and S Corporations are eligible. Section 1202(b) limits the capital gain eligible for exclusion to the greater of $10 million or ten times the basis of the QSBS sold in a given year. Section 1202(c) limits the company’s ability to purchase its own stock. To navigate Section 1202 and its limitations, investors should always seek legal and tax advice to ensure they remain eligible for the gain exclusion.

In Practice

Investors in early-stage companies often push to include QSBS representations (reps) and covenants in preferred stock purchase agreements to ensure the QSBS being purchased remains QSBS. In QSBS reps, the issuer represents as of closing that it is complying with Section 1202 requirements, subject to a fiduciary out if the board of directors determine that maintaining the stock as QSBS is not in the corporation’s best interests. QSBS covenants require the issuer to comply with the requirements of Section 1202 after closing. Section 1202 may influence the structuring of a business, such as incorporating as a C Corporation or separating assets into separate entities to stay below the $50 million asset limit. Investors may try to “stack” QSBS by gifting parts of QSBS to get around the $10 million exclusion limit (this strategy is complicated and requires avoiding certain pitfalls).

Bottom Line

Section 1202 provides a tremendous benefit to start-up company investors, founders, and early employees. Founders and early company employees should consider Section 1202 when deciding which type of entity to form to run the business. Investors should consider Section 1202 when determining which companies to invest in and should consider taking steps, such as pushing for QSBS reps and covenants, to ensure the stock is QSBS.

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