If you are a well-established government contractor, your company may have progressed from being a small one or two person cash basis S corporation to a multi-shareholder accrual basis C corporation (C Corp). As a business owner, you’ve probably heard about all of the disadvantages of a C Corp for income tax purposes, including double taxation on profits and distributions, the inability to use cash-basis accounting if gross receipts exceed $5 million, and losing out on selfemployment tax savings by utilizing distributions and taking a modest but reasonable salary. However, there are also considerable tax benefits that are afforded to C Corps and their shareholders.
Section 1202 Qualified Small Business Stock (QSBS) Capital Gains Exclusion
There is a potential tax break that can help level the tax playing field for C Corps. It is the Section 1202, Small Business Stock Gain Exclusion. It was one of many tax extenders that were made permanent through the Protecting Americans from Tax Hikes (PATH) legislation that was passed in December 2015.
Typical of tax law, there are conditions that must be met to be able to utilize Section 1202. For C corporation stock to be recognized as QSBS:
- The corporation must use at least 80% of its assets value in the active conduct of a qualified trade or business.
- The corporation’s aggregate gross assets cannot exceed $50 million.
- The corporation cannot purchase any of its own stock from shareholders or related persons within a 4 year period beginning two years before the issue date of the stock.
- Shareholder must own shares of stock in a C corporation that meets the above requirements.
- Shareholder must be an individual (Grantor Trusts are acceptable).
- Shareholder must own shares for 5 years to qualify for Section 1202 gain exclusion.
- Shareholder cannot redeem more than 5% of the corporation QSBS for 2 years starting 1 year prior to the date of issue.
- 50%, 75%, or 100% of capital gains on the sale of stock can be excluded based on stock acquisition dates, per the table below:
How it Works
The shareholder is limited to $10 million of the gain exclusion per issuer of stock, or 10x the adjusted basis of all qualified stock of the issuer, whichever is greater. Any additional gain related to the stock is taxed at 28% (not 20%). Example:
Per the example below, for stock acquired after September 28, 2010, the tax savings are even greater:
Section 1045 Exchange
In addition to the Section 1202 provision, if you are not ready to retire, or the purchaser of your company wants current management to retain some ownership, Section 1045, Small Business Stock Rollover of Gain, gives the owner of QSBS an option to reinvest the stock sale proceeds in the QSBS of another company. To qualify:
- You must meet all the Section 1202 corporate and shareholder requirements discussed above, except that you only need to have purchased your stock 6 months before the sale to qualify for Section 1045 treatment. QSBS must be held for 5 years to qualify for Section 1202 capital gain exclusion.
- You must reinvest in QSBS of a new company within 60 days of the sale of your QSBS.
What CohnReznick Thinks
Whether you choose to take advantage of the Section 1202 capital gain exclusion, the Section 1045 gain deferral, or both is a decision that should be made in conjunction with a knowledgeable tax advisor. This article is a general discussion of the Sections 1202 and 1045 tax rules. Tax law is complex and everyone’s tax position is unique. This article does not cover the many nuances and exceptions to the general rules that were discussed.
If you are in the process of selling your company or are considering an exit strategy, please contact CohnReznick to determine whether taking advantage of the Section 1202 QSBS gain exclusion and/or the Section 1045 QSBS small business rollover would be beneficial to you.