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Section 1202 is an often overlooked planning opportunity that could provide a tax-favored exit strategy for owners of small businesses taxed as C corporations. The gain on stock issued after Sept., 27, 2010, may qualify for a 100 percent exclusion. For stock issued after Aug. 9, 1993, but before Sept. 28, 2010, a smaller exclusion percentage will apply. The exclusion does not apply to stock issued prior to those dates.
The exclusion is limited to the greater of $10 million or 10 times the stockholder’s adjusted basis in the stock disposed. For Section 1202, the adjusted basis includes the fair value of the contributed property.
The principal qualification requirements are:
Incorporation of a partnership can be used to benefit from the exclusion. For example, assume an individual incorporated a partnership for which the equity’s tax basis is $1 million and its fair value was $10 million. A qualifying sale of that stock for $30 million could result in the exclusion of $20 million of the realized gain.
Up to $100 million of gain can be excluded from taxation under Section 1202. The gain on the date of conversion is not eligible for exclusion; as such, the $9 million of gain on the conversion date would continue to be taxed at capital gains rates upon disposition.
Also note, converting a partnership to a C corporation tax status can be accomplished using tax elections so that there are no interruptions of business operations.
Without regard to the potential of a Section 1202 exclusion, the reduced corporate tax rate of 21 percent incentivizes business owners reinvesting earnings to achieve growth and/or reduce debt to consider converting from an S pass-through entity to a C corporation tax status. The lower corporate tax rate reduces the costs of both financing growth and reducing debts since both are accomplished using after-tax dollars.
The potential of a Section 1202 exclusion should be considered when analyzing whether a conversion to C corporation status will produce tax savings that can be used to finance growth since the exclusion may eliminate the eventual taxation of that growth. Section 1202 limits the form of the disposition transaction to a stock sale (an asset sale will not qualify); as such, consideration should also be given to the impact that a stock transaction would have on the buyer’s purchase price (buyer’s generally prefer asset transactions).
As it seems with all things tax, complexity abounds in making this determination since the tax cost of an asset sale was increased as a result of 2017 Tax Cuts and Jobs Act. Gains on the sales of self-created patents, inventions, models or designs, as well as secret formulas are now taxed as ordinary income, not capital gains.
Navigating this tax incentive can be a complex process, so we encourage you to work with a tax advisor to further explore Section 1202 and the entity choice most suitable for your business. For more information on tax-saving strategies, contact Doeren Mayhew’s tax advisors today.
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