All too often, an entrepreneur walks in our office, and I am able to “blow his/her mind.” The reason? Quite simply, it is a tax provision that allows certain qualifying owners to exclude potentially millions of dollars of gains on the sale of their stock from their income.
IRS Code section 1202 allows certain founders and early investors that qualify the ability to exclude either: 50% (stock acquired 8/10/93 – 2/18/09); 75% (stock acquired 2/18/09 – 9/29/10); or 100% (stock acquired after 9/28/10) of gains recognized on the sale of the stock of their Company, if the stock was acquired directly from the issuer at a time when it meets some other qualifications.
The excludable amount of gain is computed at the GREATER of 10 times the investment by the seller; or $10 million. You must have held the stock in question for 5 years and at the time you acquired the shares, the tax basis of the Company’s gross assets was under $50 million. If the stock was acquired by contributing property to the corporation, any built-in gain on the contributed property will not qualify for exclusion (regular long-term capital gains on sale), BUT the fair value will count as the basis for the “10 times investment” alternative ceiling on exclusion of gain.
The stock MUST be originally issued by a Corporation and the Company must be an active trade or business (i.e. it cannot be a company that performs services in health, law, engineering, architecture, accounting, finance, or mineral extraction, etc.).
Now here are some interesting items to keep in mind that make this even more exciting:
- If the company was originally an S corporation when you got your stock, and it converted to a C corporation afterward, your stock MAY qualify for 1202, regardless. The rules state that if, at the time of sale, the Corporation was a C corporation for “substantially all” of the holding period of the holder, the stock may qualify. This area is complex and one we find every year we have to work with new clients to unravel the facts. Reach out to one of KN+S team members if you have this situation. Keep in mind that the appreciation is only excludable from the date onward from the C corporation conversion date.
- There are certain stock transactions or redemptions that could retroactively void the ability of a stockholder or other stockholders during a certain time frame to use this exclusion, so you need to be aware of these. If a certain amount of transactions took place before your sale and within a certain number of months on either side of the sale, your sale may not qualify for 1202 treatment. Again, we recommend you reach out to one of our 1202 KN+S experts.
- Certain states do recognize the same tax benefits of 1202 stock treatment. Not all states adhere to the federal treatment, however. When it comes to Section 1202, Massachusetts adopted the federal treatment of 1202 starting in 2022. Prior to this, they had a different set of rules. Massachusetts only allowed the 50% exclusion from gain, regardless of the date of acquisition. Massachusetts also had a reduced 3% rate (a 40% discount to the regular tax rate) on the taxable gain of stock that meets some different qualifications. To qualify for the 3% rate, the stock must: be held for three years or more; be in a corporation which is domiciled in Massachusetts; be incorporated on or after January 1, 2011; holding less than $50 million in assets at the time of the investment; and is in an “active business” under Section 1202 of the Internal Revenue Code.
- If you happen to gift your shares or they are inherited, the holding period and treatment tacks on to the recipient. This can be quite a game changer to the recipient, and we use this quite often when thinking about estate planning for families. This can be a huge strategy for a founder and his family, but it should be done early on if possible. Think about having 2 or 3 $10 million exclusions because you listened to your CPA!
- If done correctly and in advance, the use of gifting some of your founder’s shares to a non-grantor trust for the benefit of other family members is one of the coolest and most impactful wealth preservation strategies you can do for your family. By using this strategy, you can “pyramid” your 1202 exemption for the family (i.e. you get $10mm and each trust (beneficiaries) gets ANOTHER $10mm) – potentially – 100% tax-free. Please give us a call if you are interested in ideas like this.
- There are two reasons you may want to exercise your options earlier, rather than later. First, if you exercise before the $50mm in asset value is reached, your newly acquired stock could qualify for 1202 treatment. Once the Company value exceeds the $50mm value, any new stock issued after that point will never qualify for 1202 treatment. Another reason is that you begin the 5-year holding period only on exercise and the earlier you exercise the better. Also, most likely, the value (and thus the potential tax implications on the date of exercise) will be less impactful.
- Finally, if your liquidity event occurs prior to achieving a 5-year holding period, we can recommend a strategy to avoid being currently taxed on your gains AND potentially obtain the 1202 exclusion at a later date. Again, please give us a call if you are interested in ideas like this.
As you can see, Code Section 1202 is life-changing for many founders and investors when there is an exit event. We work with so many of our clients educating them about the power of 1202 and love when it comes to fruition. It’s not uncommon for our firm to have 20 or more clients affected positively by 1202 each and every year. By having good strategic advisors that proactively guide you throughout your Company’s journey, you just may be one of those happy sellers, someday. Feel free to reach out to a KN+S tax expert if you have questions on this very important topic.
Jeffrey Solomon, CPA, is the Managing Shareholder at Katz, Nannis + Solomon, P.C. If you have any questions or would like to speak with one of our tax professionals, please contact our office at 781-453-8700.