Your Small Business Stock May be a Pot of Gold Come Time to Sell
If the stock you own in a privately held corporation meets certain requirements, you won’t have to pay capital gains on those shares (likely up to $10 million) when you go to sell them.
Small Business Stock Gains Exclusion — if you’re a shareholder of a privately held corporation and you’re not familiar with these words, you’re welcome for the introduction. First, let’s be honest, these five words seem boring — really boring, and you would be well within your right to recognize and ignore them as layered legal-tax-“this is why I hired a CPA and business attorney” jargon.
Well, you’re right — this term comes straight from the Internal Revenue Code. Section 1202 to be precise. And Section 1202 of the tax code tells us that if your small business stock meets a number of requirements, then upon your sale of those shares of small business stock, you will be able to exclude 100% of the capital gains up to the greater of (a) 10 times the aggregate adjusted basis of the stock at the time of the issuance, and (b) $10 million. Do I still have you? Did you black out for a moment there? I know, that was a lot of tax stuff crammed into one sentence. I didn’t really care for it either.
However difficult to read, let’s go ahead and unpack that last bit. It’s important to you. If the stock you own in a privately held corporation meets the requirements enumerated below, then you won’t have to pay capital gains on those shares (likely up to $10 million) when you go to sell them.
Section 1202 Requirements
1. The stock was issued by a domestic C-corporation or a limited liability company taxed as a C-corporation.
Not an S-corporation, and not a limited liability company taxed a partnership. If you don’t know, ask your CPA or business attorney.
2. The issuing C-corporation engages in a “qualified” trade, which means it is not a hotel, restaurant, financial institution, real estate company, farm, mining company or business relating to law, engineering, or architecture.
If it seems a bit odd and arbitrary that the IRS carved out these industries, I don’t disagree. On top of that, the IRS doesn’t provide much guidance on who, what, when, where or why on this piece. An all-too-common IRS truism.
3. The use of at least 80% of the corporation’s assets is for the active conduct of one or more of said qualified businesses.
So, if 20% or less of the corporation’s assets are used to engage in one of the carved-out industries above, then you’re good.
4. The stock was issued to an eligible shareholder.
This means you – the eligible shareholder. An eligible shareholder is basically everything and everyone that isn’t a corporation. It can be people, trusts, estates, and even partnerships, though that gets complicated fast and is beyond the scope here.
5. The stock was originally issued after August 10, 1993, in exchange for money, property not including stocks, or as compensation for a service rendered.
This one’s easy. Did you receive the shares from the corporation after August 10, 1993?
Also, of great importance here – you must have obtained the shares directly from the corporation. That is, if you obtained your shares from another shareholder, then this entire thing is blown, and your shares will not qualify for Section 1202 status.
6. On the date of stock issue and immediately after, the issuing corporation had $50 million or less in assets.
The corporation must not have had more than $50 million of tax basis in its assets at any time between August 11, 1993, through the moment immediately after the issuance of the stock to you, the shareholder.
7. The stock must be held for five years from issuance before it can be disposed of.
How’s your math? Has it been five years or more since you received the shares of stock from the corporation?
8. The issuing corporation does not significantly redeem its stock within a two-year period beginning one year before the issue date. A significant stock redemption is redeeming an aggregate value of stocks that exceed 5% of the total value of the company’s stock.
There’s a bit of timing nuance here, but the corporation must not have redeemed its stock from any other shareholders either shortly before or shortly after the date you were issued your shares.
Okay, how’d we do? If you have a lot of checked boxes above, congratulations – you may have stock that qualifies for the capital gains exclusion discussed above. Even if after doing this exercise you’re invariably certain your stock qualifies, you still really ought to check with your CPA and business attorney to cross those t’s and dot those i’s to make sure you’re lucky enough to keep that pot of gold and skip the tax man come time to sell those shares of small business stock.
Kevin Tibolt is a business attorney at Minor at Brown, PC whose passion for serving others guides his every move as an advisor, strategist and team member. Kevin relishes the role of outside general counsel to his clients, where he can gain a holistic understanding of his clients and their businesses. His practice includes forming businesses, corporate governance, mergers and acquisitions, debt and equity financings and commercial contracting. email@example.com direct dial number 303-376-6051