IRC 1202: The most important tax code section for founders to understand

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The tax code is said to be some 80,000 pages, but one small section stands out as the most important for founders of startups. IRC 1202, also known as the Qualified Small Business Stock (“QSBS”) Exclusion, is a tax provision that allows founders to exclude up to 100% of capital gains from the sale of QSBS.  

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However, our experience at Anomaly CPA has found that there are traps for the unwary that you must consider in the early stages of your startup to take advantage of this lucrative tax benefit. 

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The maximum amount of capital gain exclusion is $10 million per shareholder, or 10 times the adjusted basis in the stock.  

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IRC 1202 offers an unparalleled opportunity for founders to reduce or potentially eliminate federal capital gains tax upon the sale of their business. By qualifying your startup for IRC 1202 stock, founders can keep more of the profits from their successful ventures, reinvest in new opportunities, and grow their wealth rapidly.  

The basic requirements for 1202 stock

At its most basic level, to qualify as a QSBS and take advantage of IRC 1202, a company:

• Must be a domestic C corporation: The company must be a C Corporation incorporated in the United States.  Companies that are formed internationally do not qualify, nor do LLCs or S Corporations.
  • You may consider converting an existing LLC to a C Corporation to take advantage of this. For example, you are currently structured as a Limited Liability Company, taxed as a Partnership (filing Form 1065).  You realize that you want to attract venture capital and qualify for IRC 1202.  When you convert to a C Corporation, your holding period will begin and you will qualify for a future exclusion at the greater of $10M OR 10X the basis of your holding in the Company on that date of conversion. This is an area of significant planning for some that should be addressed with both tax strategists and corporate counsel well ahead of time. ‍
• Must have gross assets of $50 million or less: The company's gross assets must not exceed $50 million immediately before or immediately after issuing of the qualified small business stock.  
  • While this may be confusing at first glance, this only matters when the stock is issued.  For 99% of founders, their original issuance stock is when the balance sheet is far under $50M.  If you sell your startup for $500M but when you received the stock at issuance, it was worth under $50M, you are in the clear. 
  • We’ve found this provision does come into play when VCs are investing down the road, as they won't qualify for 1202 if the balance sheet has over $50M immediately before and after their investment. For example, the balance sheet has $48M immediately before the VC writes a $3M check.  Immediately after this investment, the balance sheet now has $51M, which would disqualify the VC from 1202 stock on this investment. 
  • The valuation of intangible assets can create complexities with this requirement and should lead founders to seek counsel from a tax professional.  For example, you are issuing stock to an investor who reviews your balance sheet and sees $20M of cash and some fixed assets.  However, you realize that you haven't valued the Intellectual Property of your product/business.  If this IP were extremely valuable, you theoretically may be over the $50M cap without even knowing it.‍
  • Accounting for depreciation: you may account for depreciation of fixed assets when calculating the $50M asset test.  There are significant planning techniques available in this area. 

• Must be an active business: The company can't be a passive investment vehicle. The company must be engaged in the active trade or business, and at least 80% of the business’s assets are used in the active conduct of that business.  There are several excluded industries, including real estate, which we are often asked about (that would be nice).  

• Services businesses: A business whose principal asset is the reputation or skill of one or more of its employees, such as medicine, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics or brokerage services. These industries are also found as “SSTBs” within the QBI deduction laws under IRC 199A.

• Financial businesses: A business whose principal activity is the performance of services in the fields of finance or investing, such as banking, insurance, financing, leasing, investing.  

• Farming businesses: A business whose principal activity is farming, such as livestock farming or growing crops. 

• Real estate businesses: A business whose principal activity is real estate development or leasing or any real estate investment trust.

• Mining businesses: A business whose principal activity is mining natural resources, such as oil or minerals.  

• Hospitality and restaurant businesses: A business whose principal activity is hospitality or restaurant services, such as a hotel or restaurant, may not qualify if it is considered to be a service business. We've found ways to work around this for some groups, but it's fact and circumstance-driven.  

• Holding period: to take advantage of the gain exclusion, you must hold the stock for at least 5 years. The clock starts ticking on the date you formally acquire (or your investors acquire) stock from the C Corporation.
  • If you start as an LLC and then later convert to a C Corporation, your holding period begins on the date of that conversion. Unfortunately, you cannot revert back to the date you set up your LLC. 

The specifics of the gain exclusions

Depending on when the QSBS was acquired, IRC 1202 allows for the exclusion of a percentage of capital gains from federal income tax (state tax treatment varies):

1. 50% exclusion for QSBS acquired before February 18, 2009

2. 75% exclusion for QSBS acquired between February 18, 2009, and September 27, 2010

3. 100% exclusion for QSBS acquired after September 27, 2010.  This is the most common exclusion seen today.  

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The gain exclusion is capped at $10 million per shareholder OR 10 times the adjusted basis in the stock per shareholder. This latter provision is commonly overlooked by founders infusing initial capital and intellectual property into the business.  Take for example, a founder who contributes $2M in cash to get their project off the ground.  They eventually sell for $11,000,000 and their accountant surprises them by telling them they only have to pay taxes on $1M!  

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However, in this scenario, they overlooked the 10X basis provision, which would allow for $20M tax free, making the entire stock sale tax free.

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In some cases, we have strategically offset tens of millions in gains by utilizing the 10X basis provision instead of the $10,000,000 provision.  

To maximize your IRC 1202 benefits, be aware of these common pitfalls:

1. Significant redemptions by shareholders: The company must be careful with stock redemptions from related parties and significant shareholders.  This is an extremely complex area of the law that can jeopardize the entire IRC 1202 pool for investors.
   • If you have or ever plan to redeem stock from a founder, you should check with both your legal counsel and your CPA prior to doing this.
   • If you have or ever plan to redeem a large portion of your company’s stock back from investors (whether one or many) you should bring in counsel to avoid triggering these rules.

2. Not documenting the original issuance: Oftentimes, we find founders forget to document their original stock purchase from the company, as it can be de minimis.  Regardless of how you incorporate, ensure that the founding team has their stock certificates, your accountant records this in the general ledger properly and you document in your company minutes the appropriate value of the company at issuance.  These small items will go a long way in the event of a future audit. 

Putting it all together and understanding IRC 1202’s valuable benefit

IRC 1202 can create significant windfalls for those willing to take the risk in the startup world. On the surface, qualifying for QSBS under IRC 1202 can seem straightforward but as your situation becomes more complex, there are multiple advanced planning techniques that are available for founders to ensure they fully maximize their benefits, sometimes beyond the $10M baseline exclusion. 

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The information provided in this article does not constitute accounting, legal or financial advice and is for general informational purposes only. Please contact an accountant, attorney, or financial advisor to obtain advice with respect to your business.