Making A Comeback: Section 1202 Stock

We are going tax-geek for this post.

Let’s blame Daryl, a financial advisor with Wells Fargo. He has been studying and asking about a particular Code section.

Code Section 1202.

This section has been a dud since 1993, but last year’s changes to the tax Code have resurrected it. I suspect we will be reading more about Section 1202 in the future.

What sets up the tension is the ongoing debate whether it is better to do business as a “C” corporation (which pays its own tax) or an “S” corporation (whose income drops onto its owners’ individual returns, who pay tax on the business as well as their other personal income).

There are two compelling factors driving the debate:

(1) The difference between corporate and individual tax rates.

For most of my career, top-end individual tax rates have exceeded top-end corporate tax rates. Assuming one is pushing the pedal to the floor, this would be an argument to be a C corporation.

(2)  Prior to 1986, there was a way to liquidate (think “sell”) a C corporation and pay tax only once. The 1986 tax act did away with this option (except for highly specialized – and usually reorganization-type – transactions). Since 1986 a C corporation has to pay tax when it liquidates (because it sold or is considered to have sold its assets). Its assets then transfer to its shareholders, who again pay tax (because they are considered to have sold their stock).

Factor (2) has pretty much persuaded most non-Fortune-500 tax advisors to recommend S corporations, to the extent that most of the C corporations many tax practitioners have worked with since 1986 have been legacy C’s. LLC’s have also been competing keenly with S corporations, and advisors now debate which is preferable. I prefer the settled tax law of S corporations, whereas other advisors emphasize the flexibility that LLCs bring to the picture.

Section 1202 applies to C corporations, and it gives you a tax break when you sell the stock. There are hoops, of course:

(1)   It must be a domestic (that is, a U.S.) C corporation.

(2)   You must acquire the stock when initially issued.

a.     Meaning that you did not buy the stock from someone else.

b.    It does not mean only the first issuance of stock. It can be the second or third issuance, as long as one meets the $ threshold (discussed below) and you are the first owner.

(3)   Corporate assets did not exceed $50 million when the stock was issued.

a.     Section 1202 is more of a west-Coast than Midwest phenomenon. That $50 million makes sense when you consider Silicon Valley.

b.    If you get cute and use a series of related companies, none exceeding $50 million, the tax Code will combine you into one big company with assets over $50 million.

c.     By the way, the $50 million is tested when the stock is issued, not when you sell the stock. Sell to Google for a zillion dollars and you can still qualify for Section 1202.

(4)   You have owned the stock for at least five years.

(5)   Not every type of business will qualify.

a.     Generally speaking, professional service companies – think law, health, accounting and so on – will not qualify. There are other lines of businesses – like restaurants and motels - that are also disqualified.

(6)   Upon a qualifying sale, a shareholder can exclude the larger of (a) $10 million or (b) 10 times the shareholder’s adjusted basis in the stock.

Folks, a minimum $10 million exclusion? That is pretty sweet.

I mentioned earlier that Section 1202 has – for most of its existence – been a dud. How can $10 million be a dud?

Because it hasn’t always been $10 million. For a long time, the exclusion was 50% of the gain, and one was to use a 28% capital gains rate on the other 50%. Well, 50% of 28% is 14%. Consider that the long-term capital gains rate was 15%, and tax advisors were not exactly doing handstands over a 1% tax savings.

In 2010 the exclusion changed to 100%. Advisors became more interested.

But it takes five years to prime this pump, meaning that it was 2015 (and more likely 2016 or 2017) by the time one got to five years.

What did the 2017 tax bill do to resurrect Section 1202?

It lowered the “C” corporation tax rate to 21%.

Granted, it also added a “passthrough” deduction so that S corporations, LLCs and other non-C-corporation businesses remained competitive with C corporations. Not all passthrough businesses will qualify, however, and – in an instance of dark humor – the new law refers to (5)(a) above to identify those businesses not qualifying for the passthrough deduction.

COMMENT: And there is a second way that Section 1202 has become relevant. A tax advisor now has to consider Section 1202 – not only for the $10-million exclusion – but also in determining whether a non-C business will qualify for the new 20% passthrough deduction. Problem is, there is next to no guidance on Section 1202 because advisors for years DID NOT CARE about this provision. We were not going to plan a multiyear transaction for a mere 1% tax savings.

Nonetheless 21% is a pretty sweet rate, especially if one can avoid that second tax. Enter Section 1202.

If the deal is sweet enough I suppose the $10 million or 10-times-adjusted-basis might not cover it all.

Good problem to have.