Section 1202 Stock And A House Tax Proposal

I am not a fan of fickleness and caprice in the tax law.

I am seeing a tax proposal in the House Ways and Means Committee that represents one.

It has been several years since we spoke about qualified small business stock (QSBS). Tax practice is acronym rich, and one of the reasons is to shortcut who qualifies – and does not qualify – for a certain tax provision. Section 1202 defines QSBS as stock:

·      issued by a C corporation,

·      with less than $50 million in assets at time of stock issuance,

·      engaged in an active trade or business,

·      acquired at original issuance by an eligible shareholder in exchange for either cash or services provided, and

·      held for at least five years.

The purpose of this provision is to encourage – supposedly – business start-ups.

How?

A portion of the gain is not taxed when one sells the stock.

This provision has been out there for approximately 30 years, and the portion not taxed has changed over time. Early on, one excluded 50% (up to a point); it then became 75% and is now 100% (again, up to a point).

What is that point?

The amount of gain that can be excluded is the greater of:

·      $10 million, or

·      10 times the taxpayer’s basis in the stock disposed

Sweet.

Does that mean I sell my tax practice for megabucks, all the while excluding $10 million of gain?

Well, no. Accounting practices do not qualify for Section 1202. Not to feel singled- out, law and medical practices do not qualify either.

I have seen very few Section 1202 transactions over the years. I believe there are two primary reasons for this:

                 

(a)  I came into the profession near the time of the 1986 Tax Reform Act, which single-handedly tilted choice-of-entity for entrepreneurial companies from C to S corporations. Without going into details, the issue with a C corporation is getting money out without paying double tax. It is not an issue if one is talking about paying salary or rent, as one side deducts and the other side reports income. It is however an issue when the business is sold. The S corporation allows one to mitigate (or altogether avoid) the double tax in this situation. Overnight the S corporation became the entity of choice for entrepreneurial and closely-held companies. There has been some change in recent years as LLCs have gained popularity, but the C corporation continues to be out-of-favor for non-Wall Street companies. 

 

(b)  The sale of entrepreneurial and closely-held companies is rarely done as a stock purchase, a requirement for Section 1202 stock. These companies sell their assets, not their stock. Stock acquisitions are more a Wall Street phenomenon.

So, who benefits from Section 1202?

A company that would be acquired via a stock purchase. Someone like … a tech start-up, for example. How sweet it would have been to be an early investor in Uber or Ring, for example. And remember: the $10 million cap is per investor. Take hundreds of qualifying investors and you can multiply that $10 million by hundreds.

You can see the loss to the Treasury.

Is it worth it?

There has been criticism that perhaps the real-world beneficiaries of Section 1202 are not what was intended many years ago when this provision entered the tax Code.

I get it.

So what is the House Ways and Means Committee proposing concerning Section 1202?

They propose to cut the exclusion to 50% from 100% for taxpayers with adjusted gross income (AGI) over $400 grand and for sales after September 13, 2021.

Set aside the $400 grand AGI. That sale might be the only time in life that someone ever got close to or exceeded $400 grand of income.

The issue is sales after September 13, 2021.

It takes at least five years to even qualify for Section 1202. This means that the tax planning for a 2021 sale was done on or before 2016, and now the House wants to retroactively nullify tax law that people relied upon years ago.

Nonsense like this is damaging to normal business. I have made a career representing entrepreneurs and their closely-held businesses. I have been there – first person singular - where business decisions have been modified or scrapped because of tax disincentives. Taxing someone to death clearly qualifies as a business disincentive. So does retroactively changing the rules on a decision that takes years to play out. Mind you – I say that not as a fan of Section 1202.

To me it would make more sense to change the rules only for stock issued after a certain date – say September 13, 2021 – and not for sales after that date. One at least would be forewarned.   

Should bad-faith tax proposals like this concern you?

Well, yes. If our current kakistocracy can do this, what keeps them from retroactively revoking the current tax benefits of your Roth IRA?  How would you feel if you have been following the rules for 20 years, contributing to your Roth, paying taxes currently, all with the understanding that future withdrawals would be tax-free, and meanwhile a future Congress decides to revoke that rule - retroactively?

I can tell you how I would feel.

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.

The Qualified Small Business Stock Exemption

Let’s say that you are going to start your own company. You talk to me about different ways to organize:

(1) Sole proprietor – you wake up in the morning, get in your car and go out there and shake hands. There is no paperwork to file, unless you want to get a separate tax ID number. You and your proprietorship are alter-egos. If it gets sued, you get sued.

(2) Limited liability company – you stick that proprietorship in a single-member LLC, writing a check to your attorney and secretary of state for the privilege. You gain little to nothing tax-wise, but you may have helped your attorney (and yourself) if you ever get sued.

(3) Form a corporation - a corporation is the old-fashioned way to limit your liability. Once again there is a check to your attorney and secretary of state. Corporations have been out there long before LLCs walked the land.

You then have to make a decision as to the tax flavor of your corporation: 

a.    The “C” corporation – think Krogers, Proctor & Gamble and Macy’s. The C is a default for the big boys – and many non-bigs. There are some goodies here if you are into tax-free reorganizations, spin-offs and fancy whatnot.

Problem is that the C pays its own tax. You as the shareholder then pay tax a second time when you take money out (think a dividend) from the C.  This is not an issue when there are a million shareholders. It may be an issue when it is just you.

b.    The “S” corporation – geared more to the closely-held crowd. The S (normally) does not pay tax. Its income is instead included on your personal tax return. Own 65% of an S and you will pay tax on 65% of its income, along with your own W-2, interest, dividends and other income.

This makes your personal return somewhat a motley, as it will combine personal, investment and business income into one. Don’t be surprised if you are considered big-bucks by the business-illiterate crowd.

The S has been the go-to corporate choice for family-owned corporations since I have been in practice. A key reason is avoiding that double-tax.

But you can avoid the double tax by taking out all profits through salaries, right?

There is a nerdy issue here, but let’s say you are right.

Who cares then?

You will. When you sell your company.

Think about it. You spend years building a business. You are now age 65. You sell it for crazy money. The corporation pays tax. It distributes whatever cash it has left-over to you.

You pay taxes again.

And you vividly see the tax viciousness of the C corporation.

How many times are you going to flog this horse? Apple is a multinational corporation with a quarter of a trillion dollars in the bank. Your corporate office is your dining room.

The C stinks on the way out.

Except ….

Let’s talk Section 1202, which serves as a relief valve for many C corporation shareholders when they sell.

You are hosed on the first round of tax. That tax is on the corporation and Section 1202 will not touch it.

But it will touch the second round, which is the tax on you personally.

The idea is that a percentage of the gain will be excluded if you meet all the requirements.

What is the percentage?

Nowadays it is 100%. It has bounced around in prior years, however.

That 100% exclusion gets you back to S corporation territory. Sort of.

So what are the requirements?

There are several:

(1) You have to be a noncorporate shareholder. Apple is not invited to this soiree.

(2) You have owned the stock from day one … that is, when stock was issued (with minimal exceptions, such as a gift).

(3) The company can be only so big. Since big is described as $50 million, you can squeeze a good-sized business in there. BTW, this limit applies when you receive the stock, not when you sell it.

(4) The corporation and you consent to have Section 1202 apply.

(5) You have owned the stock for at least 5 years.

(6) Only certain active trades or businesses qualify.

Here are trades or businesses that will not qualify under requirement (5):

(1) A hotel, motel, restaurant or similar company.

(2) A farm.

(3) A bank, financing, leasing or similar company.

(4) Anything where depletion is involved.

(5) A service business, such as health, law, actuarial science or accounting.

A CPA firm cannot qualify as a Section 1202, for example.

Then there is a limit on the excludable gain. The maximum exclusion is the greater of:

(1) $10 million or

(2) 10 times your basis in the stock

Frankly, I do not see a lot of C’s – except maybe legacy C’s – anymore, so it appears that Section 1202 has been insufficient to sway many advisors, at least those outside Silicon Valley.

To be fair, however, this Code section has a manic history. It appears and disappears, its percentages change on a whim, and its neck-snapping interaction with the alternative minimum tax have soured many practitioners.  I am one of them.

I can give you a list of reasons why. Here are two:

(1) You and I start the company.

(2) I buy your stock when you retire.

(3) I sell the company.

I get Section 1202 treatment on my original stock but not on the stock I purchased from you.

Here is a second:

(1) You and I start the company.

(2) You and I sell the company for $30 million.

We can exclude $20 million, meaning we are back to ye-old-double-tax with the remaining $10 million.

Heck with that. Make it an S corporation and we get a break on all our stock.

What could make me change my mind?

Lower the C corporation tax rate from 35%.

Trump has mentioned 15%, although that sounds a bit low.

But it would mean that the corporate rate would be meaningfully lower than the individual rate. Remember that an S pays tax at an individual rate. That fact alone would make me consider a C over an S.

Section 1202 would then get my attention.