Imagine a technology executive has an idea and gathers investors to turn that idea into reality. Prior to the enactment of the Tax Cuts and Jobs Act (TCJA) in 2017, this new organization may have been formed as a partnership or an S corporation. Investors often favored the single level of taxation using a flow-through entity over the C corporation regime, paying a 35% corporate-level tax and then paying a shareholder tax of 15 or 20% when that income was distributed as a dividend.
TCJA cut the corporate rate from 35 to 21%, potentially reversing this historic benefit of flow-through taxation. The hurdle that causes many new businesses to avoid choosing C corporation taxation is the second level of taxation incurred when cash is distributed to the shareholders. The impact of this second level of taxation often depends upon the plans of the business with respect to cash: Will the cash be used internally to fuel growth, or will some portion of the cash be returned to the owners? The real bonus can be the taxation relief offered to certain start-up businesses that qualify for Internal Revenue Code section 1202, “partial exclusion of gain from certain small business stock,” which can apply when the stock has been held for more than five years.
What is the section 1202 exclusion?
Section 1202 of the Internal Revenue Code provides an exclusion from taxation for a limited amount of gain on the sale of Qualified Small Business Stock (QSBS) acquired from the corporation at original issuance and held for more than five years. In addition to the shareholder qualifications, the corporation must meet certain organizational tests, one being that the corporation must have been taxed as a domestic C corporation throughout its existence. (For more information on qualification and investments through flow-through entities, see this article.)
Generally, the amount of QSBS gain excluded from taxation is limited to the greater of $10 million reduced by prior eligible gains taken into account by the taxpayer from the same issuer or 10 times the adjusted basis of stock disposed during the tax year. This limitation is generous; however, it can be increased depending upon the circumstances.
Gifting of QSBS
At this point, the technology executive has spent six years growing his idea as well as the corporation, and the original investment is now worth $50 million. The company is ready to sell, but the executive would like to accomplish some estate planning prior to the sale.
QSBS must generally be acquired on original acquisition; however, gifted QSBS generally retains the benefits of the original holder. With a little planning, these retained benefits create the opportunity for receiving multiple exclusions by gifting stock to another individual or to a trust that is regarded as a separate taxpayer.
For this to work, the transferor must actually give the stock to another individual or trust—and, consequently, all the resulting proceeds from sale. This could cause problems for an investor who needs to retain the value for lifestyle or other financial reasons.
When considering a gift of QSBS, you must also consider the market value of the stock transferred via the gift: A gift given closer in time to a transaction will likely have higher value than shares transferred much earlier in time. This means that waiting too long to make the gift could cause the transferor to utilize more of their transfer tax exemption and possibly create a current gift tax obligation. To decrease the transfer tax consequences, consider structuring the original acquisition and investment both individually and through regarded trusts. This up-front planning could allow for multiple exemptions while potentially capturing a lower valuation for transfer tax purposes.
The phased transaction
First, let’s assume all requirements of section 1202 are met for the corporation operating the business and shareholders holding the shares. At the founding, the executive received stock in exchange for a minimal capital contribution. Post-incorporation, the executive worked to develop technology and business relationships; the company raised capital after three years and the executive invested an additional $5 million.
After 10 years of success, the shareholders decided it was time to create individual liquidity. At this point, the executive’s investment is worth $50 million. The original investment has a value of $20 million, the second investment $30 million. The buyer is not going to purchase the entire company and is requiring the executive retain $30 million of his investment.
As aforementioned, the limitation on the exclusion under Section 1202 is the greater of $10 million reduced by prior eligible gains taken into account by the taxpayer from the same issuer or 10 times the adjusted basis of stock disposed during the tax year. The $10 million limitation is cumulative; however, the 10-times basis limitation is on an annual basis.
Low basis stock first
Our executive is selling $20 million of stock in the first transaction. Choosing to sell the low basis stock first results in a $10 million exemption on the initial sale—but unfortunately, this means there will be $10 million of taxable gain.
Five years later, the buyer decides to purchase the remaining shares. The purchase price for the executive’s position is $60 million. The basis in these shares was $5 million, generating a gain of $55 million. Utilizing the 10-times basis limitation, the executive receives a $50 million exclusion on the second position. Tax will be paid on $5 million in gain for this second transaction.
The total exemption in this scenario was $60 million, and the executive paid tax on $15 million of taxable gain.
High basis stock first
Many would jump immediately to selling high basis stock first to limit tax expense on the initial sale. Had the executive decided to sell the high basis stock first, the exclusion would be $20 million, with no taxable gain. To generate this exclusion, the executive would have utilized two-thirds of his basis, or $3.3 million. The multiple of the 10-times basis would have been $33.3 million, resulting in wasted “basis” utilization in a $20 million sale; the potential benefit of $13.3 million of exclusion was lost.
In the second transaction, $1.7 million of basis could be utilized to calculate the 10-times basis limitation. This would generate an exclusion of $16.7 million and taxable gain of $43.3 million.
The total exemption in this scenario was $36.6 million, and the executive paid tax on $43.3 million of taxable gain.
The planning in this scenario reduced the amount of taxable gain by $28.3 million. This is possible because the $10 million limitation does not reduce an exemption calculated by multiplying 10 times the taxpayer’s basis.
Utilizing the $10 million limit first increases the total limitation available by $10 million. In the situation described above, there was an additional benefit because selling the high basis stock first left a portion of the 10-times basis limitation unused. This was possible because there were multiple blocks of stock, and 10 times the basis in one of those blocks did not create a number greater than $10 million.
Planning to maximize gain exclusions under section 1202 can be quite complicated and thus requires forethought; however, if done correctly, it could be the key to unlocking a lower corporate tax rate for privately held companies.