Knowing What Counts Podcast

Tax-Free Exit: Section 1202 Stock Exposed

• Tim Provost, CPA • Episode 9

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What Is 1202 Stock?

Millions of dollars in potential tax savings are hiding in plain sight for many business owners. Section 1202 stock, also known as Qualified Small Business Stock (QSBS), represents one of the most powerful yet underutilized tax strategies available to entrepreneurs planning their exit.

Tax expert Phil Giguere breaks down this remarkable provision that allows eligible business owners to exclude up to 100% of capital gains when selling qualified small business stock. The numbers are staggering - on a $10 million business sale, QSBS status could save over $2 million in federal capital gains taxes alone, plus avoiding the additional 3.8% Net Investment Income Tax. When state tax benefits are factored in, the combined savings can approach or exceed $3.3 million.

Whether you're launching a new venture, considering converting an LLC to a C-Corporation, or mapping out your eventual exit strategy, this episode provides critical insights into potentially saving millions through proper tax planning. 

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Speaker 1:

Welcome to the Knowing what Counts podcast, the place where expert guidance meets smart financial decisions. Whether you're a high net worth individual or a thriving business, the experts at MPCPAs are here to help you protect and optimize your wealth. Let's get started, because success begins with Knowing what Counts. Because success begins with knowing what counts.

Speaker 2:

Could a little-known tax provision help you save big on capital gains? In this episode of Knowing what Counts podcast, we explore Section 1202, stock what it is, who qualifies and how it can improve significant tax advantages for business owners and investors. Don't miss this deep dive into one of the most valuable tools for entrepreneurs looking to maximize their exit strategy. Welcome back everyone. I'm Sofia Yvette, co-host slash producer, back in the studio with Phil Giger, partner at MPCPAs. So, phil, how's it going?

Speaker 3:

I'm good. How are you doing today, Sophia?

Speaker 2:

I'm doing well, Phil.

Speaker 3:

Great.

Speaker 2:

So go ahead and introduce yourself to our listeners today, Sure.

Speaker 3:

So my name is Phil Jaguer. I'm a partner here at MPCPAs. I've been here since 2006. We're a full-service firm, but I specialize mostly in high net worth individuals with a focus on private equity. I also work with a lot of closely held family businesses and help advise them on their tax strategies.

Speaker 2:

So, Phil, what is QSBS and what does it aim to accomplish?

Speaker 3:

So QSBS is defined by Code Section 1202. It is a very large topic. We could probably do two hours on this, but I won't make anyone do that. It is a tax incentive for the owners of small businesses on their exit, on their sale of their small businesses. The owners of small businesses on their exit, on their sale of their small businesses. It was introduced in 1993 as an incentive for entrepreneurs and investors to invest in these types of small businesses.

Speaker 2:

What are the key benefits for investors?

Speaker 3:

So the key benefit for investors in these small businesses is a tax benefit, so it's the greater of $10 million or 10 times your basis in the stock when you sell. If you had a $10 million gain on the sale of your business, you'd be able to exclude all of that gain from your tax return in the year you sell your business. If you take that $10 million and you multiply it by the capital gains rate of 20%, that's a $2 million savings on the sale of your business. The other great thing about this is that is not subject to the net investment income tax, which is a 3.8% tax on additional investment income. All in all, you could potentially not pay tax of $2,380,000 on a $10 million sale of your business.

Speaker 3:

The other side of that is also that it's 10 times your basis, so it's the greater of. If you had a taxpayer who invested $2 million into the business to start, then their potential 1202 exclusion is 10 times that 20 million, so they could sell their business for 20 million and still also pay no tax on that sale. So it's a really great planning opportunity for small businesses. The other great thing is that it's a per shareholder exclusion and so let's just say you had 10 equal shareholders of a business and they sold their business for $100 million. They would each get the $10 million exclusion and the entire sale would have no tax. So it's really a pretty cool tax planning strategy.

Speaker 2:

Wow, my goodness, it certainly does sound like it has some nice benefits. What has made 1202 so popular? Nice benefits. What has made 1202 so popular.

Speaker 3:

So to talk about that, we kind of have to go back a little bit and say why wasn't it popular, since it's been around since 1993? When it first came into being in 1993, it was not 100% exclusion, it was only a 50% exclusion. So on your $10 million gain, you would only be able to exclude $5 million. There was also some AMT ad backs.

Speaker 3:

Not everyone really thought it was worth all the effort to do this 1202 stock. That all changed in 2010 when Congress changed the exclusion to 100% and they also removed the AMT ad back. So we started seeing more and more of it after that ad back. So we started seeing more and more of it after that and then in 2013, when the net investment tax came into play another reason why you would want to do this because you can avoid that 3.8% additional tax. But then the big change happened in 2017 with the Tax Cuts and Jobs Act, tcja. That was the big change because it lowered the corporate income tax rate down from the highest of 35% down to 21%. It made being a C-Corp and running the business as a C-Corp and operating as a C-Corp much more palatable to the shareholders to not have to pay at that high tax rate of 35%. Tax rate of 35%. So now we see more and more businesses starting up as C-Corps to take advantage of the 1202 because they know they can have that nice low corporate tax rate.

Speaker 2:

So, phil, what are the key requirements to qualify as QSBS?

Speaker 3:

In order to have qualified small business stock, your business first has to be considered a qualifying small business. The Internal Revenue Code lays four hurdles that you have to get past to be considered a qualified small business. The first is that you have to be a domestic C-Corp. So no foreign corporations, no partnerships, no S corporations. You have to be a regular old US C-Corp. The second test is that you have to pass the gross assets test, and so that is both before and immediately after you become a C corp. The gross assets of the business have to be $50 million or less. So these are supposed to be for small businesses, so they want to make sure that you're considered a small business $50 million or less. The third hurdle is that 80% of the assets of the business must be used in the trade or business. So third hurdle is that 80% of the assets of the business must be used in the trade or business, so you can't have a bunch of investments or things like that. All the assets of the business need to be used in the business. And then the last hurdle is that it has to be a qualified trader business, and so the code lists out what is considered, what is not considered a qualified trader business and that is your service company. So healthcare, engineering, accounting, things like that Any services where the reputation or skill of one or more of the employees is the main asset of the business. So service businesses are not qualified. Other financial businesses banking, things like that do not qualify. Farming does not qualify, and hotels, restaurants and other businesses like that do not qualify. But basically anything else should be able to qualify under 1202.

Speaker 3:

So now you've passed all those tests, you have a qualifying small business. The next test is that you have to in the hands of the shareholder. It has to be considered qualified small business stock, and so the shareholder must be an individual. Trust, estate or partnership Can't be a corporate shareholder. It must be original issuance stock so no one else could have owned the stock before you. There are definitely some exceptions to this we could probably do a whole podcast on that but it's got to be original issuance stock and you have to have held it for at least five years. So if you go over all those hurdles, you now have qualified small business stock.

Speaker 2:

So, Phil, do states also allow QSBS exclusion?

Speaker 3:

So the answer to that is yes and no. It depends on the state. Every state has its own set of rules and laws. Most do, some don't. The big states. That is yes and no. It depends on the state. Every state has its own set of rules and laws. Most do, some don't. The big states that don't California, new Jersey, pennsylvania and some states have a hybrid, for example, in Massachusetts up until 2022,. It's a hybrid.

Speaker 3:

Massachusetts only conformed with the Internal Revenue Code up until 2005. So in Massachusetts you could sell your business and you could have a 100% exclusion on the Fed side. But in Massachusetts, because Massachusetts only conformed up to 2005, it would only be a 50% exclusion in Massachusetts. They did change that and so now you can get both 100% exclusion on the federal as well as Massachusetts. And that's a really big deal because now, with the millionaire's tax in Massachusetts on any income over a million, there's an additional 4% tax. So if we take into account your $10 million sale, you have your capital gains rate of 20%. That's a $2 million savings. You have the net investment tax. That's another $380,000 of savings. And then in Massachusetts, that's a $2 million savings. You have the net investment tax. That's another $380,000 of savings and then in Massachusetts it's a potential another $900,000 in savings. So we're getting close to $3.3 million savings on your $10 million gain by having this 1202 in Massachusetts.

Speaker 2:

Now is it possible to convert an already existing business into a QSBS.

Speaker 3:

Yes, a lot of times these startups will begin as partnerships, as LLCs, and they will operate as an LLC, as a partnership, and the members of the partnership may decide that they want to pursue 1202, and they can elect to convert that partnership into a C corporation. As long as they meet all the other hurdles of being qualified small business, then yes, you can convert an LLC partnership into a C corp and have 1202 stock. The only drawback there is that the five-year holding period starts when you convert, so you can't convert and then immediately sell and get your 1202 exclusion. You have to convert and then wait your five years and then you can sell to and then immediately sell and get your 1202 exclusion. You have to convert and then wait your five years and then you can sell to get the exclusion.

Speaker 2:

So, bill, can I give QSBS stock to my children?

Speaker 3:

Yes, that is one of the things for original issuance. You can inherit, you can gift 1202 stock. One of the planning strategies there is that every individual gets that $10 million exclusion. If I was the only owner of this business, I would get my 10 million and that was it. If, let's say, I sold it for 50 and I had a $50 million gain, but if I wanted to gift my two kids stock, they would also each get that $10 million exclusion. So it's a way to spread that gain around and limit the tax for the family and things like that.

Speaker 2:

Well, catch you on the next episode. Phil, I hope you have a fantastic rest of your day.

Speaker 3:

Thank you, you too.

Speaker 1:

Thanks for listening to the Knowing what Counts podcast. Ready to optimize your wealth and protect your future, visit TheMPGroupCPAcom or call 413-739-1800 to connect with our team of experts. Remember, success is about knowing what counts.