Interest in the 1202 Exclusion Increases with its Benefits, says ABA Webinar

Tax advisors report increased client interest in the Section 1202 exclusion of gain on qualified stock because the benefits of the exclusion have become greater. But, according to panelists at a recent American Bar Association webinar, the IRS needs to provide more guidance on this complex law.

Section 1202 Gain Excluded from Income

Section 1202 allows eligible shareholders to exclude some or all of their gain on the sale or exchange of qualified 1202 stock. To exclude 1202 gain, however, eligible shareholders, qualified stock, and the issuing corporation all must satisfy a certain requirements.

The 1202 exclusion is intended to encourage investment in new and risky companies. But the webinar panelists noted that these are not explicit limitations. For instance, the exclusion might also apply to:

  • publicly traded corporations, and
  • domestic corporations that conduct foreign businesses.

Increased Interest in 1202 Exclusion

The panelists agreed that tax advisors are fielding more questions from clients about the 1202 exclusion.

This heightened interest comes partly from legislative changes that have made the exclusion more valuable. For example:

  1. The original 50% exclusion increased to 100% for gain on 1202 stock issued after September 27, 2010.
  2. Excluded gain on 1202 stock issued after September 27, 2010, is no longer an alternative minimum tax (AMT) preference item.
  3. Excluded 1202 gain escapes the 3.8% tax on net investment income.

Section 1202 and Choice of Entity

Increased interest in choice-of-entity issues has also led to more questions about the 1202 exclusion.

Small businesses have traditionally been more likely to organize as pass-through entities, such as partnerships and S corporations. However, the 2017 Tax Cuts and Jobs Act is prompting many businesses to consider a C corporation structure instead.

Benefits of Section 1202 vs. 199A

This is largely because of the new 21% corporate tax rate, which reduces the “tax drag” caused by the corporate income tax. The panelists noted that the Section 199A deduction for qualified business income is supposed to offer comparable tax benefits for pass-through entities.

However, the 199A deduction is set to expire at the end of 2025. In contrast, the 21% corporate tax rate and the 1202 exclusion are both permanent—at least, as permanent as anything else in the Code.

Startup Tax Planning with the 1202 Exclusion in Mind

The higher profile for choice-of-entity questions has also changed the way tax advisors and clients approach the 1202 exclusion. In the past, 1202 issues most commonly arose after a stock sale. Now, however, many clients are looking forward, taking the 1202 exclusion into account before they set up a company or make an investment.

The panelists noted two features of 1202 that can make it especially valuable for start-up companies:

  • Start-up activities may qualify as the active conduct of a trade or business.
  • The $50 million dollar asset limit for a qualified business depends on tax basis, not fair market value.

These aspects make 1202 a powerful tool in business planning.

How 1202 Can Benefit a New Business

Consider this hypothetical:

  1. A new venture raises $49 million in its first investment round—so it stays under the $50 million asset ceiling.
  2. The business spends that money on things with little or no tax basis, such as research and experimentation or bonus depreciation property.
  3. The business then does a second investment round, raising another $49 million.
  4. Again, the business can spend that money in ways that minimize tax basis.
  5. This process can be repeated multiple times, allowing the business to raise and spend significant amounts of money without going over the $50 million asset ceiling.
  6. In the meantime, the business can significantly increase its intangible assets, like goodwill.
  7. The result is a business that stays below the $50 million asset ceiling, even as its fair market value increases far above that level.

The strategy may be even more effective if the business operates first as a pass-through, and then converts to a C corporation. This can increase the basis of the C corp’s stock, which effectively increases the adjusted-basis limit on each shareholder’s annual exclusion.

Section 1202 Exclusion Pitfalls

Despite its benefits, the 1202 exclusion has shortcomings. The panelists agreed that the biggest problem is the lack of guidance from the IRS and the courts. This is especially troublesome because the exclusion is complex and there is substantial uncertainty about:

  • The treatment of debt and options that can be converted to equity
  • Valuation and amortization when property, especially intangible property, is exchanged for stock
  • How a qualified corporation satisfies the requirement to use 80% of its assets in an active trade or business
  • What happens when pass-through entities hold 1202 stock
  • What constitutes a qualified trade or business

Another Section 1202 Comparison with 199A

Some of these issues are especially frustrating when compared to the more plentiful guidance for similar components of the 199A deduction. For example, the panelists noted the substantial overlap between the rules for a 1202 Qualified Trade or Business (QTOB) and a 199A Specified Service Trade or Business (SSTB). Proposed regulations offer significant guidance on SSTBs, but they are expressly limited to 199A. Thus, they don’t help clarify the 1202 rules.

Similarly, the Section 199A regulations include a de minimis exception that lets a business with small amounts of service income avoid the SSTB category. However, 1202 does not have anything similar, raising the risk that a very small amount of income from a non-QTOB can exclude all of the stock from 1202.

More Section 1202 Guidance, Please!

Finally, the panelists expressed a unanimous hope that Section 1202’s higher profile with taxpayers will prompt the IRS to issue more guidance on its complexities.

Kelley Wolf, JD, LL.M

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