As a founder, you’re probably going to issue yourself a significant number of shares in your company. The goal there, of course, is to make some (ideally, a large amount) of money down the road. But the amount you’ll be able to pocket hinges on how you handle your taxes.
Fortunately for you, Section 1202 of the Internal Revenue Code (IRC), also known as the “Partial Exclusion for Gain from Certain Small Business Stock,” can help you limit your tax liability. In fact, it can also help you incentivize angel investors to get involved with your company. This key piece of legislation can spell pretty significant tax benefits for any individual taxpayer who invests in small American businesses.
To help you help both you and potential individual investors understand this tax perk, let’s dig in.
Section 1202 101
At its core, this portion of the IRC is designed to encourage taxpayers to invest in small businesses. It does this by excluding the capital gains earned on some small business stocks from federal tax. In fact, I.R.C. § 1202(a)(4) says that up to 100% of qualified small business stock acquired after the economy-stimulating Small Business Jobs Act of 2010 can be excluded from capital gains.
Assuming you can get your startup’s stock to qualify (more on that later), you can do two key things. First, you can see a dramatic reduction in what you need to pay in taxes when you sell your shares.
Secondly, you can incentivize investors to get involved with your company by helping them understand these potentially dramatic tax savings. The more shares you plan to issue in exchange for their investment, the more they’ll benefit from this tax regulation.
A quick capital gains review
When you sell a stock, any profit gets taxed as capital gains. To simplify this, let’s say you bought a share for $10 and sold it for $30. The IRS considers those $20 capital gains.
If you held the asset (in this case, the share) for less than a year, the profits are short-term capital gains, and they get taxed at your current income tax rate.
If you hold the share for more than a year, it becomes a long-term capital gain. At that point, unless you or your investor make less than $40,400 annually — or $80,800 if filing jointly — the capital gains get taxed at a rate somewhere between 15 and 28%. In other words, if you or your investor can sit on the share for a year or longer, there’s a pretty good chance you’ll pay less in taxes on capital gains than on your general income.
All this said, the details of Section 1202 offer even more dramatic tax benefits, namely, the exclusion of up to 100% of your profits from capital gains — and the resulting taxes. Long story short, this section of the IRC can help you and your angel investors pocket at least 15% more when you sell your stock.
That assumes, though, that both the stock you issue and the situation that follows align with Section 1202. So let’s look at the requirements.
The parameters to qualify
Section 1202 has been amended several times. The latest amendment says that qualifying small business stock acquired after September 27, 2010, can get up to 100% excluded from capital gains. In other words, if you’re issuing stock now or in the future, you’re in good shape timeline-wise.
But beyond that, the IRC lays out several other requirements to qualify for this exclusion.
Qualifying small businesses
In order for your startup’s stock to qualify for this tax benefit, you need to be a domestic C-corporation. Additionally, you need to have assets totaling $50 million or less leading up to the stock issue and immediately after issuance. You also have to be using at least 80% of your assets to conduct your business.
I.R.C. § 1202(e)(3) also excludes some types of businesses from qualifying. Specifically, your business can’t be:
- One that offers services that hinge solely on the “reputation or skill of one or more of its employees,” which could include health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services
- A banking, insurance, financing, leasing, investing, or similar type of company
- A farming operation
- A business involved in producing or extracting products from mines, wells, or natural deposits
- A hotel, motel, restaurant, or similar business
That can feel limiting, but the IRC gets pretty granular here. If you’re not sure if your startup’s stock could qualify under Section 1202, talk to our team. We can help you assess your company’s alignment with this portion of the IRC.
Qualifying taxpayers and situations
Once you confirm that your stock could qualify, you need to make sure that you or your investor can align with the parameters, too.
For starters, corporations aren’t eligible for this exclusion. Your investor can’t be another corporation, which disqualifies venture capital firms. Most angel investors can qualify, though.
Both founders and eligible investors need to hold their stock for at least five years to be eligible for Section 1202’s exclusion.
Things you can’t do with qualifying stock
Two years after your company issues the stock, a clock starts ticking. In the four years that follow, your company can’t purchase any of the stock back from yourself or your investor.
Also, you need to hold off on “significantly” redeeming your stock between one and three years after the stock issue date. That means you can’t redeem an aggregate value of stock that totals 5% or more of your company’s value, or you and your investor will lose the Section 1202 exclusion.
Maxing out Section 1202
You and your angel investors can exclude capital gains up to either $10 million or 10 times the adjusted basis of the stock. Anything above that maximum gets taxed at 28%.
A note about state taxation
It’s also worth pointing out that not all state taxes align with federal tax regulations. You might still be subject to state taxes even if your stock meets all of the requirements for capital gains exclusion.
All told, IRC Section 1202 can provide you and your angel investors with some pretty impressive tax benefits — assuming your startup’s stock qualifies and you can hang onto it for at least five years. Ultimately, you want to be sure that your company aligns with the requirements before you approach investors with this perk in your pocket or sell any shares yourself.
We can help. As specialists in both tax code and the startup world, our ShayCPA team is available to evaluate your situation and find out if your C-corp qualifies. To get started, contact us.