This might sound like a prime tax shelter, but Section 1202 has been "ignored" for years, according to Liddy Karter, president of the Angel Investor Forum, a venture capital advisory firm in Old Lyme, Conn. To jump-start investor interest in the provision, Congress raised the ante early this year; it bumped the tax exclusion to 75% on gains from the sale of certain small business stock issued after the date of enactment (Feb. 17, 2009) and before Jan. 1, 2011. "That's better, but Section 1202 needs more changes before people really start to use it," Karter says.
Luckily for affluent investors, more changes just may be in the cards. In the meantime, financial planners should take a long look at Section 1202 and see if it can benefit their clients, be they angel investors or entrepreneurs.
Why the lack of enthusiasm for Section 1202? When this provision was created in 1993, the tax rate on long-term capital gains was 28%. Even though the long-term capital gains rate was subsequently reduced to 20% and then 15%, the Section 1202 50% exclusion always applies to a 28% tax rate. Therefore, that exclusion sets the tax on qualified sales at 14%. When everyone can get a 15% tax rate on long-term gains, jumping through the hoops of Section 1202 to get a 14% rate is not appealing.
The American Recovery and Reinvestment Act of 2009 expands the Section 1202 tax exclusion to 75% from 50%. With the same 28% base rate, a 75% exclusion brings the effective tax rate on Section 1202 gains down to 7%, a much more attractive number, at least on the surface.
The real-world impact of the greater tax exclusion will be muted, according to Luis Villalobos, founder of Tech Coast Angels in southern California, the largest angel investment network in the United States. "Part of the gain excluded from regular income tax under Section 1202 is considered a preference item for the alternative minimum tax," he says. "Many angel investors are subject to the AMT. Even with a 75% exclusion, the AMT paid by those investors will take away most of the tax advantage newly gained from Section 1202."
Despite the AMT drawback, there are times when Section 1202 can be valuable. Villalobos says that Section 1202 has helped him save tax on investment gains in some prior years. What's more, a 7% tax rate on an investment made in 2009 or 2010 could turn out to be very appealing if a client realizes a small company investment profit in a future year when the default tax rate on long-term gains is 20% or higher, as now seems likely.
Therefore, financial planners who advise entrepreneurs or angel investors may do well to know the basics rules of Section 1202. The exclusion is available only for investments in what is called "qualified small business stock" (QSBS). Only shares issued by regular C corporations can qualify as QSBS.
Besides the C corporation requirement, there are other hurdles that must be cleared to qualify for the Section 1202 exclusion. The stock must be acquired at its original issue, and the shares must be held for at least five years.
In addition, when the stock is issued, "the company must have aggregate gross assets of less than $50 million, including the proceeds of the stock sale," explains Matthew Bartus, a partner in the Palo Alto, Calif., office of the law firm Dorsey & Whitney. "And at least 80% of the value of the corporation's assets must be used in the active conduct of a qualified trade or business," Bartus adds.
A trade or business can issue QSBS only if it does not operate in certain prohibited areas. Specifically, QSBS cannot be issued by companies in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, farms, hotels, restaurants and the production or extraction of minerals, oil or natural gas.
That leaves many types of businesses eligible for the 1202 tax exclusion, Karter notes. "Angel investors usually want to back companies that have high growth potential," she says. "Often, that leads to investments in technology areas, such as biotech. However, you can get the tax exclusion from lower-growth businesses like computer repairs or metals distribution, for example."
If your clients want to claim the 1202 tax exclusion, there is one more rule they must follow, according to Karter. A business owner or investor who profits from the sale of QSBS can exclude gains up to 10 times his or her basis in stock issued by the corporation and disposed of during the year, or $10 million reduced by any gain excluded in prior years, whichever is greater.
If someone sells QSBS under the conditions mentioned above, they may be able to take another tax break. Indeed, the 14%-plus AMT rate prevailing in the past few years has been so unattractive that the other tax benefit of Section 1202 may have been the dominant one; investors can roll over sales proceeds from the sale of QSBS to the purchase of other QSBS, deferring all the income tax.
More specifically, an investor who holds QSBS for more than six months can use the sales proceeds to buy other QSBS within 60 days. While the gain is deferred, the original holding period of QSBS is added to the holding period of replacement QSBS. All the gain will qualify for the Section 1202 exclusion if the combined QSBS holding period is at least five years.
Even this Section 1202 opportunity is not without its flaws, though. Some industry experts say that reinvestment window is not long enough. "I'd like to see the reinvestment window extended from 60 days to one year or at least nine months," Karter says. "When a small company is sold, it may take two to three months just to get everything sorted out. Extending the time frame would give investors more of a chance to keep rolling over gains, tax-free."
Regardless of whether the window for rollovers opens further, there is a chance that Section 1202 could be enhanced even more. "In one proposal for the fiscal year 2010 budget, the Obama administration proposes eliminating capital gains tax on the sale of qualified small business stock issued after Feb. 17, 2009," reports Ted Hollifield, a partner in Dorsey & Whitney's Palo Alto office.
Under that proposal, the tax exclusion on a sale by an individual or other non-corporate taxpayer would be increased to 100%. Also, the AMT preference item for Section 1202 exclusions, which currently dims the appeal of the tax break for many angel investors, would be eliminated.
"That would be a big help," Villalobos says, referring to the proposed change to Section 1202. "However, most investors don't choose to invest in a small business because they might pay tax at a lower rate in five years or more. No one really knows what the tax rates or the AMT rules will be then. For a greater impact, Congress could pass a law saying that all sales of qualified small business stock after Feb. 17, 2009, would be free of capital gains tax and the AMT. A law like that would definitely stimulate lots of sales, freeing up more capital to invest in small businesses."
TO C OR NOT TO C
Unless and until Section 1202 is further modified, the current law will be in place for QSBS issued through 2010. What are the implications for financial planners?
For entrepreneurs and their planners, setting up a company to generate a potential future 1202 tax exclusion is mainly a matter of making sure that stock issued will be QSBS. Assuming it's a company that does not operate in a proscribed area, a client probably can pass the QSBS tests by structuring the company as a C corporation, rather than an S corporation or a limited liability corporation (LLC). Observers are divided about whether that would be a savvy move.
"Back in the 1990s, many angel investors preferred C corporations," Karter recalls. "By now, though, the rules for LLCs have become so well-established that most business startups are structured as LLCs. They're more flexible than C corporations, they avoid the corporate income tax and they allow the pass-through of tax losses to investors."
Daniel Cullen, leader of the tax advice and controversy client service group in the Chicago office of the law firm Bryan Cave, also feels that the C corporation restriction hampers the use of Section 1202. "Many people who start businesses today prefer LLCs," he says. "If the rules were changed to cover LLCs as well, Section 1202 would be more effective in encouraging investments in small businesses, as Congress intended. For now, though, I think business owners should consider all the factors when selecting a business structure rather than choosing a C corporation just to get the Section 1202 exclusion."
Villalobos isn't as negative about the C corporation restriction as some others are. "Although S corporations and LLCs offer some tax benefits, there are also tax advantages to setting up a business as a C corporation," he says. "Losses on the sale of small business stock can be deducted, up to $1 million, against ordinary income. The rollover-of-gain opportunity provided by Section 1202 is actually provided by Section 1045 of the tax code. All of those potential tax advantages are available only if the business is a C corporation."
At the same time, there may be drawbacks to S corporations and LLCs that business owners don't know about. "In some cases, investors will get 'phantom income,'" Villalobos says. "Taxable income from the business will pass through to investors, but there will not be enough cash distributions to pay the tax on that income."
Some LLCs may require extensive drafting of the documents, while others might cause a "nightmare of accounting," as Villalobos puts it. "Of the new small companies in high-potential businesses, the ones angels investigate, I'd estimate that the majority are structured as C corporations, which can avoid the legal and accounting problems of LLCs."
What's the bottom line for financial planners advising entrepreneurs? "If there's a strong expectation that the business will have a long period of losses, then set the business up as an S corporation or an LLC," Villalobos says. "If that's not the case, the business might be better off as a C corporation."
If a client chooses the C corporation structure, shares issued have a good chance of becoming QSBS, and any gains might get a tax break via Section 1202. This may help to attract investors and might eventually provide some tax relief to the entrepreneur when the company's stock is sold.
For financial planners advising clients who are considering angel investments, business structure is one more factor to consider. While the "don't let the tax tail wag the investment dog" maxim certainly applies, investing in QSBS provides the opportunity for low-taxed gains in the future, a prospect that may have a huge payoff if capital gains tax rates have gone sky-high by the time the angel is ready to reap some heavenly profits.