Capital gains taxes can be painful for everyone, but particularly painful for high-bracket clients.
They might owe the increased 20% tax on long-term gains, the 3.8% surtax on net investment income and various stealth taxes. But Toby Johnston, a CFP and CPA who is a partner with the Private Client Services practice at Moss Adams, a Seattle-based accounting and consulting firm, mentions an “often overlooked” opportunity in Section 1202 of the tax code.
“In some cases, all of the gain can be excluded from tax,” Johnston says. The Protecting Americans from Tax Hikes Act of 2015 recently made a 100% exclusion permanent, retroactive to 2015.
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SMALL IS BEAUTIFUL
The Section 1202 exclusion, which is generally capped at $10 million of gains per stock issuer, applies to the profits of noncorporate taxpayers on sales of “qualified small business stock.” Multiple conditions apply, but Johnston notes some key points.
The stock must be in a domestic company that was a C corporation for substantially all the time that the shares were held. The company’s assets must total no more than $50 million when the stock was issued, and immediately thereafter; the investor must acquire the QSBS at its original issue, rather than on a secondary market.
Moreover, at least 80% of the firm’s assets must be used in an active business in a qualifying field, as defined in Section 1202. The disqualified list includes most service firms as well as those in the banking, farming and hospitality sectors, along with some energy and mining companies. “In my experience working in Silicon Valley,” says Johnston, whose office is in Campbell, Calif., “many early-stage investments in C corporation technology companies meet the requirements for the exclusion.”
Shares must be held for at least five years to get the 100% exclusion. Lesser tax breaks apply to QSBS acquired before Sept. 29, 2010.
“The five-year holding period for the 100% exclusion was first met in late September 2015,” says John Wheeler, a certified financial planner, CPA and PFS who is a senior financial consultant with Castle Wealth Advisors in Indianapolis. “The total exclusion and the law making it permanent are still new, and people are learning the fine points.”
For instance, shares can be transferred via lifetime gifts or bequests at death. “The recipient will be treated as holding QSBS stock, with the tax advantages,” Wheeler says. The original purchase date will determine the holding period. The rules are the same if QSBS shares are distributed from a partnership to its partners.
Someone who owns a QSBS for more than six months but sells it before five years may be able to defer the tax on any gains by buying another QSBS issue within 60 days. The holding period from the first stock will be transferred to the second one.
Section 1202 of the tax code has been around for years, but its benefit was not always bountiful. “It was enacted in 1993 with a 50% exclusion,” Wheeler says, “but the taxable portion of any gain was taxed up to 28%.”
If 50% of a QSBS gain was taxed at 28%, the effective tax rate would have been 14% — a modest saving when the top capital gain tax rate subsequently was lowered to 15%.
In addition, QSBS gains may have been subject to the alternative minimum tax, adding to the ultimate tax bill. The impact of the AMT is related by Mary Kay Foss, a director with Sweeney Kovar, an accounting firm in Danville, Calif.
“I had a client who was one of the founders of a large social media company,” she says. “He sold some of his shares to an insider the year before it went public and benefited from Section 1202.” However, the QSBS gain then was a “preference item” for the AMT.
“The client sold more shares the next year, after the offering,” Foss says. “The huge tax paid for the first year sunk him into the AMT, so there was no benefit from Section 1202 the following year.”
She adds that Section 1202 “absolutely” has become more attractive, with a 100% exclusion of gains and no AMT exposure, under the PATH Act of 2015.
C CAN BE THE CATCH
Beyond the AMT and the partial tax on gains in prior years, other factors have dampened enthusiasm for Section 1202. Martin E. James, a CPA and PFS who is managing member of Martin James Investment and Tax Management in Mooresville, Ind., has not had any clients use the exclusion.
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“That’s mainly because most of our clients’ corporations are S corporations, not C corporations,” he says. An S corporation avoids the corporate income tax and any income or loss flows through to shareholders’ personal returns.
“Another problem with applying the Section 1202 exclusion,” James says, “is trying to convince a buyer to purchase the company’s stock instead of its assets.
Most buyers are concerned about potential legacy liabilities that would come with the stock.”
As Gary Pittsford, a certified financial planner who is president and CEO of Castle Wealth Advisors, puts it, “Who knows if chemicals were dumped illegally or if someone fell and broke his neck in the parking lot? Even at a low price, business buyers usually won’t want to purchase stock.”
According to Wheeler, the decision to structure a company as a C corporation, with potential tax-free profits in the future, depends on the type of business. “Someone starting a business in the hopes of attracting angel investors and eventually going public, for instance, might choose a C corp,” he says.
Clients who invest in privately held companies may not be aware of the Section 1202 opportunity. Johnston asserts that advisors can help by bringing up the potential tax savings and urging clients to keep good records of their stock purchase, to show the date of the transaction and the amount paid.
“Someone making an investment that eventually may qualify for QSBS treatment should ask the company to certify that it is a domestic C corporation with $50 million or less in assets that would qualify for the exclusion,” Johnston says. “Investors also should keep track of the date when their investment reaches the five-year holding period. You wouldn’t want to sell right before it hits the threshold if waiting would have resulted in significant tax savings.”
Johnston notes some businesses fall into a gray area as to whether they’re “active” and thus qualify for the 1202 exclusion.
“If a company is in the gray area,” he says, “one tactic is to file the tax return without claiming the 1202 exclusion, and pay the tax. Then, file an amended return, claim the exclusion and request a refund. There might be more scrutiny of an amended return, but this plan reduces the risk of a large underpayment penalty.”