IRC Section 1202: Huge Effect on Gazelles

Joseph W. Bartlett

In December 2015, after intense lobbying by, e.g., the Angel Capital Association (“ACA”) and parties interested in the early stage / innovation economy in the U.S. the so-called PATH Act makes permanent the exclusion of 100 percent of the gain on the sale or exchange of qualified small business stock (QSBS) acquired after September 27, 2010 and held for more than five years. The PATH Act also permanently extends the rule that eliminates the 100 percent excluded QSBS gain as a preference item for Alternative Minimum Tax (AMT) purposes. In addition, QSBS gain excluded from income is not subject to 3.8 percent Obamacare tax on “Net Investment Income” from capital gains (and other investment income) on high-income taxpayers. [1]

As is often the case, this development was not treated as headline news, despite the fact that the effect on U.S. gazelles (David Birch’s nickname for startups seeking to journey “from the embryo to the IPO” my phrase) and subsequent job creation is likely to be huge.

There are various conditions that must be satisfied before gain on the sale of stock is eligible for the exclusion. Thus, the stock must have been held for at least five years; and during the 5-year holding period, the corporation must meet the “active business” requirement. In order to meet that requirement, a corporation must (a) be an eligible corporation (which generally means a domestic C corporation) and (b) use at least 80 percent of its assets, measured by value, in the active conduct of one or more “qualified trades or businesses.”

Generally, any trade or business can be a qualified trade or business. However, a number of rules provide for special treatment of certain businesses and business assets, namely:

1. One of the special rules imposes a bar against certain service oriented business from qualifying as a qualified trade or business. These non-qualifying businesses include:

  • (a) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performance arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees;
  • (b) any banking, insurance, financing, leasing, investing, or similar business;
  • (c) any business of operating a hotel, motel, restaurant, or similar business; and
  • (d) Any farming business, or any business involving the production or extraction of natural resource products with respect to which a depletion deduction is allowable under Code Section 613 or 613A.

2.  Rights to computer software are treated as an active business asset if they produce “active business computer software royalties” meaning:

  • (a) The corporation is engaged in the active conduct of a trade or business of developing, manufacturing, or producing computer software;
  • (b) the royalties are attributable to computer software developed, manufactured, or produced by the corporation;

3.  A corporation cannot meet the active business requirement for any period during which more than 10 percent of the total value of its assets consist of real property that is not used in the active conduct of a trade or business.

4.  Working capital is generally treated as used in the active conduct of a qualified trade or business if the working capital is reasonably required for the operation of the business, or is held for investment and reasonably expected to be used within two years to finance research and experimentation or fund additional working capital needs. After two years, no more 50 percent of the active business assets may constitute working capital.

5.  A per-issuer limitation is imposed on amount of gain to which the 50% exclusion can be applied. Specifically, the amount of gain from the disposition of QSB stock issued by a single corporation which is eligible for the exclusion by a taxpayer is limited to the greater of $10,000,000 or 10 times the aggregate adjusted bases of QSB stock issued by that corporation and disposed of by the taxpayer during the taxable year.

In order for gain allocated to an individual by a partnership to qualify for this treatment, (i) the gain must be attributable the partnership’s sale or exchange of stock which is QSB stock in the hands of the partnership  (i.e., meets all of the requirements to be QSB stock” treating the partnership as an individual for this purpose” and was held by the partnership for more than five years), and (ii) the individual taxpayer’s share of such gain must be attributable to a partnership interest held by such individual on the date on which the partnership acquired the QSB stock and at all times thereafter until the disposition of the QSB stock by the partnership. Increases in the individual taxpayer’s interest in the partnership after the date on which the partnership acquired the QSB stock are ignored in determining the amount of gain eligible for exclusion in the hands of the individual taxpayer.

Why does the permanency of Section 1202 constitute such a big deal? In this author’s judgment, the principal reason is that, based on conversations with a number of clients and other individuals and enterprises in the startup economy, there is a good deal of ignorance about Section 1202, caused in part by the fact that, in the past it repeatedly came into force and then lapsed … which tends to make institutions and entrepreneurs, plus their lawyers, somewhat indifferent.

Now that 1202 is on the books and will stay there, all of us need to appreciate the ultimate horror show. A well advised investor in a qualified small business is offered the opportunity to sell its shares four years and 11 months after they were originally acquired, the shares issued by an eligible QSB. The individual accepts the offer and in the process pays a significant tax on capital gains then descends into a helpless rage and/or sues his advisers. Publicizing the permanent existence of 1202 is the best way to avoid that calamity.

[1] For details, see Olsen, “Section 1202: Small Business Stock Gain Exclusion,” Greenstein Rogoff Olsen & Co. LLP, Groco CPAs & Advisors, Jan. 16, 2016.

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