The magical application of section 1202 to C corporation shareholders seems too good to be true, with millions of tax dollars being saved. However, following the significant reduction in the corporate tax rate in the Tax Cuts and Jobs Act, many S corporation shareholders are wondering why they are still being excluded from this valuable benefit.
A pile of cash and a pile of pennies on a scale.
Section 1202 went into effect in 1993 and excludes certain percentage gains capitalized on the sale of Qualified Small Business Stock (“QSBS”), provided the stock is held for more than five years. For qualified small business shares acquired after September 27, 2010, 100% of the gain recognized on the sale of shares may be excluded from the taxable income of C corporation shareholders. That wasn’t a typo! If the rules of Section 1202 apply and the stock was acquired after 2010, a C Corporation shareholder need not recognize any gain associated with the sale of its stock. The exclusion of Article 1202 is limited to the taller of $10 million or 10 times the aggregated adjusted basis of the QSBS spent by the company and divested by the taxpayer.
Congress’s intent was to incentivize taxpayers to start and invest in small businesses. However, by limiting Section 1202’s eligibility to C corporations, the larger entity classification population of S corporations may not attract as many start-up investors, even though S corporations represent more small businesses in the United States. While current law allows a small business qualified under Section 1202 to have a brief stint as an S corporation, the lack of definition around the timing and the need for startup companies to be flexible in their early years does not make it easy the benefits of Section 1202 for Shareholders of the S corporation.
The ability to limit 1202 to C corporations to avoid double taxation once at the C Corporation and again at the shareholder level may have paid off more since the corporate tax rate was 35%. However, with the significant reduction in the corporate tax rate to 21%, limiting Section 1202 to only C corporations appears to provide inequality for S corporation shareholders and hamper S corporations’ ability to appropriately attract additional investors. lure using the 1202 tax incentive.
Going through the simple example below highlights that a C Corporation pays only about 28% of what an S Corporation would pay in the same transaction, reduced from about 47% when C Corporation’s tax rate was 35%. The shareholder of C Corporation can not only benefit from a reduced corporate tax rate of 21%, but also from the 1202 exclusion on the sale of their shares. Unfortunately, S Corporation shareholders still have to pay a 29.6% tax rate (i.e., 37% minus the 20% QBI deduction) on operations, plus a tax rate of at least 20% on the sale of their stock.
In this example, X Company was incorporated with the following shareholders and contributions.
Shareholder Contribution
C Corporation analysis
Let’s assume that over the five-year period, the C corporation generates taxable income of $126,000,000 and pays federal tax payments of $26,460,000 ($126,000,000 * 21%). Angela decides to sell her shares of C Corporation after the five-year period when the company is valued at $450,000,000. For simplicity, no dividend payments were made by the C Corporation to Angela during the 5-year holding period.
When Angela sells her 45% interest for approximately $202,500,000 (450,000,000 x 45%), she will generate a realized gain of $182,500,000 (202,500,000 – 20,000,000). However, provided all Section 1202 requirements are met, Angela can exclude the greater of $10,000,000 or $202,500,000 (which is ten times her 20,250,000 adjusted tax base in the QSBS sold). Therefore, none of Angela’s profits from the sale of QSBS would be taxable at the federal income tax level.
S Corporation analysis
Applying the same example to an S corporation, the taxable income of $126,00,000 will result in federal income tax payments of $37,296,000 (126,000,000 x 29.6%). A rate of 29.6% was used assuming the highest individual income tax rate of 37% minus the 20% QBI deduction. Since the income allocated to Angela will increase her external tax base, Angela’s base will increase from $20,250,000 to $76,950,000 (20,250,000 + (45% x 126,000,000)). For simplicity, no distributions were made by the S Corporation during the 5-year holding period.
When Angela sells her stock for $202,500,000, her realized and recognized gain would be $125,550,000 (202,500,000-76,950,000). Assuming a 20% long-term profit rate applied to the stock sale, Angela would pay $25,110,000 (125,550,000 x 20%) in federal income tax.
The sole use of a C corporation versus an S corporation would save approximately $30,000,000 in taxes associated with the taxable income generated during the holding period and sale of company stock.
1202 Comparison C Corp vs S Corp
Don’t assume that the example only shows such a large tax difference because no distributions were made during the 5-year holding period. The difference a business cash distribution would make would be negligible. The maximum tax rate on a qualifying C Corporation dividend for an individual shareholder would be 23.8%. For the S corporation, a distribution would only lower the base in pre-sale shareholder stock and increase profits that are taxed at 20%.
While it’s important to advocate for S companies to get the 1202 benefit, the benefit may not apply to every company. Here are some highlights of the 1202 exclusion that taxpayers should be aware of.
How small does my company have to be for the inventory to be considered QSBS?
Qualifying small business stock is defined as stock issued by a company that has a qualified small business. a qualified small business is currently defined as any domestic C corporation whose total gross assets (cash, the FMV of contributed property, and adjusted C corporation asset base) before and immediately after the issuance of shares does not exceed $50,000,000. The shares must be purchased by the shareholder for cash, property or consideration for services when originally issued.
Does the business have to be an active trade or corporation?
Yes. For the shares to be considered QSBS, the company must meet an active business requirement for substantially the entire period of ownership. To meet the active business requirement, at least 80% of the company’s assets must be used by the company to actively perform one or more qualified crafts or businesses. The value of the company’s assets is measured for these purposes, which means that the value of all assets, including self-created intangible assets such as goodwill, must be taken into account when applying the 80% test.
Are certain professions or businesses excluded from the 1202 exclusion?
Yes, the following companies are not considered qualified trade or business for purposes of 1202.
any trade or business involving the provision of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business involving the principal assets of such trade or business is the reputation or skill of one or more of its employees
· all banking, insurance, financing, leasing, investment or similar activities
any business that operates a hotel, motel, restaurant or similar business
owning, trading or renting real estate is not treated as actively conducting a trade or business (since no more than 10% of the total value of assets can be real estate that is not used in active trading or commercial)
S Corporation stockholders are also disadvantaged in the gift or bequest of their S Corporation stock. AC corporation that qualifies as QSBS can implement certain tax schedules that keep QSBS status in effect for their beneficiaries (i.e., sons, daughters, and granddaughters). This would allow beneficiaries to receive the same 1202 benefits upon the eventual sale of QSBS as the person from whom they inherited the shares. However, the ability to pass such a significant federal exclusion from taxable income is not available to shareholders of S corporations and therefore gives them an unfair advantage when they want to keep a company in the family for generations.
As the Internal Revenue Code seems to be constantly changing, it is important for legislators to review the various incentives provided in the past to gauge the potential impact of the new legislation. With a C corporation tax rate of only 21%, it seems unreasonable not to allow Section 1202 benefit for shareholders of S corporations. Incorporating S Corporations to boost small businesses seems like a good idea. The more entities that can use 1202, the more likely small businesses are to grow.
Janice has been with businesskinda for 5 years, writing copy for client websites, blog posts, EDMs and other mediums to engage readers and encourage action. By collaborating with clients, our SEO manager and the wider businesskinda team, Janice seeks to understand an audience before creating memorable, persuasive copy.
