Section 1202 Small Business Stock: Avoid tax at company exit

What is Section 1202 Stock?

Section 1202 (also referred to as the Small Business Stock Gains Exclusion) is a section of the Internal Revenue Code (the “IRC”) that allows excluding from federal tax the capital gains realized from the sale of stock in small business corporations. This tax break was designed to incentivize investing in small businesses.

Normally, the positive difference between the stock’s purchase price and the sale prices is taxed as capital gain. For example, if stock was bought at $100,000 and was later sold at $500,000, there will be a $400,000 capital gain added to a taxpayer’s taxable income.

Section 1202 allows excluding up to $10,000,000 of capital gains (or 10 times the adjusted basis of the stock, whichever is greater) from one’s taxable income if certain conditions are met:

1. The issuing corporation must have been a domestic C corporation since the date of stock issuance (see our article on the various types of business entities here).
2. The issuing corporation must not have had “aggregate gross assets” in excess of $50 million at any time prior to or immediately after the issuance of the stock.
   a. Rights to computer software that produces royalties are included in the gross assets.
3. The issuing corporation must not be primarily engaged in any of the non-qualified activities. Some of them include:
   a. any trade or business where the principal asset is the reputation or skill of 1 or more of its employees (most professional services)
   b. any banking, insurance, financing, leasing, investing, or similar business
   c. any farming business (including raising or harvesting trees)
   d. any business of operating a hotel, motel, restaurant, or similar business
4. At least 80% of the issuing corporation’s assets must be used in the operation of the qualifying business during the taxpayer’s entire holding period.
5. The stock must be held for at least 5 years prior to the sale.
6. The stock must be acquired directly from the issuing corporation.
7. The stock must be acquired for cash, stock, or services.
8. To claim the benefit, the taxpayer must not be a C corporation itself.
9. To claim a 100% gain exclusion, the stock must have been originally issued after September 27, 2010.
   a. Stock originally issued after February 17, 2009, and before September 28, 2010, is eligible for a 75% gain exclusion.
   b. Stock originally issued before February 18, 2009, but after August 10, 1993, is eligible for a 50% gain exclusion.
10. The stock must actually qualify as “stock” for federal income purposes.
    a. Unvested stock, warrants, and stock options themselves don’t count as stock.

Certain other exceptions and requirements apply. Please consult with an attorney or a tax advisor.

Do SAFEs and convertible notes qualify as stock?

An important issue to consider when negotiating fund-raising instruments as the investor is what qualifies as stock for the purposes of Section 1202. Many early-stage investments are conducted in the form of SAFEs (Simple Agreements for Suture Equity) and convertible notes. These instruments, in general, provide the opportunity for early investors to have their monetary contribution converted into stock at a discounted rate later. The conversion typically occurs simultaneously with a major funding round led by sophisticated investors or can happen at an agreed-on future maturity date.

Some SAFEs and convertible notes may not qualify as stock for Section 1202 purposes. Whether SAFEs and convertible notes qualify as stock affects how early a taxpayer may claim the Section 1202 tax brake (are the five years counted since the instrument was issued or since it converted to stock?)

The IRS stated in its Notice 94-47 that “the characterization of an instrument for federal income tax purposes depends on the terms of the instrument and all surrounding facts and circumstances.” The IRS further noted that, “no particular factor is conclusive in making the determination of whether an instrument constitutes debt or equity. The weight given to any factor depends upon all the facts and circumstances and the overall effect of an instrument’s debt and equity features must be taken into account.” The following factors are considered in determining whether an instrument qualifies as equity or debt:

1. Whether there is an unconditional promise on the part of the issuer to pay a certain sum on demand or at a fixed date in the reasonably foreseeable future;
2. The label placed on the instruments by the parties;
3. Whether holders of the instrument possess the right to enforce the payment of principal and interest;
4. Whether there is identity between the holders of the instruments and stockholders of the issuer;
5. Whether the instruments give the holders the right to participate in the management of the issuer;
6. Whether the rights of the holders of the instruments are subordinate to the rights of general creditors;
7. Whether the issuer is thinly capitalized;
8. Whether the instruments are intended to be treated as debt or equity for non-tax purposes.

Takeaways

Section 1202’s gain exclusion is some of the most attractive tax benefits available to founders and venture capitalists. It is an important strategic point to consider when choosing the right entity type for your business, as Section 1202 capital gains exclusion is only available with regard to qualifying stock in C corporations. Consult with an attorney to assess your company’s needs and goals when deciding on the business entity type.

Investors may consider purchasing stock directly instead of investing in SAFEs and convertible notes to maximize Section 1202 tax benefits. Otherwise, an attorney can assist in structuring the funding instruments in a way that increases the chances that they qualify as stock for Section 1202 purposes.