Private Equity Funds Should Revisit Potential Tax Benefits of Section 1202

Section 1202 was enacted in 1993 to incentivize investment in certain small corporations and permitted a taxpayer other than a corporation to exclude from gross income 50 percent of gain recognized from the sale or exchange of qualified small business stock (QSBS) held for more than five years. Over time, the exclusion of gain offered by section 1202 lost its appeal due to a falling capital gains tax rate and the effect of the alternative minimum tax (AMT) on many eligible investors. Congress recognized the dwindling benefits of section 1202 and enacted temporary, and later permanent, legislation that excluded 100 percent of the gain recognized from the sale or exchange of QSBS and eliminated the gain excluded by section 1202 as an AMT preference item.

Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), many private equity investments were structured as C corporations, often to utilize the blocker effect of a C corporation for foreign or tax-exempt investors. The availability of the section 1202 exemption was an added benefit in the case of qualifying investments. The TCJA reduced the corporate tax rate to 21 percent, repealed the corporate AMT, and preserved the state and local income tax deduction for corporate taxpayers. When these changes are considered in conjunction with the section 1202 exclusion, private equity funds may find that a C corporation is the preferred investment vehicle, notwithstanding the reduced individual tax rate of 37 percent and the new section 199A deduction for owners of passthrough entities.

Overview of section 1202

There are four main requirements of section 1202. First, the stock must be QSBS, or stock of a C corporation that was “originally” issued after August 10, 1993, to a non-corporate taxpayer in exchange for money or property or as compensation for services performed. QSBS may also include stock acquired by gift, inheritance, or received in exchange for QSBS in certain non-taxable transactions.

The second requirement is that, as of the date of stock issuance, the issuing corporation must be a “qualified small business.” A qualified small business is a domestic C corporation if:

• The aggregate gross assets of such corporation (or any predecessor thereof), at all times after August 10, 1993, and before the issuance of the stock being tested, do not exceed $50 million;
• The aggregate gross assets of such corporation immediately after the issuance of the stock being tested (determined by accounting for amounts received in exchange for the issuance) do not exceed $50 million; and
• Such corporation agrees to submit to the IRS and its shareholders any reports that the IRS may require to carry out the purposes of section 1202.

“Aggregate gross assets” refers to the sum of the amount of cash and the aggregate adjusted basis of all other property of the corporation (with the adjusted basis of any property contributed to the corporation being determined as if the basis of the property were equal to its fair market value at contribution). It should be noted that stock that otherwise qualifies as QSBS as of the date of issuance will not lose that status if the issuer subsequently exceeds the $50 million threshold.

The third requirement is that during “substantially all” of the taxpayer’s holding period of the stock, the issuing corporation must satisfy an “active business requirement.” The active business requirement is satisfied if at least 80 percent (by value) of the assets of the corporation are used in the active conduct of one or more qualified trades or businesses (QTBs). The corporation must be an eligible corporation, defined as any domestic corporation other than certain excluded corporations such as a domestic international sales corporation, a regulated investment company, a real estate investment trust, a real estate mortgage investment conduit, or a cooperative. A QTB is any trade or business other than certain excluded businesses. Any trade or business involving the performance of services or of which the principal asset is the reputation or skill of one or more of its employees is an excluded business.

The final requirement is that the taxpayer must hold the QSBS for more than five years. Special holding period tacking rules may apply if the QSBS stock is converted into other stock of the same issuer, or if the QSBS is acquired by gift, inheritance, or as a transfer from a partnership.

Limitation on gain exclusion amount

If the section 1202 requirements are satisfied, the aggregate amount of excludable “eligible gain” equals the greater of (1) $10 million (reduced by the aggregate amount of any eligible gain previously excluded by the taxpayer in prior taxable years from dispositions of QSBS issued by the corporation), or (2) 10 times the aggregate adjusted bases of QSBS issued by the corporation and disposed of by the taxpayer during the taxable year. It should be noted that because a corporation could have up to $50 million in assets at the time of stock issuance, the maximum amount of gain eligible for exclusion could reach $500 million.

Conclusion

Structuring a fund investment as a C corporation has the potential downside of two layers of tax, one at the C corporation level and a second at the shareholder level. If investments can be structured to qualify for the benefits of section 1202, however, private equity funds may be content to pay more tax on a year-to-year basis if gain can be excluded under section 1202 on exit.