January 15, 2019

Section 1202 Coupled with the Reduced Corporate Tax Reinvigorates Choice of Entity Discussion

By James Dieterle, Manager, Tax & Business Services

Section 1202 Coupled with the Reduced Corporate Tax Reinvigorates Choice of Entity Discussion Tax & Business

Since 2015, non-corporate taxpayers have been able to dispose of certain small business stock and exclude the entire gain from their federal taxes pursuant to a Internal Revenue Code Section 1202. Owners of Qualified Small Business Stock (QSBS), also known as Section 1202 Stock, are permitted to exclude 100% of the gain on the sale of qualifying QSBS. The tax rate reduction under the Tax Cut and Jobs Act (TCJA), passed in December 2017, and effective as of January 1, 2018, has reduced the discrepancy between the effective corporate and individual tax rates. With the TCJA’s reduced corporate tax rate to a flat 21%, structuring an entity as a C Corporation for 2018, and beyond, may now be more appealing.

Generally, to qualify for the for a Section 1202 gain exclusion, five criteria must be met:

  1. The stock must have been directly acquired via an original issuance from a U.S. C corporation;
  2. Both before and immediately after stock issuance, the C corporation’s tax basis in gross assets must not exceed $50 million;
  3. The C corporation and its shareholders must consent to supply documentation regarding QSBS;
  4. The C corporation must conduct certain qualified active trades or businesses, and;
  5. The stock must be held for more than five years.

If a domestic entity were to organize as a C Corporation, or convert to a C Corporation that conducts certain qualified active trades or business, then, not only would the entity benefit from a 21 percent tax rate, but when the shareholders sold their stock after a 5 year holding period, the owners would be able to exclude gain up to the greater of $10 million or 10 times the adjusted basis of the investment (which would eliminate “double taxation” in most circumstances.)

In the circumstance that a shareholder has not owned QSBS stock for five years, the shareholder has the option of deferring some or all of the gain. In order to take advantage of gain deferral, the shareholder must have owned the QSBS for more than six months on the date of the sale and reinvest the proceeds into newly acquired QSBS within 60 days of the sale of the prior QSBS. The holding period and adjusted tax basis from the original shares will roll over into the newly acquired QSBS, effectively deferring the federal income tax recognition event.

Your Marcum professional can help you navigate reforms and plan for your particular situation.

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Tax & Business, Corporate Tax