How To Reduce Capital Gains Taxes
The recent passage of the Tax Cuts and Jobs Act (TCJA) increased interest in C Corporations. The Act permanently reduced the federal income tax rate on C Corporations from 35% to 21%. The widespread media coverage has led company founders, shareholders, and investors to ask whether they would benefit from being a C Corporation.
There is another less publicized provision of the IRS Code that may also benefit shareholders of C Corporations. Specifically, Section 1202 of the Code allows owners of stock in C corporations to exclude from federal income taxes up to 100% of the gain on that stock. Section 1202 provides this and additional tax exclusions for stock that meets the definition of Qualified Small Business Stock. (“QSBS”).
Section 1202 is intended to encourage new business investment, and there are numerous requirements that must be met to take advantage of its benefits. Most notably, the stock must be held for at least five years. In addition, the taxpayer claiming the section 1202 exclusion must not be a corporation, and the stock must be held in a company that is organized as a C Corporation, and thus cannot be an S Corporation. To qualify as a Small Business, the aggregate assets of the corporation prior to and immediately after the taxpayer acquires the stock must not exceed $50 million.
For those shareholders whose ownership of stock meets the requirements of a QSBS under Section 1202, the tax benefits can be considerable. The specific amount of tax exclusion largely depends on the date in which the stock in the QSBS was acquired. The exemption percentage varies from 50 to 75 to 100 percent and the more recent the acquisition the more potent the tax breaks. For example, for stock in a QSBS that was acquired after September 27, 2010, Section 1202 excludes 100 percent of the gain from the sale of that stock.
Considering the substantial tax advantages associated with Section 1202 stock, it isn’t surprising that there are myriad ways in which to lose those benefits. For example, the Code includes provisions that penalizes companies that attempt to use Section 1202 to replace a prior investment of stock in a QSBS. Likewise, stock doesn’t qualify as a QSBS if the company previously repurchased stock under certain circumstances. When the penalties associated with the stock repurchase is triggered none of the stock is deemed to be a QSBS and the associated tax benefits disappear. This is far from a complete list of the potential minefields that need to be avoided to take full advantage of Section 1202.
Despite the complexity of complying with Section 1202, founders, shareholders, and investors in C Corporations have a potentially powerful tax mitigation strategy at their disposal. Where possible, your investments should be structured to take advantage of the tremendous benefits of Section 1202.