The IRS code Section 1202 is among the most significant advancements for startups in a long time, yet relatively few angel investors and business owners are aware of it. It may be a fantastic opportunity for angel investors and startups to develop their businesses. Tech entrepreneurs are issuing qualifying small company stock to grab the opportunity. However, there are a few requirements that small business shareholders must be aware of, to qualify for this tax credit. This article helps to understand the benefits of section 1202, the recently changed rules in section 1202, and capital gain exclusion for investors.
Section 1202 capital gain exclusion
Section 1202 of the Internal Revenue Code was recently expanded by Congress, giving angel investors and business owners considerable tax advantages. Up to $10 million per investment, 100% of profits associated with startup investments are tax-free because of the Section 1202 tax exclusion. Entrepreneurs may also deduct profits of up to $10 million owing to this rule. Let’s learn more in detail.
What is a qualified small business?
The US government’s Qualified Small Business Stock (QSBS) program significantly encourages investment in small firms by offering investors enticing tax advantages through Section 1202’s capital gain exclusion. When you participate in qualified businesses, you can avoid paying taxes on your profits if you own QSBS. The QSBS capital gain exclusion develops to assist businesses in enticing investors with substantial tax breaks on offer and to persuade and retain important personnel via employee stock options.
Recently changed rules of QSBS
Since it was passed in 1993, Section 1202’s tax incentive has virtually been inactive. Following President Trump’s signing of the Tax Cuts and Jobs Act into law, which became effective on January 1, 2018, the corp tax rate was lowered from 35% to 21%. It resulted in a rise in the usage of the C-Corporation. Tax consultants concluded that Section 1202 offered significant advantages to businesses that choose to operate as C-Corps, particularly in terms of its advantages for investors, early employees and founders.
According to Patrick Smith of CliftonLarsonAllen, many other sorts of firms are not considered qualifying enterprises under Section 1202 for capital gain exclusion, although most early-stage tech startups are. He points out that the following companies are expressly exempt –
- Services in medicine, legislation, finance, actuarial science, engineering, performing arts, consultancy, sports, finance, or brokerage services.
- Enterprises related to banking, insurance, finance, leasing, and investment.
- The business related to natural resources, mining, or farming.
- Hospitality services.
What is small business gain exclusion?
Section 1202, first passed in 1993 as a component of the Revenue Reconciliation Act, was created to motivate non-corporate taxpayers to invest in certain small enterprises. The exclusion was subsequently modified, gradually raising to the current 100%, in the American Recovery and Reinvestment Act of 2009 and the Small Business Jobs Act of 2010. Any QSBS obtained after September 27, 2010, was rendered irrevocable in 2015 due to The Protecting Americans from Tax Hikes Act.
Eligibility requirements for the capital gain exclusion
If the investor and the firm satisfy certain requirements, capital gain exclusion may be a viable choice for an investment in a startup. The following criteria must be met to qualify for this exemption, while this list is not exhaustive:
|Eligibility Criteria||For The Company||For The Investor|
|Nature of Company||Domestic C company||Individual, private equity organization, or investment partnership taxed as a partnership|
|Gross Assets||Under $50 million at or promptly after issue||-|
|Qualified Fields||Production, retailing, wholesale, or tech||-|
|Asset Utilization||At least 80% of assets used in eligible enterprises||-|
|Stock Issuance Date||Following August 10, 1993||-|
|Stock Purchase||-||First issuance, not on secondary market|
|Purchase Method||-||Cash, property, or exchanged for a service|
|Ownership Duration||-||Minimum ownership of five years|
For The Company:
- The company must qualify as a domestic C corporation with gross assets under $50 million either at the time of issuance or shortly thereafter.
- The business must operate within industries like production, retail, wholesale, or technology to be eligible.
- A minimum of 80% of the company’s assets must be employed in one or more qualified businesses.
- The issuance of the stock must have occurred after August 10, 1993.
For The Investor:
- Eligible investors include individuals, private equity organizations, or investment partnerships taxed as partnerships.
- The purchase of stock must take place during its initial issuance rather than on a secondary market.
- Shares must be obtained using cash, property, or received through a service-based exchange.
- Ownership of the shares must be maintained for a minimum duration of five years.
How much of the capital gains on QSBS can be excluded?
The rule has now been changed to permit up to 100% of the capital gain exclusion depending on the stock’s issuance date, despite previously having a 50% exclusion ceiling. The capital gain exclusion is often forgotten about or discovered after the sale has already occurred, costing startup investors a significant difference in their tax bill. When the entire 100% capital gain exclusion is applied, a capital gain that would otherwise be subject to a tax rate of 23.8% may instead be subject to a tax rate of 0%, which would increase the investment return of nearly 33%.
Pros and cons of QSBS for startup companies
- The QSBS exemption was developed through section 1202 to assist businesses in attracting investors with tax benefits and recruiting and keeping important personnel with employee stock options.
- Section 1202 benefits investors, as they gain significantly from the prospect of minimal or no taxation on earnings through capital gain exclusion.
- Even if there are no direct tax advantages for the fledgling company, issuing QSBS may still be beneficial since it makes for a strong selling point when seeking money.
- Additionally, as the legislation permits businesses to issue QSBS as payment for services, it may be utilized as a perk to draw in top talent or to reward and keep workers.
The advantages of QSBS may be substantial, and the fundamental guidelines are very simple, but as with so many other things, every coin has two sides.
- Ensuring such regulations are followed at all times during the investment duration is crucial for both businesses and investors.
- Certain events, including share redemptions, could invalidate the QSBS status of the shares.
- As a result, it’s essential to exercise caution and seek wise advice from tax experts with knowledge of QSBS.
- It’s crucial to comprehend the QSBS treatment while employing a Convertible Note or SAFE, and especially its timing.
A possible drawback for the firm issuing QSBS is the need for a C corporation to be eligible, which is more difficult to set up initially and may result in greater income taxes due to double taxation. But some of those issues may be resolved with good tax preparation with your CPA and thorough documentation.
QSBS for investors
Investors should take advantage of QSBS through section 1202 since it allows them to pay fewer taxes on successful investments. Let’s understand in detail –
Requirements of investing in QSBS
The main criteria for the QSBS tax exemption for investors change based on when the stock was bought and the time it has been kept. The following lists the prerequisites to qualify for the capital gain exclusion and the possible results for qualified stock purchased after September 27, 2010.
- Investors may only invest as individuals, trusts, or certain pass-through entities; they cannot invest as C-corporations.
- If this pertains to you, be careful to receive specific tax guidance from your tax expert since the taxation for investors using a Special Purpose Vehicle (SPV) depends on the entity’s form.
- To be eligible for the maximum capital gain exclusion, the stock must be retained for more than five years.
- Profits from equities held for longer than a year but less than five years are taxable as long-term capital gains.
- The maximum permitted gain, which is $10 million or 10 times the initial investment amount, is the limit on profits.
- The investor might well be able to conduct a tax-free rollover if the stock was held for less than five years but over six months by reinvesting their whole gains into a different QSBS in less than 60 days after surrendering the original stock.
- Investments made via a self-directed IRA are not free from QSBS.
QSBS tax benefits for investors
You could avoid paying income tax if you invest in QSBS and the value rises. Section 1202 of the Tax Code, available online, contains a description of the QSBS tax exemption regulations. The US Small Business Administration offers a helpful description of the tax exemption status on its website. The tax incentive to an investor is subject to several regulations and requirements. Still, the most important thing to remember is that you may earn up to $10,000,000 or 10 times the asset’s adjusted taxable value, whichever is greater. You don’t have to worry about paying any taxes. Take note that the tax basis for the stock acquisition is equal to the cash paid plus the fair market value of any acceptable non-cash contributions.
How can Eqvista help keep track of your stock?
Effective usage of QSBS can reduce an investor’s tax obligation and enhance a company’s capacity to raise funds. However, key guidelines must be followed to get and keep QSBS certification. Thus, it is crucial that all parties be aware of and uphold the standards.
Eqvista is a very advanced cap table tool designed with founders’ like you in mind. You can effortlessly monitor and manage your firm’s shares directly from Eqvista because of its user-friendly method and sophisticated programming. All you have to do is establish your business profile and use the app to issue shares electronically.