If you have recently sold, are looking to sell or even considering an investment in C corporation stock in a small business, you may want to consider your eligibility for the benefits under Internal Revenue Code Section 1202.
Section 1202 of the tax code allows taxpayers to exclude some or all of the gain on the sale of qualified small business stock. Whether you’re eligible or not depends on if you satisfy certain shareholder and corporate level requirements, such as being a non-corporate taxpayer who purchased the issued stock after Aug. 10, 1993.
Read “Can You Benefit from Section 1202 Exclusion of Gain from the Sale of Your Small Business Stock” to find a complete list of requirements.
As the interest in Section 1202 has grown in recent years, thanks to the increased gain exclusion percentage and reduction in corporate tax rates, so too have questions regarding eligibility. Historically, little guidance outside of the code itself and regulations have been provided on this particular section. However, earlier this year IRS Private Letter Ruling 202319013 provided clarification and guidance into one important question surrounding eligibility.
Active Business Requirement of Section 1202
Section 1202 includes an “active business” requirement, which states that to be eligible, a corporation must use at least 80% of its assets in the active conduct of a qualified trade or business. The Section also provides a list of trade or businesses who are ineligible. One of those exclusions includes any trade or business in which its principal asset is the “reputation or skill of 1 or more of its employees…” So if your business’ principal asset hinges on your employees, your company cannot receive the benefits of Section 1202. It is this aspect of the code that was the focal point of the ruling.
The Private Letter Ruling
The company in question was a provider of cloud services and software. Its employees possessed technical skills and knowledge of the company’s processes and methodologies. The question became whether the company’s principal asset was 1) the reputation/skill of one or more employees or 2) the company’s intellectual property.
The IRS concluded the principal asset was the intellectual property; therefore, the company was in fact deemed to be a qualified trade or business for Section 1202 purposes. The ruling noted:
- The processes and methodologies were unique to the company and not usable by the employee at similar companies; and
- The company could recruit and train other employees to perform substantially identical services.
What This Ruling Means
Section 1202 can be a crucial consideration for taxpayers looking to invest or trying to determine how to best structure their business. The potential federal tax savings on a sale of eligible stock with a gain of $10 million could be as much as $2.4 million between income and net investment income (NII) taxes. As such, proactively determining if your company is eligible is important. This Private Letter Ruling provides additional guidance for companies trying to make that determination.
Work with your tax advisers to determine if an existing or potential investment is eligible for 1202, as well as strategies to maximize any tax benefits through diligent tax planning. Planning prior to making an investment may be the key to qualification.
Contact Adam Fink at afink@cohenco.com or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.
