Tax Free Startup Company Stock

If you are not familiar, last December the Congress and the President made permanent one of the most significant tax breaks probably ever made available to founders and investors in startups. They created something that they could have rightfully called, “Tax Free Startup Company Stock.”

What am I talking about?

Well, last December the Congress and the President made permanent the 100% exclusion from tax on gain from the sale of qualified small business stock held for more than 5 years. Since September 27, 2010, when the 100% exclusion first went into effect at President Obama’s urging, it had always been set to expire every 6-12 months. Now it is here to stay.

This means that if you found a startup company, or you buy stock in a startup company, and that startup company is a C corporation engaged in a “qualified trade or business” (see definition quoted below) with less than $50 million in gross assets (both before and after you and others invest), you can completely avoid tax on up to $10M in gain on the sale of that company’s stock.

This doesn’t work if you form your new business as a LLC taxed as a partnership or an S corporation.

Section 1202 is a big deal, and one that you ought to carefully consider when selecting an entity form for your business, or what types of businesses to invest in.

But, as you might imagine, Section 1202 does have a number of limitations and qualifications.

I received a question about some of those limitations this morning.

The Question Went Like This:

Joe, I thought I remembered a $1 million limitation on how much 1202 stock a company could issue in a given year but looking through your blog and a number of other sources it seems I’m confusing 1202 with some other tax benefit. Does this ring a bell? Is there a limit (other than the gross assets, active business and use of proceeds tests) I need to think about?

The Answer To This Queston Is:

There is no limit on how much 1202 stock a company can issue in a given year, except for the $50M gross assets limitation you mention above.

Section 1202(d) defines the term “qualified small business” as any domestic corporation which is a C corporation if:

“(A) the aggregate gross assets of such corporation (or any predecessor thereof) at all times on or after the date of the enactment of the Revenue Reconciliation Act of 1993 and before the issuance did not exceed $50,000,000,
(B) the aggregate gross assets of such corporation immediately after the issuance (determined by taking into account amounts received in the issuance) do not exceed $50,000,000, and
(C) such corporation agrees to submit such reports to the Secretary and to shareholders as the Secretary may require to carry out the purposes of this section.”

Thus, while there is no express limitation on how many shares a company can issue that qualify as Section 1202 “qualified small business stock,” (see definition below) once the company has in excess of $50M in gross assets, it cannot issue qualified small business stock at all.

If you are recalling a $1 million limit of some kind, you are probably thinking of Section 1244. Section 1244 allows an ordinary as opposed to a capital loss on an investment in a C corporation, if you are one of the first $1 million invested.

Section 1244 is about losses. Section 1202 is about gains.

Section 1202 is a significant tax benefit to consider as you plan how to start and invest in companies.

*********Definitions below

“Qualified small business stock” means any stock in a C corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993, if—
(A) as of the date of issuance, such corporation is a qualified small business, and
(B) except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its original issue (directly or through an underwriter)—
(i) in exchange for money or other property (not including stock), or
(ii) as compensation for services provided to such corporation (other than services performed as an underwriter of such stock).

“Qualified trade or business” means any trade or business other than—
(A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, daccounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,
(B) any banking, insurance, financing, leasing, investing, or similar business,
(C) any farming business (including the business of raising or harvesting trees),
(D) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
(E) any business of operating a hotel, motel, restaurant, or similar business.

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