Section 1202 Stock or How to Prepare for a Capital Gains Tax-Free Exit At the Outset

What is Section 1202 Stock?

Section 1202 is a provision of the Internal Revenue Code (“IRC”) that allows the exclusion of capital gains realized from the sale of small business stock from taxable income. This tax incentive serves to encourage investment in small businesses.

As a general rule, the taxable capital gain is calculated as the difference between the purchase and sale prices of stock. For instance, if stock is acquired at $100,000 and sold for $500,000, a $400,000 capital gain is added to the taxpayer’s taxable income. Conversely, the Section 1202 exclusion allows one to legally avoid paying tax on capital gains of up to $10,000,000 (or 10 times the adjusted basis of the stock, whichever is greater).

Conditions for Section 1202 Benefits to Apply

For Section 1202 benefits to apply, certain conditions must be met:

1. The issuing corporation must have been a domestic C corporation since the stock in question was issued.
2. The issuing corporation’s aggregate gross assets, including rights to computer software generating royalties, cannot exceed $50 million before or immediately after stock issuance.
3. The issuing corporation must not primarily engage in certain enumerated non-qualified activities, including professional services, investment, farming, and hospitality.
4. At least 80% of the corporation’s assets must be used in the operation of the qualifying business during the taxpayer’s entire holding period.
5. The stock must be held for a minimum of 5 years before sale.
6. Stock must be directly acquired from the issuing corporation.
7. Stock must be obtained for cash, stock, or services.
8. The taxpayer claiming the benefit cannot itself be a C corporation.
9. For the full $10,000,000 tax exclusion to apply, the stock must have been issued after September 27, 2010. Stock issued between February 17, 2009, and September 28, 2010, qualifies for a 75% gain exclusion; stock issued before February 18, 2009, but after August 10, 1993, qualifies for a 50% gain exclusion.
10. The stock must qualify as “stock” for federal income purposes, so unvested stock, warrants, and stock options are excluded.

Additional exceptions and requirements may apply; please consult with a legal or tax professional.

Do SAFEs and Convertible Notes Qualify as Stock?

Many early-stage investments involve SAFEs and convertible notes, allowing investors to convert their contributions into stock at a later date or funding round. It is an essential consideration for investors negotiating fundraising instruments whether SAFEs (Simple Agreements for Future Equity) and convertible notes qualify as stock under Section 1202.

Notably, some SAFEs and convertible notes may not meet the criteria for Section 1202 stock. This implicates the timing of when Section 1202 tax benefit can be claimed: whether the five-year clock starts since the issuance of the instrument or its conversion to stock.

The IRS, in Notice 94-47, emphasized that the characterization of an instrument for federal tax purposes depends on the instrument’s terms and surrounding circumstances. No single factor is decisive, and all factors must be considered. Factors include:

1. Whether the issuer made an unconditional promise to pay a specific sum on demand or at a fixed future date.
2. What labels the parties assigned to the instrument.
3. Whether the holder is entitled to enforce principal and interest payments.
4. Whether the holder participates in the issuer’s management.
5. Whether the issuer is thinly capitalized.
6. Whether the instruments are intended to be treated as debt or equity for non-tax purposes.
7. Whether the rights of the instrument holders are subordinate to the rights of general creditors.

Key Takeaways

IRC Section 1202 offers substantial tax benefits for founders and venture capitalists but only applies to qualifying stock in C corporations. This makes it a crucial consideration when selecting the business entity type at the business’s outset. It is advisable that you consult with an attorney prior to registering your business entity to assess your business needs and goals as a whole and make an informed decision.

Investors may opt to purchase stock outright instead of investing in SAFEs and convertible notes to maximize Section 1202 tax benefits. Experienced legal counsel, such as , can assist in structuring funding instruments in a way that increases their eligibility as Section 1202 stock.

The CommLaw Group Can Help!

With a proven track record in commercial law, our firm will be happy to become a trusted advisor in preparing your startup for the next significant venture capital investment. Don’t let any postponed legal issues derail your success story; let us help you navigate the complexities of startup law so that you can focus on what you do best – building your business. Contact us today to set your startup on the path to success and ensure your legal matters don’t deter potential investors.

Please contact Jonathan Marashlian or Diana Bikbaeva if you have any questions.

Disclaimers: The information provided is believed to be accurate at the time of writing but may be subject to rapid changes in laws. Timely consultation with an attorney is recommended for current information.

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