Use IRS Code Section 1202 to sell your multimillion-dollar startup tax-free


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Vincent Aiello


Spencer Fane attorney and business owner Vincent Aiello helps businesses solve legal problems to secure revenue flow and reduce business risks.

Whoever said you can’t have your cake and eat it too should have called their accountants and lawyers first.

These professionals often receive inquiries from founders, equity investment firms and venture capitalists looking for ways to save on or avoid capital gains taxes on future business sales. Both lawyers and accountants encourage clients to examine the tax savings offered by setting up a Qualified Small Business (QSB) C-Corporation at the initial business formation stage. Using a QSB can eliminate capital gains tax due on the future business sale if the company is established and stock issued pursuant to Internal Revenue Code Section 1202.

Many startups often simply default to a robotic use of S-Corporations, partnerships, and LLCs, but savvy tech founders should consider the excellent long-term tax savings afforded by IRS Code Section 1202.

This article provides a general overview concerning the major requirements and tax savings provided by forming a startup entity structured to maximize the capital gains tax exclusion in IRC 1202.

IRC 1202 excludes capital gains tax realized on the sale of qualified small business stock (QSBS) of non-corporate taxpayers if the stock has been held for more than five years. QSBS is stock in a C-Corporation originally issued after August 10, 1993, and acquired by the taxpayer in exchange for money, property or as compensation for services. The corporation may not have gross assets in excess of $50 million in fair market value at the time the stock is issued.

Prior to 2010, only part of the capital gain on QSBS was excluded from taxable gain under section 1202 and the portion excluded from gain was an item of tax preference subject to alternative minimum tax. This rule was changed for stock acquired after September 27, 2010, and before January 1, 2015, such that the gain on such stock was fully excluded and no portion of the gain was an item of tax preference. This change was made permanent by the Protecting Americans from Tax Hikes Act of 2015, signed into law on December 18, 2015.

Given the changes to IRC 1202, it constitutes a significant tax savings benefit for entrepreneurs and small business investors. However, the effect of the exclusion ultimately depends on when the stock was acquired, the trade or business being operated, and various other factors.

Qualifying for Section 1202’s capital gains tax exclusion takes careful planning

The critical plan to be determined at the outset is the future stock sale, which must be structured as a sale of QSBS for federal income tax purposes to achieve capital gains tax exclusion. This can be a challenge, as buyers typically prefer asset acquisitions permitting a step-up in basis and future goodwill amortization.

In many business sales today, buyers expect stockholders to roll over a portion of their equity, or receive stock or membership interests in a new entity as part of the transaction. Imprecise planning will cause the QSB stockholders to forfeit the QSBS gain exclusion and owe tax on the sale. This can happen if there is an impermissible equity rollover to an LP, or receipt of LLC equity.

However, a Section 368 tax-free reorganization provides options where target stockholders may exchange their QSBS for buyer stock. This is a scenario seen most frequently when the buyer is a public company. If not all of the buyer’s stock is QSBS, then the amount of available Section 1202 gain exclusion would be capped at the value of the qualifying stock, and gains tax would be due on the non-qualifying amount.

However, when properly assessed and implemented, the IRC 1202 gain exclusion allows stockholders, founders, private equity and venture capitalists to claim a minimum $10 million federal income tax exclusion on capital gains for the sale of QSBS, or up to 10 times the aggregate adjusted basis of QSB stock issued by such a corporation.

As outlined below, corporate formation, company operations and stock ownership must meet certain requirements enumerated in IRC 1202, the primary requirement being the stock sold must be QSBS in a C-Corporation that has been held by the stockholder for more than five years.

Tax savings under 1202 can be dramatic. For example, using a 23.8% federal income tax rate, stockholders selling $10 million dollars’ worth of QSBS qualify to save over $2.38 million in taxable gain. (The rate is based on a 20% federal capital gains rate, plus 3.8% federal net investment income tax. Individual states may not permit gain exclusion. Some states do not levy capital gains tax, while others, like California and New York, assess gains on the sale of QSBS.)

While this capital gain tax cap may seem limiting at first glance, IRC 1202 also provides for a 10 times gains cap exclusion if the founders increase the value of cash or property contributed to a corporation in exchange for QSBS.

Generally, Section 1202 provides that every taxpayer enjoys a minimum $10 million capital gains tax exclusion for gain incurred from selling QSBS. The same taxpayers can exceed the $10 million cap, provided the taxpayer paid cash or contributed property in exchange for the QSBS they received.

How do you take advantage of the 10x capital gains exclusion?

The capital gain exclusion is limited to 10 times the amount of contributed cash or 10 times the property value contributed to the corporation in exchange for QSBS. For example, if a taxpayer contributes $20 million in property or assets to a corporation, when the issued QSBS sells for $220 million, some or all of the first $20 million would be subject to long-term capital gains tax, and the balance of $200 million would be eligible for Section 1202’s gain exclusion.

Contributing significant cash and assets increases the aggregate cost basis above the $10 million cap. Section 1202(e)(8) states: “rights to computer software which produces active business computer software royalties (within the meaning of section 543(d)(1)) shall be treated as an asset used in the active conduct of a trade or business.”

The value of this contributed property can be used to increase the aggregate basis.

The $10 million and 10x gain exclusion caps are not mutually exclusive

Many founders mistakenly interpret IRC 1202(b)(1)(A)&(B) to mean the $10 million and the 10 times gain exclusion caps are mutually exclusive.

The timing of how a QSB stock sale is structured (longer than one year), allows the seller to leverage both gain exclusion caps. The first $10 million gain exclusion cap is utilized on the sale of the first $10 million of QSBS, which may leave no further gain exclusion in later years or the potential of the 10 times aggregate basis gain exclusion.

As noted above, the QSBS must have been originally issued after September 27, 2010, to qualify for the 100% gain exclusion. QSBS issued after February 17, 2009, and before September 28, 2010, is eligible for a 75% gain exclusion, and this decreases for earlier issuance dates.

Section 1202 eligibility requirements

Section 1202 has numerous corporate and stockholder level eligibility requirements. These conditions must be satisfied to exclude capital gains tax under Section 1202.

Some of these requirements include:

  • All QSBS must be acquired directly from a domestic (U.S.) C-Corporation. Only stock acquired from a C-Corp qualifies for QSBS treatment. It must also be sold while the issuer is a C-Corporation.
  • Further, the company’s C-Corporation status should be properly documented and maintained from the date of issuance to the date of sale. QSBS cannot be issued by Partnerships and S-Corporations.
  • The stock must be acquired directly from the corporation in exchange for cash, property or services. Cash consideration for QSBS can be paid on a per-share basis for founder stock, or in the form of convertible note preferred stock. Property contributed in exchange for QSBS includes intellectual property, software or other tangible assets contributed by the founders to start the company. The exchange of property for QSBS should be memorialized in a written agreement outlining the property contributed.
  • There is a mandatory five-year holding period for QSBS commencing on the issuance date. QSBS sold before the five-year holding period would need to be reinvested in replacement QSBS per Section 1045. Under Section 351 non-recognition exchange, QSBS can be exchanged for QSBS or non-QSBS as part of a Section 368 tax-free reorganization.
  • Subject to various exceptions, the holder of the originally issued QSBS must also be the seller of the QSBS. However, other strategies exist wherein stockholders can increase gain exclusion amounts by utilizing grantor trusts if QSBS is acquired through an original issuance. Stockholders can also make lifetime gifts of QSBS, make transfers upon a stockholder’s death, or make distributions from the partnership to a partner. Generally, the original holder will be the ultimate seller.


The QSBS exemption can provide a tech startup exceptional tax savings:

  1. 100% gain exclusion on QSBS sales
  2. The ability to defer taxable gains and roll over gains
  3. The opportunity to stack the exclusion amounts to magnify tax savings through the use of grantor asset protected trusts.

This can amount to hundreds of millions of dollars saved on capital gains tax typically due on a business sale.

Disclaimer: This material has been prepared for general informational purposes only. It is not intended to provide, and should not be relied on for, specific tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. The material is based on information believed to be reliable. No warranty is given as to its accuracy or completeness and it should not be relied upon as legal advice.

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