Startup Best Practice – Tax Benefit – Can 1202 Help You in 2013?

Courtesy of Lourdes Perrino, Taft

Section 1202 of the Internal Revenue Code is often overlooked when it comes to startup tech companies. This code section can be applied to the benefit of startup tech companies by turning much or all of the profit of a successful startup into tax-free gain. Time is of the essence, however, because the 100% exclusion is set to expire on Dec. 31, 2013.

Section 1202 provides for a 50% exclusion from capital gain on gain from qualified small business stock (QSBS) issued after Aug. 10, 1993, and before Feb. 18, 2009. This exclusion was increased to 75% for stock issued from Feb.18, 2009, through Sept. 27, 2010, and then to 100% for stock issued from Sept. 28, 2010, through Dec. 31, 2013. In general, the amount of QSBS gain that can be excluded from income is the greater of $10 million or 10 times the aggregate adjusted bases of the QSBS issued by the corporation and disposed of by the taxpayer during the taxable year. Shareholders eligible for this exclusion include individuals and pass-through entities only; corporate shareholders are not eligible.

There are several requirements for stock to fall within the definition of QSBS, including:

• The stock must be issued by a domestic C corporation, with aggregate gross assets that are less than or equal to $50 million before or immediately after issuance.

• The corporation must use at least 80% of the assets (by value) in an active trade or business.

• The corporation must not be a service corporation.

• The shareholder must not sell the stock prior to five years from the date of issuance (i.e., shareholder must hold onto the stock for at least five years).

When a shareholder goes to sell his QSBS, any gain (up to the maximum amount stated above) will be excluded from income as long as these requirements are met. Startup tech companies should look into taking advantage of this provision while the 100% exclusion is still in effect since the exclusion will revert back to 50% after 2013. Companies should also talk with a tax planner about the possible advantages of issuing new stock in 2013.

Lourdes is an associate in Taft’s Tax and Start-Up and Growth Companies practice groups. She received her J.D. from University of Cincinnati College of Law and her LL.M. in Taxation from New York University School of Law. To contact her or any member of the Tax and Start-Up and Growth Companies practice, email VC@taftlaw.com

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