Section 1202 Tax Matters

Recently, I was reminded of the “downside” of a successful exit, specifically, that capital gains earned on investment in a startup are, generally speaking, subject to taxes. In other words, the IRS wants its piece of that nice big check. Wouldn’t it be nice if you could just keep it all instead?

So, before I go any further, let me be crystal clear, I am not a tax accountant, tax advisor, or financial advisor – and this post is not intended to provide tax advice. It is intended to alert you to the possibility that a little planning might go a long way in enabling founders, early employees, and early investors in startups to take advantage of certain features in the U.S. federal tax code. Many people, including even some tax professionals who do not deal with small business sales often, are unaware of the possibilities – and I want to encourage you to find out more to enable any eligible stockholders to benefit. Consult your tax accountant, tax attorney, and/or corporate attorney to navigate the details, please!

What am I talking about, you might wonder? The opportunity that is embedded in Section 1202 of the U.S. Tax Code. 

What is the purpose of Section 1202? To provide targeted tax relief for investors who risk their funds in new ventures and small businesses, including investors, founders, and even early employees. Think of it as a small business tax incentive. The good news? Many startups can qualify.

What is the potential benefit? While it has been updated over time, this tax advantage is now permanent and, since 2010, allows individuals to avoid paying taxes on up to 100% of the taxable gain recognized on the sale of qualified small business corporation stock (sometimes referred to as QSBS). While the tax benefit in the U.S. tax code applies to federal tax liability, many states also follow the federal tax treatment, which can mean even more substantial savings.

Think of it this way: If your startup grows into a success and then its stock is sold (aka the sale of QSBS) as part of an exit, you are generally liable to pay taxes on the amount of the gain in value. If you and the startup qualify for Section 1202 treatment, you may avoid paying taxes on up to 100% of that taxable gain.

Who is potentially eligible for Section 1202 tax treatment? The qualification rules for Section 1202 treatment are complicated, and you do have to have some documentation to prove that you meet them, so be sure to get expert advice for your individual case. However, in general, there are both stockholder-level requirements to be met as well as corporation-level requirements. The good news is that many high-potential startups and their investors can qualify.

At a high level, startups must be organized as an eligible corporation (This is most domestic C corporations with a few uncommon exceptions. Note that S corporations and many LLCs do not qualify), be considered “small” (defined as less than $50M in assets within specific rules), be engaged using at least 80% of their assets in the active conduct of a qualified business (there is a list of unqualified business types; however, they are not common for high-potential startups) during the taxpayer’s holding period of the stock, and avoid any disqualifying “significant” redemption activities. Part of qualifying for Section 1202 tax treatment of gains will involve getting information from the startup to confirm that these requirements are met. Also, one of the reasons you need to care about and plan for potential 1202 tax treatment is that some of the decisions made at the earliest stages of startup formation, such as what sort of company organization to form matter, so you need to be thinking ahead. Unfortunately, some attorneys who are willing to assist newly forming startups for very little in legal fees may not be considering the potential for long-term success and may suggest using LLCs or S-corporations for short-term cash flow reasons, resulting in disqualification for future 1202 treatment for founders and investors. Ask questions and delve into the pros and cons carefully. Such decisions can be more consequential than you realize!

If the startup meets the Section 1202 requirements, there are also shareholder-level requirements that must be met. First and foremost, the eligible shareholder must purchase shares on original issuance by the company (not purchased from another shareholder). In general, eligible shareholders are all non-corporate shareholders, including individuals, trusts, and estates. There are some exceptions, so do ask an expert if you want to explore those. Note that this means that it is certainly possible for startup founders, early employees who are holding stock (not options), advisors paid in shares, and individual investors (like angels) who purchase stock (not SAFEs, convertible notes, etc. until such time as those investment vehicles are converted into shares on the cap table) to be eligible. 

Finally, this is a small business tax incentive designed to support the growth and flourishing of small businesses. That means there is a substantial holding period to ensure that the investment provides needed resources to help the small business succeed. The stock must be held for more than five years from generally the date when the stock was issued before it is disposed (sold).   

Consider the following as food for thought on how you might be able to take advantage of such potentially excellent tax savings:

• Think ahead when forming a startup. Choosing a domestic C corporation can have real advantages – and don’t forget my advice about choosing a Delaware C corporation if you are expecting to raise significant capital.
  
  
• Consider granting restricted stock instead of options to co-founders and even early employees to kick off that holding period. Do not forget to pay attention to potentially relevant 83(b) considerations (ask your lawyer).
  
  
• As an angel investor, consider investing in priced rounds and asking whether the startup and investing entity meets the Section 1202 requirements. While SAFEs and convertible notes have their place, they also delay starting the Section 1202 holding period. Also, if you are investing via an angel fund, explore with the fund’s legal counsel if there is a way to potentially qualify for Section 1202 tax treatment.
  
  
• When, hopefully, great things are happening, and you are planning ahead for a substantial gain, engage your advisors to maximize your chances of taking advantage of Section 1202 tax treatment. Some complexities extend out potentially a year or more before exit, so if things are going well and at least some shareholders are approaching or exceeding that five-year holding period, it makes sense to get expert advice on avoiding traps that might inadvertently disqualify some stock.

Thanks for making your way through a pretty tax technical post! Again, I am not a tax advisor, nor should you rely on this post as tax advice. Instead, I hope this post has highlighted some of the reasons you might want to learn more about some of the valuable tax incentives that might be available to those engaging in trying to change the world from within the startup ecosystem and will entice you into learning more so you choose to engage who can help you apply Section 1202 to your particular situation(s). Hanging onto as much of that hard-earned gain as possible makes success sweeter!