Section 1202 Capital Gains Tax Exclusion Nick Gruidl and David Sterling September 26, 2013

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1 Nick Gruidl and David Sterling September 26, 2013

2 Presenters David Sterling, Partner and National Leader of M&A Tax Practice Experienced in consolidated returns, C corporations, S corporations, partnerships, cooperatives, mergers, acquisitions and divestitures Nick Gruidl, Washington National Tax Partner Focuses on corporate merger and acquisition activity; spin-offs, bankruptcy and debt restructuring, private equity transactions, consolidated group issues; analysis of net operating loss issues, and partnership taxation 1

3 Overview Section 1202 of the Internal Revenue Code (all Section references are to the Internal Revenue Code) provides 100% exclusion from adjusted gross income ( AGI ) of any gain recognized by a noncorporate investor on the sale of qualified small business ( QSB ) stock: - Held for more than five years, and - Acquired after September 27, 2010, and before January 1, Section 1202(a) otherwise provides for an AGI gain exclusion of 50% for QSB stock issued after August 10, 1993, and 75% for QSB stock issued after February 17, 2009, and before September 28, The portion of capital gain not excluded from AGI is taxed at a maximum rate of 28% under Section 1(h). 2

4 Overview The effective capital gains tax rates for QSB stock sale gains held for more than five years are as follows: - Stock acquired after August 10, % - Stock acquired after February 17, 2009, and before September 28, % - Stock acquired after September 17, 2010, and before January 1, % Section 1045 also provides a tax-free rollover for stock sales by noncorporate investors that would have qualified for the Section 1202 exclusion if the stock was held for more that five years and the following requirements are met: - The stock was held more that six months, and - The sale proceeds are reinvested in new qualifying stock with 60 days. 3

5 Qualified Small Business Requirements A QSB must be a C corporation QSB stock must be acquired at its original issue QSB stock must be originally issued for money, property or services No redemptions of QSB stock are allowed within two years before or after issuance The aggregate gross assets of a QSB (or any predecessor thereof) must not exceed $50 million "immediately after" the stockholder acquired the stock A QSB must meet an active business requirement during "substantially all" of a taxpayer s stock holding period 4

6 Active Business Requirement The active business requirement is met if the QSB uses at least 80% of its assets (by value) in conducting one or more businesses other than: - Health, law, engineering, architecture, accounting, 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 one or more of its employees - Banking, insurance, financing, leasing, investing, or similar business - Farming - Production or extraction of certain minerals - Operation of a hotel, motel, restaurant, or similar business. 5

7 Section 1202 Limitations Ceiling on Section 1202 Exclusion Section 1202(b)(1) limits a taxpayer s Section 1202 gain exclusion from the disposition of a QSB issuer s stock to the greater of $10 million or 10 times the adjusted basis of the issuer s stock sold during the taxable year. Alternative Minimum Tax The portion of Section 1202 gains not excluded from AGI under the 50% or 75% exclusions, plus 7% of the excluded gains, are subject to the Alternative Minimum Tax, which increases the effective income tax rates on these Section 1202 gains to approximately 14.98% and 8.47%. 6

8 Gross Asset Measurement and Subsidiary Rules Gross Asset Measurement The amount of a QSB s assets is the adjusted basis of its assets except for contributed assets, which are measured at their fair market value at contribution. Subsidiary Assets and Activities Under Section 1202(e)(5)(A), if an issuing corporation owns more than 50% by value or voting power of a subsidiary corporation, it shall be deemed to own its ratable share of the subsidiary s assets and to conduct its ratable share of the subsidiary s activities. 7

9 Flow-Through Entities If a Section 1202 gain is recognized by a flow-through entity (e.g., a partnership, LLC treated as a partnership or S corporation), the Section 1202 exclusion is available to a noncorporate partner, LLC member or S corporation shareholder ( investor ) with respect to their proportionate share of the excludible gain, so long as the investor (1) held his interest in the flow-through entity (the entity ) when the entity purchased the QSB stock and continuously thereafter (2) to the extent that interest in the entity is not greater than when the entity acquired the QSB stock. 8

10 Example Transactions Growth Capital In 2013 a manufacturing C corporation with $25 million in assets issues $10 million of stock to a private equity fund, which is a limited liability company with individual members. The $10 million is used to buy new equipment. The active business requirement is met. No redemptions of stock are made within two years of the stock s issuance. The stock is latter sold in 2019 for $30 million. The $20 million gain is excluded from the AGI of the private equity fund s members under Section

11 Example Transactions S Corporation Acquisition with no Section 338(h)(10) Election In 2013 a new C corporation ( Newco ) issues $25 million of stock to a private equity fund, which is a limited liability company with individual members. Newco issues $20 million of debt. Newco acquires Target Company ( Target ), a manufacturing S corporation with $60 million of assets and $15 million of debt for $45 million The adjusted basis of the target s assets is $30 million. No Section 338(h)(10) election is made to treat the acquisition of Target s stock as an asset acquisition. The active business requirement is met. 10

12 Example Transactions S Corporation Acquisition with no Section 338(h)(10) Election No redemptions of stock are made within two years of the stock s issuance. The stock is latter sold in 2018 for $75 million. The $50 million gain is excluded from the AGI of the private equity fund s members under Section

13 Example Transactions S Corporation Acquisition with a Section 338(h)(10) Election In 2013 a new C corporation ( Newco ) issues $25 million of stock to a private equity fund, which is a limited liability company with individual members. Newco issues $20 million of debt. Newco acquires Target Company ( Target ), a manufacturing S corporation with $60 million of assets and $15 million of debt for $45 million. The adjusted basis of the Target s assets is $30 million. A Section 338(h)(10) election is made to treat the acquisition of Target s stock as an asset acquisition, which steps up the basis of Target s assets to $60 million. The active business requirement is met. 12

14 Example Transactions S Corporation Acquisition with a Section 338(h)(10) Election No redemptions of stock are made within two years of the stock s issuance. The stock is latter sold in 2018 for $75 million. The $50 million gain is not excluded from the AGI of the private equity fund s members under Section 1202 because the aggregate gross assets of Newco exceeded $50 million when the stock was issued. Newco s aggregate gross assets exceed $50 million because Newco is deemed to own Target s assets, which have an adjusted basis of $60 million. 13

15 Section 1045 Tax-Free Rollover on Qualified Small Business Stock Section 1045 allows a noncorporate investor to elect to defer gain recognized on a sale of QSB stock ( old Section 1202 stock ) held more than six months where the taxpayer uses the proceeds to purchase other QSB stock ( new Section 1202 stock ) within the 60- day period beginning on the date of the sale. Gain realized but not recognized under Section 1045(a) on a sale of old Section 1202 stock is applied to reduce the basis of the new Section 1202 stock in the order such stock is acquired. To satisfy Section 1045, both the old Section 1202 stock and the new Section 1202 stock must be QSBs as defined under Section 1202(c) and, hence, must meet the six QSB requirements described previously. The active business requirement of Section 1202(c)(2) must be satisfied with respect to the new Section 1202 stock only for the first six months of the stockholder's holding period for such stock. 14

16 Section 1045 Tax-Free Rollover on Qualified Small Business Stock Section 1045 rollover treatment applies to the sale of QSB stock held by a taxpayer other than a corporation where new Section1202 stock is purchased by the taxpayer. Where QSB stock is sold by a flow-through entity (e.g., a partnership, LLC treated as a partnership, or S corporation), a noncorporate owner of the flow-through entity can take into account his proportionate share of any Section 1202 gain recognized by the flow-through entity. Therefore, an individual may take into account for Section 1045 purposes his share of (a) any proceeds and gain from a flow-through entity's sale of old Section1202 stock and (b) any purchase by the flow-through entity of new Section 1202 stock, regardless of whether the flow-through entity is owned in part by persons not eligible for Section 1202 or Section 1045 treatment. 15

17 Section 1045 Tax-Free Rollover on Qualified Small Business Stock Thus, Section 1045 rollover treatment (1) applies to a sale of old Section 1202 stock by a flow-through entity (to the extent of the individual's share thereof) matched with timely purchase of new Section 1202 stock by the individual and (2) appears to apply to (a) an individual's sale of old Section 1202 stock matched with a flowthrough entity's timely purchase of new Section1202 stock (to the extent of the individual's share thereof) and (b) the individual's share of one flow-through entity s sale of old Section 1202 stock matched with individual's share of another flow-through entity s timely purchase of new Section 1202 stock. 16

18 Section 1045 Tax-Free Rollover on Qualified Small Business Stock Where the acquisition of new Section 1202 stock results in nonrecognition of gain on old Section 1202 stock under Section 1045(a), the holding period of the old Section 1202 stock is included in the holding period of the new Section 1202 stock. New Section 1202 stock (acquired pursuant to Section 1045) is treated as acquired on the date on which the old Section 1202 stock was acquired for determining whether which Section 1202 effective tax rate applies. 17

19 Section 1045 Tax-Free Rollover on Qualified Small Business Stock Example An individual investor ( investor ) purchases newly issued Old Target Company stock during the period which qualifies for Section 1202's 0% effective tax rate (and all the other Section 1202 requirements are satisfied). After the deadline for purchasing stock qualified for Section 1202's 0% effective tax rate has expired, so that a 14% Section 1202 effective tax rate is in effect, the investor sells the Old Target Company stock and within 60 days thereafter purchases New Target Company stock pursuant to Section The New Target Company stock nevertheless qualifies for the 0% effective tax rate because under Section 1223(13) the investor s holding period for the New Target Company stock began when the investor acquired the Old Target Company stock. 18

20 Contact Information Nick Gruidl David Sterling 19