Congress enacted section 1202 in 1993 with the stated purpose of creating an additional incentive for certain types of small business investment.

The law allows investors in Qualified Small Business Stock (sometimes called QSBS) to avoid tax on up to $10 million in gains.

If you have clients with Qualified Small Business Stock, you probably know this. But you might not be aware that in some circumstances it may be possible to avoid tax on more than $10 million.

Qualifying Rules
To qualify for section 1202 special treatment, a business must be a Qualified Trade or Business (sometimes called a QTB), and for stock investments made after 2010, the stock must be held for at least five years. The stock must be in a C-corporation, and can have been acquired by the owner (which cannot be another corporation) for cash, or in exchange for property or even stock acquired in exchange for services. Though the rules are complex, the corporation generally must not exceed $50 million in aggregate assets.

The rules defining what is, and is not, a Qualified Trade or Business are also complex. Many types of business do not qualify, including accounting, brokerage, architecture, consulting, engineering, farms, financial services, health (possibly excluding medical devices), hospitality, insurance, law, and any business in which the principal or employees primarily provide skilled services.

So what does qualify? High tech, manufacturing, software, and certain types of research and development. The rules are not completely fleshed out.

Tax-Free for more than $10 Million?
In general, the first $10 million of a taxpayer’s gain (or ten times the basis, if that ten times is greater than $10 million) is tax free.

But it may be possible for a single taxpayer to, in effect, avoid tax on at least twice as much. Let us consider a simplified example. To make the numbers easier to follow, we will assume a single taxpayer. Our single taxpayer will be a couple – for these purposes the couple each has the equivalent of $5 million, which is tax-free. The couple’s basis is zero, and they have a Qualified Small Business Stock with a market value of $20 million.

In the standard case, the first $10 million would not be taxed as per section 1202, and the second $10 million would be taxed as capital gain.

Now consider the same facts, but the couple, prior to the sale of the stock, sets up a qualifying tax-exempt Business Owner Trust. The couple contributes $10 million of stock to the tax-exempt trust, and names themselves as income beneficiaries for their remaining joint lives. They keep the other $10 million.

When the stock is sold, the couple receive $10 million of income, but that income is free from tax under section 1202.

At the same time, the trust (which is tax exempt under sec. 664) also receives $10 million. It too is free of tax.

A Business Owner Trust can distribute cash to the income beneficiary each year at a set rate, such as 5%. In the example just given, the trust has $10 million. Ignoring trust earnings or gains, if the trust distributes $500,000 each year to the couple, for the next twenty years that income will be tax-free. It is tax free because the trust is considered a different taxpayer for purposes of section 1202. (Even better, the trust can and will invest the entire $10 million, pre-tax, to generate yet more wealth for the owners.)

Thus, the couple can effectively double the section 1202 exclusion. With a bit of creativity, if they had $30 million, and were willing to make the irrevocable contributions to two trusts, they could effectively avoid tax on the entire $30 million.

These are complex issues, and the goal of this email is only to make you aware of the potential planning opportunities. For more information, click here to request our guide on business sales, or call (703) 437-9720 and ask for Connor.