who told you I can’t have your cake and eat it too, should have called their accountants and lawyers first.

These professionals often get questions from founders, equity investment firms, and venture capitalists looking for ways to save on or avoid capital gains taxes on future corporate sales. Lawyers and accountants alike encourage clients to explore the tax savings offered by setting up a Qualified Small Business (QSB) C-Corporation in the initial stages of establishing a business. Using a QSB can eliminate the capital gains tax payable on the future business sale if the company is incorporated and shares are issued in accordance with Section 1202 of the Internal Revenue Code.

Many startups often just use 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 of the key 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 qualifying small business stock (QSBS) from non-corporate taxpayers if the stock is held for more than five years. QSBS is a share in a C Corporation originally issued after August 10, 1993 and acquired by taxpayers in exchange for money, property, or consideration for services. The company may not have gross assets in excess of $50 million in fair market value at the time the shares are issued.

Prior to 2010, only a portion of the capital gain on QSBS was excluded from taxable profit under Section 1202 and the portion excluded from profit was a tax benefit subject to alternative minimum tax. This rule has been amended for shares acquired after September 27, 2010 and before January 1, 2015, so that the gain on such shares was completely excluded and no portion of the gain was a tax benefit. 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, this represents a significant tax benefit for entrepreneurs and small business investors. However, the effect of the exclusion ultimately depends on when the shares were acquired, the trade or company being operated, and several other factors.

Eligibility for Section 1202’s capital gains tax exclusion requires 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 in order to achieve capital gains tax exclusion. This can be challenging as buyers typically prefer asset acquisitions that allow for an increase in base and future goodwill amortization.

In many corporate sales today, buyers expect shareholders to transfer some of their equity, or to receive shares or membership interests in a new entity as part of the transaction. Improper planning will result in QSB’s shareholders losing the exclusion from QSBS profits and being liable for tax on the sale. This can happen if there is an impermissible rollover of equity to an LP or the receipt of LLC stock.