Unlocking Tax-Free Gains: How Tech Companies Can Leverage Section 1202

Section 1202 of the Internal Revenue Code presents a significant tax savings opportunity for founders, investors, and employees of certain technology companies. It allows eligible stockholders to exclude a substantial portion – potentially up to 100% – of capital gains on Qualified Small Business Stock (QSBS), making it a powerful tool for reducing tax liability on a successful exit. However, careful planning is required to ensure eligibility, maximize the benefit, and avoid pitfalls.

Qualifying for QSBS: Key Requirements and Considerations

To qualify as QSBS, stock must meet the following requirements:

• Issued by a U.S. C-corporation after Aug. 10, 1993
  • If a company is taxed as a partnership or S-corporation, it will not qualify.  However, there are opportunities to restructure as a C-corporation to take advantage of Section 1202.

• Be acquired directly from the company
  • The stock must be purchased directly from the company (i.e., it can’t be purchased from someone else).

• Issued by a “qualified small business” (This means gross assets must have been $50 million or less at all times before the issuance and immediately thereafter.)

• • It’s important to note that the stock offering can be valued at greater than $50 million so long as gross assets do not exceed $50 million any time before issuance and immediately thereafter.
  • Special valuation rules apply when there are non-cash contributions.

• Company must meet the “active business requirement,” which means at least 80% of company assets must be actively used in a qualified trade or business
  • The IRS doesn’t want investment holding companies taking advantage of this rule.
  • Tech companies often raise large funding rounds. If too much cash sits idle rather than being actively reinvested in the business, the company could fail the 80% asset-use requirement.

• Company must be a qualified trade or business
  • Most tech companies qualify, but there are some industries that don’t. For example, businesses in finance, law, accounting, consulting, and healthcare are usually excluded. If your company relies on the reputation or skill of its employees rather than selling a product or service, it might not qualify.

It’s equally important to watch out for disqualifying distributions, such as:

• If the company makes a “significant redemption” of its shares, stock issuances can be disqualified.
• Even stock redemptions that do not rise to the threshold of “significant” can disqualify stock for that taxpayer and related parties.
• Make sure to consult a tax advisor before redeeming stock.

Shareholder Requirements for QSBS Eligibility

As previously noted, corporate-level requirements and shareholder requirements must be met for stock to be QSBS, including:

• Shareholder must be an eligible taxpayer (i.e., not a corporation)
  • Pass-through entities can hold QSBS,and the gain maintains it characters subject to unique ownership rules around the purchase date of the stock.

• Taxpayer must have held the stock for more than five years
  • It’s important to understand when a holding period starts. For example, the clock does not start running for options until they are exercised.

• Stock must be acquired through an original issuance
• Stockholder cannot have an offsetting short position with respect to the stock

Best Practices for Maximizing the Section 1202 Benefit

Advance planning is crucial to maximize the Section 1202 benefit and avoid disqualification. Best practices include:

• Plan ahead: Work with legal and tax teams early to structure stock issuances properly.
• Keep documentation in order: Potential investors may require certain documentation so they can determine if their stock purchase would be Section 1202-eligible. Additionally, if there is ever a successful exist, investors will need certain information to be able to file their tax returns.
• Consider an opinion letter: Some companies and investors get a formal tax opinion to confirm their QSBS qualification, which can help reduce IRS scrutiny later.

Final Takeaway

For tech companies looking to attract investment, incentivize employees, and plan for an eventual exit, Section 1202 is a very powerful tax strategy. If structured correctly, it could mean paying zero federal tax on millions in gains – but taking full advantage of this benefit requires careful structuring, proactive planning, and ongoing compliance with IRS rules. By ensuring that requirements are met, companies can position themselves for significant savings.

For information on how to optimize your stock structure for QSBS, reach out to your KSM advisor or fill out the form below.