Internal Revenue Code §1202 and You: Analyzing Exclusion of Gain on Sales of Small Business Stock

Section 1202 of the Internal Revenue Code allows small businesses to exclude some or all of the gain from stock sales. Small businesses can plan for this benefit when considering selling their business. Tax professionals can help determine if a business qualifies for the gain exclusion. The article focuses on businesses that do consulting, as they may not qualify for the exclusion. I.R.C. §1202 is a tax law that lets certain taxpayers exclude some or all of the profit from selling shares of a small business from their taxable income, as long as they’ve owned the shares for at least five years. The requirements for this exclusion include owning “qualified small business stock” in a “qualified small business” that is involved in a “qualified trade or business.” This law also allows for the time a taxpayer holds the stock to be “tacked on” to the time they hold other stock in certain situations. If you own stock in a small business and then exchange it for stock in another small business, you can still get tax benefits if the new stock is held for five years. This means you can keep the new stock and potentially pay less in taxes when you sell it later. The Private Letter Ruling 9810010 (1998) states that if you own stock in a small business and exchange it for stock in another company, the new stock may still be considered as qualified small business stock if certain conditions are met. To qualify, the stock must have been issued after August 10, 1993, the company must be a C corporation, and the stock must be acquired for money or services provided. Additionally, the company cannot have repurchased its stock from you or a related person in the four years before issuing the stock, and the company cannot have repurchased a significant amount of its stock in the two years before issuing the stock. The company also must be considered a “qualified small business” when the stock is issued. If all of these conditions are met, you may be able to exclude some of the gain from the sale of the stock from your income for tax purposes. If a small business stock is converted to other stock in the same company, it will still be considered as small business stock. However, it can be tricky to determine if the company qualifies as a “qualified small business” under the tax code. If a stock is considered a “qualified small business stock,” it means it’s stock in a small business that meets certain requirements. The business must be a U.S. C corporation, and its total assets can’t be more than $50 million. If the business is part of a group of connected corporations, the assets of the whole group are counted. The IRS may require a valuation of the business’s assets to make sure it meets the $50 million limit. Any business close to the limit should be ready to explain how it valued its assets. To qualify for certain tax benefits, a business must meet several requirements, including being an active, operating business. This means that at least 80% of the business’s assets must be used in its operations, and it must not be involved in certain types of businesses like banking, insurance, or consulting. The business also must be a certain type of corporation and must have limits on the amount of real estate and stock it holds. These rules can be complicated, so it’s important for business owners to understand them and seek advice if needed. In simple terms, if a company wants to qualify for certain tax benefits, it needs to be mainly involved in a specific kind of business. This means that if a company primarily provides services like healthcare, law, engineering, accounting, consulting, or others listed, it may not be able to get those benefits. There aren’t detailed rules about this, but there are some examples from the IRS that can give us an idea of how they might decide. The IRS has rules about what qualifies as a trade or business for tax purposes. If a company mainly provides services, like a law firm or financial advisor, it may not qualify. But a company that provides specialized services to the healthcare industry, with employees trained for those tasks, can still be considered a qualified trade or business. If a company sells software to medical providers and its success is tied to the expertise of its employees, it may still qualify as a qualified trade or business under the tax code. A court case called Owen v. C.I.R. established that a company’s success being tied to the efforts of key employees doesn’t automatically disqualify it. So, as long as the company is selling something other than individual expertise, it can still be considered a qualified trade or business. The IRS has said that a specific part of a court case is not definitive, but it still gives a good idea of how the law might be interpreted. There are also regulations under a different part of the tax code that give more details on who can get a tax deduction. These regulations talk about the types of services that do not qualify for the deduction. Consulting services under the tax law mean giving professional advice and counsel to help clients achieve their goals and solve problems. It includes advocacy to influence government decisions and lobbying for clients. It does not include sales or training services. Consulting should be the main focus of the business, not just an add-on to another product or service. Architecture and engineering are not considered consulting services. I.R.C. §1202 can help taxpayers save money on taxes when they sell stock. There are certain requirements that stock must meet to be eligible for the tax savings. It’s important to carefully review these requirements to see if you qualify for the tax benefit. For anyone filing taxes, it’s important to understand the rules for determining if a business is part of a larger group, especially with the changes made to the tax code. Pay attention to the rules about who owns what in partnerships, because that can affect whether a business is considered part of a larger group. Also, there are specific rules about what types of businesses don’t qualify for certain tax benefits, so be sure to look those up if your business is related to mining or extraction. And remember, the rules for these tax benefits only apply to certain types of businesses, so make sure your business fits the criteria. Steven M. Hogan is a lawyer at a law firm in Tallahassee. He helps people with their taxes and estate planning. Jacob H. Huggins is still in school, studying to become a lawyer. This column is written on behalf of the Tax Section, which is part of The Florida Bar.

Source: https://www.floridabar.org/the-florida-bar-journal/internal-revenue-code-%c2%a71202-and-you-analyzing-exclusion-of-gain-on-sales-of-small-business-stock/