IRC Section 1202: A Powerful Tool for Tax Savings and Attracting Investors

(00:00) [Music] welcome to the Cherry Bekaert tax beat a conversation about tax that [Music] matters welcome to this edition of the Cherry Bekaert tax be podcast today we are talking about one reason fast growing companies may want to be corporations for income tax purposes shareholders qualifying for qualified small business stock treatment at the time of the sell can take advantage of section 122 to exclude gain from the sell of their stock from federal income tax that's very exciting stuff so joining in today's conversation are

(00:50) barry wines director in our firm's national tax department and Molly Gill tax senior working in the transaction tax advisory team so Barry how's it going today it's going well in Tampa it's a little hot out though um how's a little hot in Tampa standards at this time of year 98 Degrees oh that's hot okay and we're not into summer yet wow okay well yeah you went that is hot all right uh and Molly how are you doing oh pretty good it's uh raining out here I'm in a a Ton's Virginia so um very very different than the 98 heat blistering out side yep for

(01:32) sure and as always joining me uh Sarah McGregor from our Greenville office Mr McGregor how's life treating you uh life is good Brooks it's post holiday so we're into uh summer season now and um always looking forward to an opportunity to talk about tax because football will be here soon enough all right well what's the weather in Greenville like today oh it's perfect uh low 80 super dry air coldfront came through last night it's just brilliant same for Richmond they're saying it's going to be the best weekend of the year so I'm

(02:10) looking forward to it all right so let's go to a little background on this uh qsb topic section 122 we got lots of terms we'll have to get into some definitions in a minute but uh when implement it properly um qualified small businesses can be a powerful tool for attracting investor ERS with funds to fuel the growth of a company shareholders can save as much as 23.

(02:38) 8% of federal tax on the capital gain realized on the sell of a small to midsize business so we got significant Stakes here and we need to overview about what it takes to qualify for this powerful tax savings benefit so let's start with you Barry provide a brief description of section 122 and and maybe uh explain some of these acronyms that we uh throw around in this area yeah thanks Brooks so QB stands for qualified small business and what that means is that looks at the company is the company a qualified small business if the company is a qualified small

(03:16) business you then move on to it from the shareholders perspective and is the stock the shareholder owns in that qualified small business qualified small business stock because there's two sets of requirements here one is for the business how the business operates as you talked about it must be a C Corp it must have $50 million of assets under a certain test when you get the stock you must have um and 80% of the assets have to be used in a qualifying traded business again we'll talk about that a little bit later so that's the business

(03:52) requirements the business has to meet those requirements in order for it to be a qualified small business flipping to the shareholder side the shareholder must have received the stock directly from the qu company so I can't have bought stock from another shareholder I must have received it directly from the company in exchange for property money or services and then the other requirement is I must have held it for more than five years so those are your two base requirements for 1202 the issue becomes is how are these

(04:28) tests applied and we'll talk about that and the key is there's a lot of different sort of traps for the unwar there's a lot of technical aspects of these tests and so you've really got to be dig down and understand those um that's really where the the the knowledge of 122 and how it operates that we've seen and we've done in the number of studies that that we can bring to the table so Molly you've done some analysis on 122 and whether the company qualifies and whether the stock itself held by the shareholder might qualify so what types

(05:08) of businesses are better suited for Section 122 than than others we see a lot of Technology businesses technology is a very broad industry and can involve a bunch of different sectors but we see a lot of technology and um from there really we just look at there's a few disqualified trades our businesses as outlined in the code so those would be businesses that rely on the skills of one or more individuals so think Professional Services and then you also cannot have a qualified small business be a hotel restaurant or anything related to real

(05:47) estate so have you seen where a couple of these uh 122 transactions have really helped out shareholders and and uh and and excluded some gain to their Ben yes definitely yes we have seen shareholders save in a big way so we had a situation in which a whole group of Founders did not have to pay any tax related to their gain as it was all excluded under Section 1202 and we've actually seen two transactions that were paused or the closing date was pushed off by in one case 15 days in the other case a month to have another trunch of shareholders

(06:25) qualify because of the significant benefits so there are a lot again there's a lot of planning on the the back end for that as well so they needed to meet that five-year hold correct so they pushed it off a bit longer to to make that happen correct all right Barry uh what two or three questions or issues do you most often encounter about section 122 so normally when we talk to uh clients and stuff that they have generally read up high level on 12 2 so they're sometimes asking more for a high level they're we talk about the detail

(07:07) we talk about the the two sets of requirements so um there seems to be a lot of misunderstanding about the 80% test how that works um you know if you think about it when when I say you have to have 80% of your assets used in your qualifying Trader business so if we're in a technology or software company like Molly mentioned you know they say well all our assets are used in that Trader business the answer is I understand that but because of the way 122 works is there some tricks and traps with regard to working capital working capital which

(07:43) is your cash your inventory your AR and in a lot of startups it's really cash and AR cannot be over 50% of your assets that we use toward this test so understanding how those tests work how it how everything sort of works together the other issue we find is um that people don't understand is sometimes they will bought back stock you know you'll start with three or four Founders and hey one of the guys wasn't working out so we'll bought back some of his stock we got an early investor we bought back some of their stock and in some

(08:20) cases that buyback of stock can cause problems for 122 it creates what we like to call blackout periods so stock issued before or after that date um may not qualify it really becomes problematic when I issue stock let's say I issue it on January 1 if I have one of these transactions later in the year all of a sudden that January 1 stock is no longer qualified small business or eligible to qualified small business stock that's a big surprise so we always try to talk through um with clients that type of thing and one of the other things we try

(08:58) to do is make sure you know you start to look at this and examine this early on because what you don't want to do is in the normal course of your business you don't want to do create a transaction that will disqualify you from being a qualified small business or maybe wipe out some of that benefit on stock you've already issued so having the knowledge of how these rules work can help you as we go along and one of the examples we have is we had a client uh there's a $50 million asset test they were going to go out and

(09:34) do a $30 million Capital raise that would have put them over the test which means none of that new money would have qualified so what we suggested and what they ultimately did is we cut that that raise into two parts so we did one part on day one which qualified the second part because it put us over the limit didn't qualify so in instead of having none of that stock qualified at least we got part of that in there so those are the type of planning and ideas that we can help bring uh to the table to to sort of manage through this

(10:12) process I think something also that we have to reiterate to clients is that the ultimate benefit of 122 is at the individual level so the company does not have to take any position on the actual benefit and beyond that to shareholders who who have similar facts can actually take different positions on how to treat their gain on their personal return so when youre running these analysis uh for a company or for shareholders um what's the hardest part about collecting information we're talking a fiveyear look back period I

(10:47) guess uh on this the stock issuance what what do you find is the most difficult part about collecting information or dealing with clients so actually for the for the analyses we actually look at the entire dur of the company's existence so if they started 15 years ago we need 15 years of data um but beyond that I think the most difficult uh information to obtain from the client is just anything to determine the value associated with the 80% test so the 80% test is based on value it's not based on the tax or accounting basis

(11:24) so clients clients tend to have a difficult time providing us with an information because it's not the information that's on their financials or their balance sheet and a way that we get around that and try and get the information another way is we ask for 409a valuations any term sheets anything that will indicate the actual value of the company at a specific point in time so having someone outside or or valuing the company for a different reason would provide some input into what the values of those assets were um during during the time

(11:59) that you're trying to measure yes exactly uh followup question do we frequently have to engage valuation people go out and I mean do a some kind of valuation work in conjunction with this or is that rare so normally again as as Molly talked about this is a this is for the the shareholders benefits so what we'll do is we'll have conversations with management we'll use the best information we have and we'll make judgments about where that value is and sometimes what happens is because if the value is very high then the 80% were well past the test so

(12:42) what we try to do is is a sensitivity analysis at what point do we need the value to be in order to meet that test and if we can get comfortable with that then the company always has that option the downside to going out and getting evaluation analysis is your doing that for a period of time in the past and so those become very suspect because you know you've sort of got you you got hindsight things along those lines I think it makes it a little bit harder to do so we try to look at objective things that were done at that time period to

(13:20) come up with that so if we were in real a real bind we may be resort to that we haven't had to do that yet so Barry um it sounds like this is a great way or or to advertise to investors say hey if you invest we're going to try our best to stay and meet the qualified small business uh uh qualification there and be a qualified small business so that you shareholder can possibly take advantage of a um QB at take advantage of this I get too many q's and S's and B's in there 122 benefit yeah the 122 benefits so um but what

(14:02) else should an investor be thinking about besides this uh before they make an equity investment in a in a company so 1202 is is is an opportunity if you have a C Corp so remember the first question you should be asking is if you're forming a business is a C Corp the best form of that business or should it be a pass through such as an escort or a partnership so really when you go through the analysis that we have seen is that you've got two issues one is cash flow from an operational perspective during the time the business

(14:42) is operating and then second what's the exit strategy on that business so if you look at the analysis that we've done on multiple entities what we find is that c Corps generally it's like the tortoise and the hair the C Corps are the hair they start out much better from a cash flow perspective because their effective rate currently is less than there is on on the passrs what happens though is on the sale because of the constraints and the tax impact on both the buyer and the seller is passrs then generally will

(15:17) jump ahead at the at the end to sort of pass that the only exception that we have found is when 122 applies so 122 is sort of like having your cake and eating it too you get the benefits during the operational period And if it qualifies for 1202 you get the benefits at the backend but as we talked about one of the requirements is a fiveyear hold so if I hold my stock four years 364 days and sell I get no benefit at five years in a day I get the benefit it is a cliff so that's one of the things you have to think about

(16:00) is what's my exit strategy you can say yes I'm going to hold it for 5 years if in four years somebody comes and offers you a lot of money for your company do you want to hold it for the extra year to get that benefit or do I want to take the the brass ring right now so that's one of the things you need to sort of of take into account the other thing that we're seeing now is that when people are investing in C Corps and they like the C Corps because because there's no issues about pass through income and things

(16:32) along those lines you just avoid a lot of that is they are asking up front whether they're the company is a qualified small business so they want to know upfront because in making an investment decision if I have two companies and I have the potential to exclude the gain on one up to $10 million or even more then and the other one doesn't offer that where am I going to invest my money if if everything else is being equal so that's why we encourage companies that are are in this situation after they're going and they

(17:09) think they they've got sort of a plan here to start doing this analysis at least on an annual basis so that you can tell the the investors yes we we're a qualified small business we've done the analysis we intend to continue to operate we've got our eye on the places where it can trip us up we've got advisors in place to help us manage through this process and do that so I think again this helps in a planning and a lot of cases we come in at the back end right at the time of sale and do the analysis that's fine if you haven't

(17:44) screwed anything up but if you have there's no ability to do that or plan around some of those things so it's one of those things that if you know about it early we suggest you look at it at least be aware of where you can trip things up whether you do the full analysis or not well this sounds just too good to be true Barry so um I made a mistake and I started as a partnership in escort now I want to go for 122 uh can I do it the answer is yes but you have to be careful about how you do that and when you do that so with the partnership rules is

(18:26) you can convert to a C Corp under a number of different ways and that conversion will start now that starts your 5year holding period so if I was at a partnership for 3 years before that that time period doesn't count it's my fiveyear stock holding period the problem becomes if the company has too the partnership has too big of a value and their assets based on that value exceed $50 million I can't convert because then I blown that test okay so you've got to make sure you don't hit that inflection point if I'm going to do

(19:03) that I've got to do it when the value is below generally that 50 million again depending on what the debt is and things like that so that becomes very critical with an escorp you can't just go back to a C Corp we have to go through a couple other steps so that the es Corp becomes the holder of the C Corp stock because in order to get the benefit remember somebody has to tribute assets into a C Corp if I just check the box to go from an S to a c that doesn't qualify it for the founders if somebody comes in after I convert it works for

(19:42) them problem is normally the founders are the ones who want the benefit so again if you talk to us ahead of time there are very some very simple steps we can do to make sure you get that benefit so the simple answer to your question is yes you can get there if you're somewhere else else but you have to be careful on how you do that and Molly we we're talking about all this but it as you mentioned earlier the benefit is really to the shareholder themselves uh when they dispose of their stock and it qualifies meets all these

(20:15) qualifications uh now this is a federal tax provision uh what do you think about states do do states have these same Provisions or does it does it matter state byst state so generally if a state conforms to the Internal Revenue code then it would qualify but we we are not offering any opinions here and we also would not like to say for certain whether or not a state is is going to accept it so we would suggest that you engage with a your Tax Repair um since it is at the individual level and and to follow that

(20:53) point is so you could have an individual in in in in a state with income tax or two two different shareholders and states with income taxes and be treated differently from the state perspective because the state applies those rules differently so it's really a shareholder by shareholder basis and again as Molly had said earlier we generally work with the companies to help them establish that they're qualified small business now one of the other things to think about here is if you think about the exit transaction so the exit transaction

(21:26) let's say happens today May 29th so now the shareholders are claiming the benefit on their 24 return filed sometime in 25 so by the time the IRS gets around to looking at this it's 27 or 28 so what we try to encourage is to do the analysis we prepare a report that the the company can gives to the shareholders the shareholder now has all of the documentation on why that stock is qualified small business stock so that if they're questioned two or three years out they're not trying to go back because all of those Founders are

(22:03) probably no longer at the company and things along those lines so again that's something we try to encourage to help make sure you get the benefit and keep the benefit once once you're eligible for it document before you go document before you go uh I think you just uh uh stated a tax truism regardless of the conversation but anyway all right let's move on to final comments here so um Molly what you got to say I think that section 12 of two is a great benefit for uh any individuals if you are invested in a qualified small

(22:44) business and um I deal with these all the time uh so if you have any questions uh always reach out to your tax preparer professional and Barry what you got to say well saving tax on $10 million of gain as you said at 23.8% that's $2.3 million that's nothing to sneeze at and it can go up depending on how much you invested the rules are tricky so be careful of what you read out on the internet there are people who will talk about it in generalities but not know the nuances so again be careful reach out if you have questions happy to have

(23:30) a conversation and Sarah I think 122 is one of those uh very cool Provisions uh in the code that provides a benefit that I think more more people more investors and companies should be taking advantage of so from my perspective I am uh I'm struck by know the you know this change in the overall benefit entity I think in the tax profession there's been a you know really big knee jerk to go to a pass through entity for quite some time and I mean and I think you know giving where we are with the 100% exclusion with

(24:18) 122 uh you really have to pause if this if this Corporation could in fact qualify under these provisions and it seems to align with your exit strategy so um interesting stuff for sure um all right so that's a wrap on today's discussion about qualified business stock and the opportunity to exclude capital gains from taxation a quick disclaimer that we are not providing tax advice on this podcast please consult with your Tax Advisor hopefully at Cherry Bekaert with your specific tax issues or to discuss information from

(24:50) today's podcast check out the firm's website at cbh.com for the latest guidance and materials on this and other tax and business topics this concludes today's podcast please like share and subscribe thank you Molly thank you Barry thank you our listeners for spending your time with us we truly appreciate it let's call it a day and go forth in peace [Music]