By: Robert Weber, Managing Partner of Great North Labs, an Upper Midwest Venture Fund
Angel investors and advisors, have you checked in with your tax advisor lately? If not, may I suggest a good reason to do that would be to discuss Section 1202 of the U.S. Tax Code.
For background, it was part of the Revenue Reconciliation Act of 1993, which had the purpose of providing targeted relief for investors who risk their funds in new ventures and small businesses. Section 1202 now allows for 100% of the gain from the sale of Qualified Small Business Stock (“QSBS”) held for five years, for stock acquired on or after Sept. 28, 2010. This 100% exclusion, unlike many other tax breaks, is permanent. (The stock must be in a C-Corporation.) The benefit is capped at the greater of (1) $10 million, or (2) 10 times the investor’s basis in the stock.
This ability to exclude 100% of the gain on the sale of stock for cash is virtually unmatched throughout the Tax Code. Yet, despite this fact, many tax advisers outside of Silicon Valley are not familiar with Section 1202. In this post, I will provide further detail about the 1202 exclusion, including commentary from Patrick L. Smith, CPA, Managing Principal/Technology Industry, CliftonLarsonAllen LLP.
What Recently Changed
The tax incentive of Section 1202 was essentially dormant since it was enacted in 1993, for reasons we won’t discuss here. Enter the Tax Cuts and Jobs Act signed into law by President Trump, which went into effect on January 1, 2018. That reduced the corporate tax rate from a high of 35% to a flat 21%, and caused a resurgence in the use of the C-Corporation. Soon, tax advisors realized that Section 1202 provided a big benefit for companies who choose to do business as a C-Corp — specifically because of its benefit for those companies’ investors (as well as its founders and early employees).
A key point, according to CliftonLarsonAllen’s Patrick Smith: “Most early-stage tech companies are considered qualified businesses under Section 1202, but several types of businesses are not.” He notes that those specifically excluded are as follows:
Professional services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services
Banking, insurance, financing, leasing, investing, or similar businesses
Farming, mining, or natural resources extraction
Hospitality (hotels, motels, restaurants, or similar businesses)
What Is Qualified Small Business Stock (QSBS)?
Section 1202 (PDF) defines “QSBS” thusly:
It is stock in a domestic C-Corporation issued after the date of enactment of the Revenue Reconciliation Act of 1993 (August 10, 1993). It must be acquired by the individual taxpayer (or a pass-through entity, but not a corporation) at the original date of issue (not in a secondary offering) in exchange for money, property (excluding stock), or as compensation for services. The latter includes advisory shares, but excludes underwriting. The company must have assets of less than $50 million at the time of the equity issuance and immediately thereafter (including cash received from the issuance), be an active business for the duration of the investment, and the individual must hold the stock for at least five years. Lastly, the company must be a qualified business, as defined above.
Patrick Smith of CliftonLarsonAllen: “Section 1202 stock is one of the most powerful tools Congress has ever provided to small businesses. It may have a significant impact in the M&A setting related to the assessment of an asset sale versus a stock sale. In certain circumstances, it could significantly mitigate the impact of the double tax of selling the assets of the company. Normally, when a C-Corp sells its assets to a buyer, the corporation pays corporate-level tax. The shareholders will then pay tax upon the liquidation and distribution of the cash. If the gain on the liquidation could be sheltered by the 1202 exclusion treatment, this could make an asset transaction more viable, which buyers love. If the C-Corp had net operating losses to shelter the corporate-level gain, there could be even more value.”
If portfolio companies are not currently structured as a C-Corp and they currently qualify, Patrick notes, structuring can be done to convert them to a QSBS C-Corp. “It is important that this is done correctly to satisfy the original issuance requirement,” he said. “Unfortunately, the five-year clock starts on the date of conversion.”
Mike Schulte, the senior analyst at Great North Labs, had this to add: “QSBS is a very powerful tax benefit that incentivizes private investment into startups. However, there are potential mishaps in structuring and documenting a transaction that can inadvertently ruin compliance. Convertible instruments, entity selection/conversion, and financial reporting are just some of the issues to understand and watch out for. It is important for issuers, investors, and each of their service providers to cooperate to ensure 1202 compliance.”
My thanks to Patrick for his commentary above, and also to my colleague Mike Schulte, who wraps up his thoughts by saying, “I think 1202 is as close to a win-win as you can get.”
I would only add one more note: When making investments, angel investors may well wish to consider investing in a fund, or as part of an angel group, that has a process to take advantage of the 1202 exclusion.
NOTE: This article is not intended to provide tax advice. Consult your tax accountant or tax attorney.
Great North Labs is an early-stage fund built, operated, and advised by successful founders. Great North has doubled down on the value of hands-on experience and relationships to accelerate startup growth in the Upper Midwest. Founded in 2017, Great North Labs’ $23.7 million Fund I was one of the region’s largest debuts. Founding Partner Robert Weber is a member of Minnesota-based Gopher Angels, PropTech Angel Group, and the Angel Capital Association. He has either personally or through Great North Labs invested alongside several angel groups including Gopher Angels, Hyde Park Angels, Sofia Fund, Wisconsin Investment Partners, Alamo Angels, Seraph Group, and Atland Ventures.