Here at Boxelder Consulting, we’re always searching for ways to help our clients navigate through the tax system successfully. Sometimes, this means that we assist our clients in resolving past tax debt by submitting an offer-in-compromise or installment agreement. Other times, this means alerting our clients to a new or seldom used tax break. In this post, we’d like to alert current and prospective clients to a tax break which can be very useful if they may sell “qualified small business stock” in the future.
Sometimes, when an investor acquires stock in a tech start-up, or an employee receives stock as compensation, that stock can ultimately become extremely valuable if the new company takes off and becomes successful. In some cases, investors and tech professionals can profit millions of dollars off a relatively small investment. This is actually more common than you might think. Suppose you’re a tech employee with a new Denver-based start-up. It’s not uncommon in these situations for the tech employee to receive stock as partial compensation. When the stock is first received, it may be almost worthless, but if the start-up becomes financially successful, then the Denver tech employee could end up sitting on a gold mine.
Though this is a great financial gain, this situation can also leave investors and tech professionals with a hefty tax bill. Luckily, the tax code has a provision which allows those who possess certain “qualified stock” to exclude a very significant amount of gain. This provision is found in Section 1202 (“Partial exclusion for gain from certain small business stock”).
Let’s go over the specifics of Section 1202 and then run through the process of filling out Form 8949. This is the form you’ll fill out when you sell qualified small business stock and invoke Section 1202. If you do intend to use this section, it’s advised that you reach out for assistance from a qualified tax professional. The professionals at Boxelder Consulting have an in-depth knowledge of Section 1202 and would be delighted to walk you through the process. We want to do our best to help investors and employees maximize their financial gains whenever they sell their qualified stock. Give us a call today at 303-317-6111 for more information.
The Requirements of Section 1202 (QSBS)
Section 1202 applies to “qualified small business stock,” and so it is meant to reward industriousness and contribute to general economic development. This means that those who intend to use it will have to comply with a number of requirements. All of these requirements have to be met, otherwise the section won’t be usable. And if you attempt to use it when it’s unavailable, your mistake will surely be identified by the IRS and you will face financial penalties.
To qualify under Section 1202, the company issuing the stock must be a domestic C corporation. At least 80% of the assets of the C corporation must be used in the operation of a trade or business which is an industry other than the following: professional services (law, accounting, etc.), financial services (banking, insurance, etc.), farming, mining, or operating a hotel, motel, restaurant, or other like businesses. The individual selling the stock must have held the stock for a minimum of five years from the date of issuance. If the stock was acquired by way of stock options, then the date of issuance is the exercise date, not the grant date.
The time when you first acquired the stock can also affect the benefits you’re eligible to receive. First, only stock issued after August 10, 1993 can be considered qualified small business stock for Section 1202 purposes. If you acquired the stock between August 11, 1993 to February 17, 2009, then you’re only eligible for 50% of the gain exclusion under Section 1202, and you would be subject to 7% of the alternative minimum tax. If you acquired the stock between February 18, 2009 to September 27, 2010, then you’re be eligible for 75% gain exclusion with 7% alternative minimum tax. Stock acquired after September 28, 2010 is eligible for the 100% exclusion and zero alternative minimum tax.
To be considered a “small business,” the tax basis of the gross assets of the company must be less than $50 million. The tax basis must be less than $50 million at all times prior to the issuance of the stock. The other requirement is that the investor must have acquired the stock by purchasing with cash or other property besides stock. If an employee receives the stock as payment in lieu of cash, then the stock is eligible under Section 1202. Section 1202 provides an exclusion of up to $10 million of gain or 10 times the tax basis of the stock, whichever is the higher.
The Basics of Filling Out Form 8949
Filling out Form 8949 can be either simple or quite complex. Everything depends on what exactly you’re reporting. Form 8949 is called “Sales and Other Dispositions of Capital Assets,” and it is used to report capital gains. The form is divided into two parts, the first part is devoted to short-term gains, and the second is for long-term gains. Because Section 1202 can only be used for stock which was held for at least 5 years, you will always report that stock on the second part. If you sell other short-term capital assets in the same year, then you will need to fill out the first section.
If you only sell your qualified small business stock, filling out Form 8949 won’t be too difficult. On the second part of the form, you will simply identify the asset you sold – in this case, your qualified small business stock – in column (a), then you will input the date you acquired it, date you sold it, and then the gross proceeds you received in columns (b), (c), and (d), respectively. Then, you will put your basis in column (e). In columns (f) and (g), you will reference Section 1202 to indicate that you intend you use this to offset gains, and then by what amount the gain will be adjusted. Then, finally, in column (h) you will input your total gain or loss after combining with your Section 1202 adjustment.
There is more to Form 8949, but this is a good overview, especially for those who only intend to use it to report the sale of qualified stock. Again, you need to contact an experienced professional to make sure you’re doing everything correctly.
The Tax Professionals at Boxelder Consulting Can Help
As you can see, the requirements of Section 1202 can be a bit tricky. There’s quite a bit of information to take in, and likely a few unfamiliar terms. This is why you should reach out to a tax professional if you’re planning to take advantage of this very useful tax break. The IRS scrutinizes this tax provision very closely; this isn’t too surprising given the very large savings which are typically at stake when this provision is used. This means that it’s imperative that you understand and fully observe all the requirements of Section 1202 and fill out Form 8949 correctly. We know that there are lots of tech investors and tech employees in the greater Denver area who currently need to use this section or will need to use this section. Whenever a Denver investor or employee receives a windfall, that’s a great thing, but it’s important that you manage your wealth as best as possible. The team at Boxelder Consulting can be of assistance. If you need help with this area, please give us a call right away. You can reach us at 303-317-6111, or contact us online.