6 minute read
This is a Game-Changing Tax Strategy Your Business Owner Clients Need to Know
As financial advisors, we always search for strategies that deliver value to our clients. And one of the most powerful yet underutilized tax benefits available today is IRC 1202, which governs Qualified Small Business Stock (QSBS). This provision offers a significant opportunity for eligible business owners to eliminate capital gains taxes when selling their business.
Let me share why this matters to your practice and your clients.
The Birth of IRC 1202
In 1993, as America emerged from recession, Congress created Section 1202 to stimulate small business investment, offering a 50% capital gains exclusion. The 2009 financial crisis prompted an increase to 75%, but the real change came on September 27, 2010, when the Small Business Jobs Act raised the exclusion to 100%.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 made this 100% exclusion permanent, turning what began as a modest tax incentive into one of the most powerful tax planning tools available to business owners today.
Here are the specific dates that determine your client's exclusion rate.
- 50% exclusion: Stock acquired August 11, 1993 - February 17, 2009
- 75% exclusion: Stock acquired February 18, 2009 - September 27, 2010
- 100% exclusion: Stock acquired after September 27, 2010
Keep in mind, there is a five-year holding period requirement, which I discuss more below. This rule always applies regardless of the acquisition date.
What is the Power of QSBS?
At its core, IRC 1202 allows qualifying business owners to exclude a significant portion of their capital gains from federal taxation when they sell their business. The exclusion can be either the greater of $10 million or 10 times the stock's adjusted basis.
However, like most valuable tax benefits, qualification requirements are specific and complex. They must be discussed with experienced legal and tax experts before your client or prospect takes any action.
Does Your Client’s Businesses Qualify?
The first thing to understand is that this benefit is exclusively for C-corporations.
Many of your business owner clients might operate S-corporations or LLCs, but for those starting new ventures or considering entity conversion, this could be a compelling reason to choose C-corporation status. The business must be an active qualifying enterprise, company assets must be under $50 million at stock issuance, and shares must be held for at least five years.
Many of your business owner clients could qualify, particularly those in technology and software development, manufacturing, wholesale and retail, and construction.
What Businesses Do Not Qualify
However, certain service-based businesses are excluded - including:
- Financial Services (advisors, investment firms, insurance companies)
- Healthcare Provider
- Professional Services (law firms, consulting firms, engineering firms)
- Any business where the principal asset is employee expertise
Some businesses engage in mixed activities - which means certain portions may qualify while others do not. This complexity is why we always suggest that your client or prospect work with qualified tax professionals to determine eligibility.
Critical Documentation for QSBS Qualification
Your clients or prospects must maintain detailed records from the moment of stock acquisition. These include stock certificates with issuance dates, corporation asset valuations at issuance, business activity records, basis calculations, and detailed transfer records if the stock was acquired through gift or inheritance.
Proper documentation from the start can prevent significant challenges when it comes time to claim the exclusion.
How Dunham Can Help
As an advisor, understanding IRC 1202 positions you to identify planning opportunities for existing business owner clients, attract new clients through sophisticated tax planning knowledge, strengthen relationships with centers of influence, and add substantial value through proactive planning.
Your Dunham Regional Director and Business Development Team can help you with creative IRC 1202 planning. We can help clients multiply the benefits of IRC 1202 through several advanced strategies.
An example of this planning is "stacking," which uses completed gift trusts to significantly multiply the exclusion amount. Strategic timing of investments can maximize the basis while coordinating exit planning and ensuring holding period requirements are met.
Gift timing strategies that preserve QSBS status can create opportunities for the next generation. These planning opportunities require careful coordination with tax and legal professionals, positioning you as the quarterback of your client's advisory team.
Structuring for QSBS Benefits: New vs. Existing Businesses
The timing of investments and entity structure decisions is important. For new businesses, the choice of entity structure should consider IRC 1202 benefits alongside other factors like operational flexibility, tax, and governance requirements.
For existing businesses, conversion analysis might present opportunities to restructure, especially when the S-Corp or LLC has strong net cash flow and selling the business in a few years is a current consideration. Exit planning must account for the five-year holding period requirement, making early planning essential.
Identifying Potential Clients for QSBS Planning
Review your clients or prospects in town for business owners who might benefit from IRC 1202 planning.
- Entrepreneurs launching new ventures considering entity structure
- Business owners nearing an exit in 5+ years
- Clients considering S-Corp or LLC conversion to C-Corp
- High-net-worth clients with significant business appreciation
Remember, the key to maximizing these benefits is early planning. The five-year holding requirement means timing and proper initial structure are important to successfully implement this structure.
Closing Thoughts
Consider the impact on your practice. By mastering IRC 1202 strategies, you position yourself as a sophisticated advisor who understands complex planning opportunities.
This knowledge can help you attract and retain high-net-worth business owner clients, strengthen relationships with centers of influence, and differentiate your practice in a crowded marketplace.
To learn more about how IRC 1202 can benefit your practice and clients, contact our Business Development Team at 858-880-5778 for your complete Financial Advisor Guide to IRC 1202.
This comprehensive resource will help you identify opportunities and implement effective strategies for your business-owned clients.
Sources:
- 1202: Small Business Stock Capital Gains Exclusion, by Tina M. DeSanty, CPA, April 30, 2023, https://www.thetaxadviser.com/issues/2013/may/clinic-may2013-story-07.html
- Tax Planning Opportunities with QSBS – “Packing” & “Stacking”, by Wealthsprire Advisors, January 1, 2024, https://www.wealthspire.com/guides-whitepapers/tax-planning-opportunities-with-qsbs-packing-stacking
- Stacking and Packing – Strategies to Maximize the Section 1202 Exclusion, by Daniel Mayo, 8/20/ 2021, https://www.withum.com/resources/stacking-and-packing-strategies-to-maximize-the-section-1202-exclusion/
- Section 1202 – An Overview, by Wealthspire Advisors, January 1, 2024, https://www.wealthspire.com/guides-whitepapers/tax-planning-opportunities-with-qsbs-packing-stacking/
- Maximizing Section 1202’s Gain Exclusion, by Frost Brown Todd Attorneys, January 17, 2024, https://frostbrowntodd.com/maximizing-the-section-1202-gain-exclusion-amount/
Disclosures:
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance. All examples are hypothetical and are for illustrative purposes only.
Information contained in the materials included is believed to be from reliable sources, but no representations or guarantees are made as to the accuracy or completeness of information.
Federal and state laws and regulations are complex and subject to change, which can materially impact your results.
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