Episode 15: Section 1202 Opportunities

Transcript

IRIS LAWS

On this episode, we’ll dive into the opportunities made possible by Section 1202. We welcome Howard Wagner and Nick Zoyhofski, two leaders of the firm’s 1202 practice. From your one stop for tax updates and analysis, I’m Iris.

DEVIN TENNEY

And I’m Devin.

IRIS LAWS

It’s Tuesday, November 25^th, and this is Tackling Tax.

DEVIN TENNEY

Before we get started with our much-anticipated guests, we always start our show with the four stories that we think might be most impactful to you. So let’s jump right into these Fast Four stories of the week.

IRIS LAWS

Well, Devin, it’s official. The shutdown has ended.

DEVIN TENNEY

I know it. Can you believe it? Feel like it’s been a part of our show for a while now, but I guess it was the longest running government shutdown in history.

IRIS LAWS

Yeah, sure was. And I’m sure, as most of you know, the agreed upon continuing resolution did not, in fact, address the healthcare tax credits that were at the core of the shutdown fight.

DEVIN TENNEY

But does that mean, like, that’s the last of what we’re going to hear about it? Like, are the credits just going to sunset or will Congress address that before it happens?

IRIS LAWS

That’s a great question. Senate Finance Committee Chair Mike Crapo announced the hearing to be held on November 19th. And he’s calling that “The Rising Cost of Healthcare: Considering Meaningful Solutions for all Americans.”

So, you know, also, as part of the funding compromise that was reached last week, that continuing resolution, Senate Majority Leader John Thune also promised a vote on the credits by mid-December. So that even, given House speaker Mike Johnson hasn’t said whether the House will also hold a vote.

DEVIN TENNEY

Has anything been shared about the proposal on what that vote would actually be for?

IRIS LAWS

You know, different ideas have been floated. You know, including a 1- to 2-year temporary extension of the credit with reduced income threshold phaseouts. It could have changing the credit to be paid to individuals rather than insurance companies, Devin, or doing away with the credit altogether and replacing it with government-funded flexible savings accounts. So, you know, it’s too early to see, but there could be some options there.

DEVIN TENNEY

Now, what happens when some of the provisions that were recently just passed and the continuing resolution run out in January? Is there a chance we could be seeing another shutdown?

IRIS LAWS

You know, unfortunately you’re right. Some of the provisions don’t last past January. And so, they will need to reconsider what happens at that point and hold a vote at that time.

DEVIN TENNEY

While state-specific, the second story points to how important it is to be tracking how states are reacting to OB3. So, Pennsylvania recently enacted its new fiscal year 2026 budget, and with it their reaction to the new federal provisions with the act.

IRIS LAWS

So, Devin, does that mean they didn’t follow all of what Congress implemented at the federal level then?

Nope. They’ve actually decoupled, meaning they have deviated from OB3’s provisions allowing for R&E immediate expensing and the new full deduction for qualified production facility expenses.

IRIS LAWS

Is that a trend, though? Is that like an indication of how other states are reacting to OB3 or is this kind of Pennsylvania’s, you know, own little situation?

DEVIN TENNEY

You know, it’s probably a little too early to tell. We haven’t seen too many states issue their full plans. But the states’ budgets, as well as political landscapes, will no doubt influence what each state does. Whether they’re going to align with federal law or do something else.

IRIS LAWS

So, sounds like a modeling opportunity then, am I right?

DEVIN TENNEY

Oh, for sure. So, if your state is one that has not yet issued their guidance, then you likely want to think through some of the variations in how that could impact your position.

IRIS LAWS

On the tariff front, activity continues with trade negotiations. So, a few things happened in the past few weeks. First, President Trump issued a new executive order changing reciprocal tariffs to exclude certain agricultural products. So, that’s things like coffee and tea, tropical fruits and fruit juices, cocoa and spices, bananas, oranges, tomatoes, and beef. Second, international deal frameworks continued to be announced, with Switzerland and Liechtenstein being the most recent on the list.

The framework would limit the tariff rate on those countries to no higher than 15%, in exchange for $200 billion in investments in the U.S. And lastly, additional frameworks for Central and South American countries Argentina, Ecuador, El Salvador, and Guatemala were also announced, focusing more on digital service taxes and regulatory requirements.

DEVIN TENNEY

Well, Iris, I have a little bit of an off-topic question. I’m kind of hesitant to even bring this up, but I’ve heard President Trump has floated the idea of a $2,000, you know, quote, “tariff dividend,” unquote, for some Americans. Anything you can share on that?

IRIS LAWS

Yeah, so, though nothing official has been announced yet, some of the rhetoric around this would equate the payments to those stimulus payments that were received during the COVID pandemic.

DEVIN TENNEY

And for our fourth Fast Four of the day, yes, another story about leadership at the IRS.

IRIS LAWS

Devin, it’s your favorite topic.

DEVIN TENNEY

Absolutely. Well, President Trump has officially rescinded his nomination of Donald Korb for IRS chief counsel and Treasury assistant general.

IRIS LAWS

Did he give a reason for that, or do we know?

DEVIN TENNEY

No, he certainly did not. And that’s even after the nomination was approved by the Senate Finance Committee in October.

IRIS LAWS

Well, that’s an interesting one. But that does wrap up our Fast Four for the week. Stick around, because we’ll be talking with Howard Wagner and Nick Zoyhofski about Section 1202 and the possibility to exclude some gains.

We are so lucky to welcome Howard Wagner and Nick Zoyhofski today to talk through an opportunity to exclude gain on the sale of qualified small business stock. Howard is a managing director in our Washington National Tax Office based out of Louisville. He’s focusing on M&A, debt instruments, 1202, and much more. Nick Zoyhofski is a senior manager in our Federal Tax Specialty Group in the firm and is one of the leaders of our Section 1202 practice. So, welcome to Tackling Tax, Nick and Howard.

HOWARD WAGNER

Thank you very much. Today’s topic is something that is truly one of the most powerful tax benefits out there for investors and businesses. QSBS, qualified small business stock, also referred to by tax geeks as Section 1202 stock, has been around since 1993 with varying exclusion percentages. Starting in 2010, the exclusion went up to 100%. So, if you buy stock that meets all of the requirements, and if you sell that stock after holding it for more than five years, it’s a significant exclusion.

You can exclude up to the greater of 10 times basis or $10 million when you sell that stock. So, if you made an investment of $5 million in Section 1202 stock, you held it for at least five years, you sell the stock at a gain, assuming all the requirements are met for the exclusion you can exclude up to $50 million of gain on that $5 million investment.

It’s a huge incentive. It’s at times thought of as an incentive primarily for startup businesses, but it also applies to new investors and existing businesses or new owners of businesses. If Nick and I put some money together to go buy the stock of another company that was previously owned by Iris and it met all the requirements, we can qualify for 1202 on that. So, it doesn’t just have to be, you know, small business startup, even though it’s called qualified small business stock.

DEVIN TENNEY

Well, Howard, I mean, that seems like this is a fairly lucrative provision in the internal Revenue Code that can come with a lot of tax savings. But to get it, I’m assuming you have to probably jump through some hoops? So, Nick, can you maybe walk us through what the basic requirements are to even qualify for this exclusion?

NICK ZOYHOFSKI

Apparently, thanks, Devin. And, yeah, so as Howard alluded to, this exclusion is a, you know, exclusion that would be reported on an individual or non-corporate shareholders tax return. So, with that being said, we generally look at two kind of buckets of basic requirements, right? We have the shareholder requirements and then we have the business requirements. The shareholder requirements, as I kind of alluded to already, it must be held by a non-corporate shareholder and they have to receive that stock at original issuance.

So, what that means is no cross-purchases. You have to actually receive the stock from the issuing corporation. The second is that you must hold it for the requisite holding period. And as we’ll talk about in a little bit, those holding periods can differ depending on when you actually receive the stock. Okay. So that’s the easy part.

HOWARD WAGNER

Nick, when you say non-corporate shareholder, that’s not just individuals. That’s also partnerships, trusts, S-corps potentially, is that correct?

NICK ZOYHOFSKI

Correct. However, generally speaking, at the exclusion level, an individual will claim the exclusion. It just will be passed out through all of those vehicles. But again, we’re starting to get a little bit nuanced. I want to try to hit on the high-level marks. So, from a business side, there’s kind of four key business requirements that we look at.

The first being, again, it has to be a domestic C-corporation that issues the stock. And as I alluded to, it has to issue that stock in exchange for cash, property or services. And right in the name qualified small business stock. Well, how do we define what a small business is? Generally, we look at the aggregate gross assets of the underlying business, the corporation.

And again, depending on the time of issuance that test is met if the aggregate gross assets of the business are less than 50 million or 75 million. The third prong is the active business requirement. And what this basically says is the majority of your assets have to be used in a qualified trade or business. And when I say majority, the code specifically outlines 80% and it has to be used at 80% for substantially all the holding period. And last but not least, you must be in what they consider a qualifying trade or business.

IRIS LAWS

Yeah. So, Nick, I mean, you outlined all of that. All of it seems like there could be some intricacies there. But I want to home in just a little bit on that last point. Jumping to you, Howard. Let’s say we meet all of those other requirements and we’re looking at what type of businesses can qualify. So, meaning, you know, can a construction company benefit from this the same as, let’s say, can an accounting firm benefit from this or something along those lines?

So, can you elaborate a little bit when he means eligible trade or business, what kinds of trades or businesses can qualify? What types of businesses?

HOWARD WAGNER

I want to preface this by saying the determination of what’s a good trade or business for Section 1202 QSBS is probably the hardest, at times, the hardest determination you have to make because these rules were written close to 30 years ago, and what businesses look like today doesn’t always fit neatly within the definitions that are in the code. So, in order for it to be a qualified trade or business, it has to be something other than what I’ll generically call, you know, personal services.

You can’t be in the business of health, law, engineering, performing arts, consulting, financial services, brokerage services, or this generic catchall of any trade or business where the principal asset of the business is the reputation or skill of one or more employees. There’s a whole lot of things that specifically don’t count. But this is really, this is the biggest area of controversy in looking at 1202 at times.

There’s been a number of IRS rulings that have been put out there. For example, the Internal Revenue Code says you can’t take it for performance of services in health, but if you’re doing a pharmacy, that may be okay, because that’s not considered the practice of medicine. If you’re doing medical devices, that may be okay. If you’re doing ancillary services like drug development and testing, that may be okay.

There’s a couple differing rulings on brokerages where at times they say a brokerage with additional services is okay. And in other times they’ve said a brokerage with additional services is not okay. The real challenging ones are software businesses. If you’ve got a traditional software-as-a-service business, that would probably count. A lot of software companies today have a mixed service model.

They’re a software company, but they also do consulting based on the software. And I think that’s an area where you may have a question as to whether it qualifies or not. But again, the personal services are generally excluded from qualifying for 1202, service businesses in general. It’s a question of what is the service you’re providing. And sometimes service businesses can be okay.

DEVIN TENNEY

Thank you for that explanation, Howard. So, as you mentioned, this is over 30 years old. Why are we talking about this right now? I know that most of our podcast episodes have been related to OB3. Did OB3 in fact have an impact on 1202 or qualified small business stock?

HOWARD WAGNER

Most definitely. They, you know, Nick mentioned, I believe, in the general requirements that the assets of the trade or business have to be $50 million at the time you make the investment and immediately after and at all times before. So, if I’ve never had more than $50 million in assets, I’ve not gone over $50 million in assets, and I don’t go over $50 million in assets as a result of issuing the stock, I can get through that qualification requirement.

The example I’d give you is if my assets are $48 million, this is under the pre-OB3 rules. And I issue $3 million of stock. That $3 million of stock is not going to qualify. If I started a company in 2011, 2012, whenever it was, there was one day where I went over $50 million in assets. My asset base today is $45 million, and I issue $3 million of stock. That $3 million won’t qualify because I tripped over the $50 million limit in the past.

What OB3 did is it raised the limit of what’s a small business from $50 million to $75 million. So, for stock issued after OB3 was enacted, you can be up to $75 million in assets and have your stock qualify as eligible for this benefit.

One of the other huge benefits of OB3 is that it added flexibility for investors on selling their stock and potentially getting partial benefit. Whether the stock was issued before or after OB3 enactment, you always get the full benefit after five years. The big change is for new stock that was issued after OB3 was enacted.

Prior to OB3, it was a five-year cliff. You had to get to the five-year holding period or you got zero 1202 benefits. The change from OB3 allows a partial benefit after three years of holding period, an increased partial benefit after four years of holding period, and a full benefit after five years. You know, this is a huge item of flexibility for investors.

I think Nick and I have been through a number of conversations with clients as they’re looking at exiting 1202 companies, and they’re three and a half years in. Under the old rules, they wouldn’t get any 1202 benefit, but their business was at the time where they either weren’t going to get another offer like this, or because of potential changes in the nature of the industry or new competitors, their business might not be worth as much. Once you got to the five-year cliff vesting, and people really had to make some decisions where at times the tax tail wagged the dog.

Now that you have this flexibility to get a partial benefit after three and four years of holding period, it really gives a lot of flexibility for people to make the right business decision without being as focused on the tax. Nick, I don’t know if you’ve got anything to add on that or just similar conversations you’ve had with clients?

NICK ZOYHOFSKI

No, I think you kind of hit the nail on the head there, Howard, and that this influx of these new rules and regulations, hopefully, that are forthcoming, will hopefully provide investors with a lot more opportunities to capitalize on this provision that they otherwise would not have been able to. And, you know, that’s part of the reason why we’re talking today, right?

IRIS LAWS

Well, and you know, Nick, Howard alluded to this a little bit, but it sounds like that $75 million threshold is really a crucial piece of this. And something that our listeners should be homing in on. Also seems like it might not be as straightforward as you might think. I mean, Howard gave some slight examples there, but could you give me a little more explanation on to how the limit works and some things that, you know, folks thinking whether they qualify or not should consider?

NICK ZOYHOFSKI

Absolutely. Yeah. So, I guess, first and foremost, a key point that Howard alluded to, and I don’t think I quite hit on during the basic requirements section, is that that $50 or $75 million test has to be met at the time the issuance occurs, and at all times previously in the corporation’s existence. So again, as Howard alluded to, breaking through that $50 or 75 percent, or $75 million, excuse me, threshold is of the, you know, is very, very critical.

One thing I wanted to talk about, again back to the OB3 provisions, what’s very, very, taxpayer favorable is they added in inflationary adjustments for not only the $75 million, but the gain exclusion, which we can talk about a little bit. But as we all know, in this world, inflation can sometimes run a little rampant.

So today we may say $75 million is a small business. And in 10 years from now, it might be a significantly higher number. So, you know, that’s another big key thing that came out of OB3. But again, so coming back to this, the asset test in general, and first and foremost we’re looking at generally speaking the tax basis of the assets.

So, we’re not looking at a GAAP balance sheet or an IFRS balance sheet or anything else prepared for, you know, lending purposes, etc. We’re looking specifically at a tax-basis balance sheet. And the reason I say generally is because if, you know, we kind of think of an organic corporation, right? We put cash in for our initial incorporation with stock, and we grow the business through that cash and operations and maybe taking on debt, this calculus can be a little bit more straightforward. Where it really comes into, you know, becomes a little bit more complex and complicated and kind of got to think through multiple different scenarios is when we talk about that contribution of property for that stock, because, again, generally speaking, we’re looking at tax basis.

However, if we contribute property, well now the measurement is fair market value not the tax basis of that property. So, for example, say again Howard and I are going to start a new business that we hope to qualify for 1202. Howard’s the money man, so he’s going to contribute cash. Me, I’ve been sitting on this old building that would be a great first step for building up a manufacturing plant. So, I’m going to contribute that. Well, we all know how property values have drastically risen in the last few years. So even though Howard is putting in $1 million and I paid almost nothing for my property, we’re going to say they’re both worth $1 million, right?

His million dollars in cash and my million dollars in the property. So even though my tax basis is very, very low in that property, and the corporation is going to receive carryover basis in that property, so on our tax basis balance sheet it’ll be very low. For this particular test, we have to measure it as if it was worth $1 million.

So, you can see how as things start to roll within your business and you know, you’re not always thinking in the back of your head about 1202, you may just make a business decision and inadvertently blow through one of those thresholds.

HOWARD WAGNER

But, you know, Nick, that’s an interesting example because for you, even though let’s say your basis in that real estate you contributed is $50,000, if you contribute it, when it’s worth $1 million, you’re deemed to receive the 1202 stock for $1 million. And when you say 10x basis or $10 million, you’re doing it off of the fair market value of the property you contributed, not your tax basis.

So, while it may have a potentially negative impact on the company as they compute their asset basis, for the contributing partner it really helps.

NICK ZOYHOFSKI

Yeah, that’s definitely a glass-half-full approach Howard, I really like that. But again, so with anything, the devil is really in the details as it relates to this gross asset test.

DEVIN TENNEY

So, well Nick I’ll be honest, much of what I’m hearing leads me to the conclusion that the QSBS rules are about as clear as mud. If I’ve learned anything, it’s that complexity and/or a lack of clear guidance can result in unanticipated pitfalls, one of which you just shared. But are there any other concerns that our listeners should be aware of?

NICK ZOYHOFSKI

Yeah, I mean, there are a litany of different traps for the unwary. A couple that come top of mind, specifically one that’s within the code, is what we commonly referred to as the anti-churning provision. So, as I alluded to earlier in the requirements, is that in order to qualify for 1202, you have to receive the stock in original issuance, not in like a cross purchase.

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So again, kind of going back to our example a little bit, if Howard and I have started a company and Howard wants to get out, but he wants his 1202 treatment and Iris wants to come in and we still meet all the requirements, so she wants her investment to also potentially qualify for 1202. Instead of, you know, having Iris simply buy Howard’s shares, we come up with this brilliant idea of saying, well, we’ll just have the company redeem out Howard and then we’ll immediately turn around and reissue stock to Iris.

Well, the framers and the writers of the code said, no, no, no, no, we’re wise to you. So they kind of said that, you know, depending on, the relationship of the parties involved, we’re going to say that if those redemptions and similar transactions occur within either a one-year window before an issuance or one year after or two years on either side of the issuance, we’re going to disqualify all issuances within that time frame.

So again, right, business has to go on. And there may be redemptions for valid business purposes and all those good things. And they may or may not trigger these rules. So again, you know, kind of, Devin you alluded to it a little bit, I think one of the biggest traps for the unwary with 1202 is simply the documentation around your position and wanting to make sure that you have a good exclusion on exit.

And, you know, I don’t want to steal Howard’s thunder here. So, I’m going to ask him to kind of, you know, talk about a recent court case in which, for all intents and purposes, it seemed like a very strong case for this exclusion. But the documentation requirements were just lacking. Howard, is that the best way to say it?

HOWARD WAGNER

Yeah. I mean, it’s a case involving what you would generally refer to as somebody, you know, a garage, you know, somebody who invented something and developed the business in their garage and, you know, small business. And you look at it over time and you say to yourself, there’s no way this business has ever gone over the $50 million limit.

HOWARD WAGNER

The problem for the taxpayer is the business started 10, 15 years ago. They don’t have any records to prove that it went, that it never went over the $50 million limit, because we’re dealing with older stock and the service is actually disallowing the deduction because they don’t have the records to prove that they always met the $50 million test.

It’s really a situation where, by all intents and purposes, there’s no reason it shouldn’t qualify. But it’s a record keeping foot fault. And when you look at the fact that 1202 goes back to businesses that have been around since 1993, I’d be interested in seeing how many people really have those 32-year-old financial records.

NICK ZOYHOFSKI

You know, a lot of times when we’re talking to our clients about 1202 or just, you know, others, you know, out in the marketplace, we’re not talking about insignificant tax savings, right? Generally speaking, this is a very, very lucrative exclusion. So, you know, just something that keep top of mind is, hey, you know, maybe it’s worthwhile investing a little bit in that documentation as you move through, you know, your holding period of 1202 to make sure that you don’t, you know, have this foot fault that this individual might be facing.

IRIS LAWS

So, all right, Howard, bring it home for us. You know, we’ve talked about the primary opportunity here. We know how it works. We know how it’s changed. We’ve even understood some pitfalls to watch out for. I guess my final question is how our listeners can make the most of it, right? Like, are there planning techniques that can sort of enhance the benefit that we’ve talked about, or what else should they walk away with knowing after today?

HOWARD WAGNER

You know, I think the first comment I’d make is the time to think about 1202 is not when you sell the stock. The time to think about 1202 is when you invest in the stock. That’s the first takeaway. Has there, is it a good trade or business at the time you invest in the stock? Are you comfortable that it’s going to qualify?

The next step would be making sure the company knows that the investors intend to qualify. If you’re going to do something that may put the investors 1202 status at risk, that doesn’t mean that the company shouldn’t make good business decisions. But there’s times where potentially modifying those business decisions might save a big 1202 benefit. If a shareholder is going to be redeemed, waiting to redeem that shareholder to get out of one of these windows that can disqualify some of the investor’s purchases can really make a big difference.

So it’s understand 1202 on the way in, understand what happens along the way and really get that documentation in place. A couple other things that come to mind are how to maximize your benefit. Let’s say I’m going to, Nick and I are going to start a new company, and we’re each going to put in $100 in sweat equity, and we build the company up to a highly successful tech company that sells for $200 million.

We’ve put in $100 each of sweat equity. The most we can exclude is $10 million. If we grow that business to where it’s worth, say, $25 million on an asset basis, fair market value of assets when we incorporate it, now we can each exclude up to 125 million, 12.5 million each on the $25 million value, times ten 125 million.

So, planning on when to incorporate an unincorporated business can really have a big impact on how much 1202 exclusion you get. One other interesting area is how you invest in new businesses when you’ve already got a successful business.

Let’s say that Nick and I have a business that’s a great business. It’s risen to a point where it’s over the $75 million or $50 million, as the case may be, asset threshold. And we want to start a new business. If we start a new business as a subsidiary of the existing corporation, then everything’s in the same corporation, and it doesn’t do anything to add to our 1202 benefit.

If, instead, Nick and I started a new business that’s brother-sister to the existing business, Nick and I own 50-50 the existing business, Nick and I own 50-50 of the new business. Then we could qualify for 1202 on the new business as well. The way the rules work for the asset test is you look at a parent-sub relationship, you don’t look at a brother-sister relationship when you’re owned by individuals. So, there’s a way to structure your investments in multiple businesses to maximize your 1202 benefit.

So, I think, you know, those are a couple of the highlights. The main takeaway is 1202 is there. It’s a huge benefit if it works, but it takes some careful planning to get there.

IRIS LAWS

Awesome. Well, thank you so much for being here today. We sure appreciate it. And, you know, you can find either Nick or Howard at our website. And please be sure to reach out if you have something that you think might be qualified for 1202. So, thanks for being here, Nick and Howard.

DEVIN TENNEY

Yeah, thank you both.

HOWARD WAGNER

Thank you very much.

DEVIN TENNEY

Each episode will bring you what we call a Focused FORsight of the week, an article or webinar that might be of interest to you. This week’s Focused FORsight is actually an interactive timeline that is now available on our website. We often hear from our clients that it’s confusing to try to keep track of all the OB3 provision changes and when they actually come into effect.

So, our Washington National Tax Office has put together this resource to help you visualize, and therefore plan for, provisions that may affect you. Be sure to search for the timeline with the title “Timeline of OB3 Tax Updates: What’s Changing and When” to get access to this valuable resource.

IRIS LAWS

And that’s our show. Thanks for joining. Our next episode will actually be in three weeks instead of two to make time for some well-deserved rest for the Thanksgiving holiday. So, we’re looking forward to seeing you then. It’ll be our last episode of the year, so keep an eye out and remember to subscribe and listen in for the next episode of the podcast.

Until next time.

ANNOUNCER

The information set forth in this podcast contains the analysis and conclusions of the panelists based upon his, her, or their research and analysis of industry information and legal authorities. Such analysis and conclusions should not be deemed opinions or conclusions by Forvis Mazars or the panelists as to any individual situation as situations are fact specific. The listener should perform their own analysis and form their own conclusions regarding any specific situation. Further, the panelists’ conclusions may be revised without notice, with or without changes in industry information and legal authorities.

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