Emerging Tax Strategy – The Rise of the “Section 1202” Company

January 19, 2018

Do you have a profitable and growing business? You may want to evaluate the use of a “Section 1202” C corporation to cut your business taxes. In general, this strategy works best with the following key facts:

1. Your business generally isn’t a professional service, finance, farming, or mining business (other exclusions and rules apply, you may need a more in-depth evaluation)

2. The business is profitable, and a 21% federal tax rate is lower than your marginal individual tax rate

3. You plan to retain substantial profits within the business for reinvestment, working capital needs, or growth

4. You plan to own the business at least another five years before any exit event would occur

What is “Section 1202”? This is a provision in the Internal Revenue Code that Congress passed in 1993, providing for a partial reduction in the capital gains tax when selling the stock in certain small C corporations. Effective in late 2010, Congress made the provision more attractive by increasing the general capital gain exception to 100%, and removing some Alternative Minimum Tax side effects that were unfavorable.

This strategy was made much more attractive by the tax reform act passed in 2017, which lowered C corporation federal tax rates to 21%, which is significantly lower than the top individual tax rate of 37%. The big downside of a C Corporation is the so-called “double-tax” regime. In short, the profits earned by a C corporation are taxed to the corporation, and then tax is paid again by the shareholder when dividends are paid, or the stock is sold. This second layer of tax could be applied with federal tax rates of up to 23.8%.

Under the new rules, and if the extensive Section 1202 criteria are met, a successful Section 1202 company could allow you to pay tax at a 21% tax rate, and then potentially avoid all capital gains taxes on sale of the business (subject to certain limits). In other words – you can potentially avoid the double-tax that makes the C corporation so unattractive for many people.

If you already have an established business structure in place, don’t write this strategy off. There are a myriad of ways to convert existing businesses into a new company that qualifies for Section 1202.

As you might suspect, there are numerous things that must be considered when evaluating this business structure, including the range of possibilities for the business’ future growth and cash needs, planned distributions to owners, possible new investors, self-employment taxes, payroll taxes, state taxes, and owner tax attributes. Don’t hesitate to contact us, or consult with your current tax advisor to make sure you make a full and thorough analysis to determine if you might qualify to benefit from this provision.