A Potential Section 1202 Trap for Founder Cashouts During Funding Rounds

At a glance

• The main takeaway: Section 1202 can offer a highly beneficial tax planning strategy to help founders grow their businesses while minimizing their tax burden.
• Understand the risks: Section 1202 also carries many nuanced requirements which, if not closely followed, could result in significant penalties.
• Next Steps: Explore Section 1202 strategies by scheduling a consultation with Aprio’s Transaction Advisory Services team.

The full story:

Section 1202 is a tax incentive created to support and grow small businesses. Like many such incentives, it can also be subject to abuse by taxpayers hoping to exploit the benefits for maximum financial gain. Although some areas of the tax law defining Section 1202 can be vague or open to interpretation, several patterns of manipulation could leave participating taxpayers open to audit risk and potential penalties. If you are considering pursuing 1202 benefits for income related to a cashout during a funding round of your business, it’s important to understand the qualifications and the risks.

Understanding Section 1202

The Small Business Stock Gains Exclusion, also known as Section 1202, is a US tax law permitting capital gains from the sale of Qualified Small Business Stock (QSBS) to be excluded from federal tax. Taxpayers can exclude between 50% and 100% of capital gains for the sale of QSBS that was held for more than five years, with the excludable amount depending on the date the stock was acquired:

• 50% exclusion for QSBS acquired between August 11, 1993, and February 17, 2009
• 75% exclusion for QSBS acquired between February 18, 2009, and September 27, 2010
• 100% exclusion for QSBS acquired on September 27, 2010, or later

Stock may be considered QSBS only if:

• It was issued by a US C-corporation, excluding hotels, restaurants, financial institutions, real estate companies, farms, mining companies, and businesses relating to law, engineering, or architecture;
• It was originally issued after August 10, 1993, in exchange for money, non-stock property, or as compensation for rendered services;
• The issuing corporation has $50 million or less in assets on and immediately after the date of issuing the stock;
• At least 80% of the corporation’s assets are used for the active conduct of one or more qualified businesses;
• The issuing corporation does not purchase any of the stock from the taxpayer two years before or after the issue date (the four-year testing period); and
• The issuing corporation does not significantly redeem its stock one year before or after the issue date, with a “significant” stock redemption defined as redeeming stock valuing more than 5% of the total value of the company’s stock (the two-year testing period).

Although Section 1202 was first enacted in 1993, it has only recently gained widespread popularity as a standard tax planning strategy for shareholders due to more recent and favorable changes, particularly the ability to exclude up to 100% gains from federal tax. With this increase in popularity came an increase in taxpayers attempting to exploit the grey areas of the incentive by reaping the benefits for scenarios that may not technically qualify. Such strategies carry high levels of risk, with pitfalls including audits, additional taxes, and steep penalties with interest.

Founder Cashout Risk

While there are many possible ways to exploit loopholes or manipulate interpretations of Section 1202 for added personal gain, this article focuses on a particular pattern among startup founders attempting to structure cashouts during funding rounds to benefit from Section 1202. Within this pattern exist two potential scenarios:

1. Secondary offering with immediate recapitalization

Scenario: A founder that has gone through one or more funding rounds decides to cash out by selling founder stock (typically common) to an investor who immediately recapitalizes the stock into the next series of funding tax-free. The investor is purchasing the stock at the value of later series funding, and the seller then takes the position that all of the proceeds from the sale are subject to 1202 benefits.

Risk:  If the founder stock that is sold does not have the same value as the later series funding, then there is risk that the difference in value would be considered income not eligible for Section 1202 exclusion.

2. Primary offering with redemption

Scenario: A founder sells his or her stock through a stock redemption in exchange for cash funded by a recent investor at the same value as later series funding. Similarly to the first scenario, the seller takes the position that the entire proceeds from the sale are subject to Section 1202 exclusion.

Risk: Like the first scenario, it may be unlikely that the founder stock has the same value as the later series funding, and the difference in value would not be eligible for Section 1202 exclusion.

Know what’s at stake

Some taxpayers have a greater risk appetite than others, inevitability leading some taxpayers to pursue the incentive despite any potential for penalties. If you’re weighing your risk appetite to claim Section 1202 benefits, make sure you fully understand what’s at stake. For example, although some taxpayers argue that the above scenarios could qualify for Section 1202 benefits as capital gain from the sale of stock, the IRS could counter that such scenarios actually reflect a payment in exchange for stock as well as a payment of something additional, such as compensation. Subsequently claiming Section 1202 benefits would amount to unreported, disguised income, that could lead to hefty accuracy-related penalties.

The bottom line

Section 1202 can provide a highly beneficial tax strategy for taxpayers, but the risk of claiming such benefits without the proper qualifications carries the potential for lofty penalties. As a tax incentive specifically intended for small businesses, startup founders and investors should take particular care in ensuring they are pursuing a well-coordinated and compliant strategy.

Taxpayers interested in learning more about Section 1202 benefits and the qualifying fact patterns should consult with a knowledgeable advisor, such as Aprio’s Transaction Advisory Services team.

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