PARTNER CONTENT
By John LeClaire, Chris Wilson, and George Davis, Goodwin Procter
Section 1202 of the Internal Revenue Code, initially adopted in 1993, enables US investors in certain US companies to realize substantial federal income tax savings if they hold equity constituting “Qualified Small Business Stock” (QSBS) under Section 1202 for at least five years and certain other conditions are met. Many states follow the federal approach.
QSBS has long been a part of the analytical framework in early-stage company formation and investing. Knowledgeable early-stage entrepreneurs and investors understand the tradeoffs associated with alternative structures and regularly consider whether to organize US businesses as C corporations, thereby creating the possibility of issuing stock that may later qualify for QSBS treatment from the start, or in tax pass through form. In many sectors (eg, life sciences), the weight of historical precedent leads a large number to choose the former path. Those who choose the latter path retain flexibility to change course by shifting to a corporate format for tax purposes later and thereby create the possibility of even greater QSBS benefits in the future.
Section 1202 Basics
The basics of Section 1202 are well established. Under Section 1202, if an eligible investor:
- acquires stock in a primary issuance from a US corporation conducting a Section 1202-eligible trade or business and having less than $50m of assets at the time of the investment,
- holds the stock for at least five years without any intervening disqualifying events such as certain redemptions or transfers, and then
- sells the stock.
the stockholder can exclude from gross income, and therefore pay no US federal income tax on gain up to the greater of $10m (worth up to $2.38m of cash savings of federal income taxes under current tax rates) out or 10x the basis of the stock, which is the greater amount for any investment larger than $1m. While eligibility for Section 1202 investments is limited to US individuals, Section 1202 generally applies on a look-through basis (subject to nuances, and traps for the unwary) for US individuals who invest in qualifying QSBS through pass through entities.
Beyond basics, investors who are deeply familiar with Section 1202 utilize several strategies to enhance potential QSBS benefits. These include:
- converting US companies in tax pass through form to C corporations for tax purposes after launch but before asset value reaches $50m, which results in a step up in tax basis for purposes of Section 1202 and thereby creates the possibility of a benefit under Section 1202 determined on the basis of 10x the stepped up tax basis (ie, as much as $499m of tax-exempt gain)
- investing in QSBS-compliant companies through multiple associated holders that are intended to qualify as separate holders for purposes of Section 1202,
- understanding the requirements and limitations for rolling QSBS into stock of an acquiror while preserving QSBS status, and
- understanding the tax economics of selling or holding QSBS relative to other equity or quasi-equity interests when an investor holds equity or quasi-equity interests of different types with differing tax characteristics.
PE Investors and Section 1202
While Section 1202 is almost always a forefront consideration in early-stage contexts, for PE and other later stage investors, by contrast, Section 1202 typically arises in one of two ways. The first occurs when the sellers of a business hold stock that is or may with time become eligible for QSBS benefits. Here, monetizing Section 1202 tax benefits is a key objective of the sellers, and thus Section 1202 needs to be a central consideration for the investor/acquiror seeking to win the deal. The second arises when a PE investor considers whether to structure its own investment in a way that may allow it to qualify for Section 1202 benefits later.
In practice, however, Section 1202 generally is not top of mind for PE investors when approaching transactions. The reasons for this vary. Increasingly US companies being sold come to PE acquirers in tax pass through form, and as such never qualified for QSBS. At least historically, the time from the closing of growth equity investments to exit has generally been shorter than the five-year holding period required for QSBS benefits, and thus the possibility of gaining QSBS benefits after five years has been of little weight. And for middle and upper middle market investors, target companies typically have long grown past the $50m asset level that is necessary to implement a Section 1202 strategy.
Yet a savvy PE investor’s checklist on the buy side includes focus on whether the owners of an investment target are, or might become, eligible for Section 1202 benefits. This is especially relevant as holding periods for investments have lengthened in recent years and the possibility grows that sellers of equity will have met the required five-year holding period for QSBS when an exit finally occurs.
QSBS opportunities can arise in surprising ways, and occasionally owners of QSBS may be unaware that they are holding it. These situations arise, for example, when an LLC has elected to be treated as a C corp or an investor utilizes a blocker corporation to make an investment in a US tax pass through entities for reasons unrelated to QSBS. Discovering that a long-held investment is (or may become) tax exempt QSBS in these situations is like finding hidden gold. In the PE industry, where investors’ value propositions often sound remarkably similar, an investor who can identify a major but otherwise overlooked tax saving for a prospective seller will certainly distinguish itself.
Attention to Section 1202 planning is also relevant for growth investors who target smaller growth companies for investment or acquisition, and for PE investors with investment strategies that align organically with the requirements of Section 1202. Factors that can create a favorable context for utilizing Section 1202 include having all or mostly taxable investors, favoring long holding periods as a matter of investment philosophy, having investments that throw off substantial taxable income from operations and underweighting the potential tax benefits that investments in tax pass through entities can afford. Certain family offices fit this profile.
And while the benefits of Section 1202 are available for US companies and investors only, savvy non-US PE investors add it to their playbook when investing in or acquiring US companies.
Finally, deeper familiarity with Section 1202 may lead to consideration of investment approaches that can appear novel or complex in order to capture and maximize all available QSBS opportunities, at least when the relevant circumstances that can make the possibility of QSBS benefits worthwhile under a cost/benefit analysis. Conversely, investors who fail to anticipate the many twists and turns that can occur while a five-year holding period is running may find that adopting a QSBS oriented structure creates later limitations in areas such as issuing equity to sellers from a platform company on a tax deferred basis.
There will always be complexities and trade-offs to be taken into account in the planning stages of any investment or acquisition. But when QSBS can be utilized without compromising principal investment objectives, the ultimate benefits realized at exit – enabling taxable US investors to keep roughly 25 cents of every dollar of investment gain instead of paying it in federal taxes – can be worth the complexity.
John LeClaire – LeClaire is the founder and co-chair of Goodwin’s nationally ranked Private Equity group and one of the most prominent private equity and growth company lawyers in the US, operating at the center of a vast network of connections and friends built up over four plus decades at Goodwin. John joined Goodwin in 1982 and has been a partner since 1989, and remains an active front line lawyer, firm strategist and industry commentator.
Chris Wilson – Wilson is a partner in Goodwin’s Private Equity group and co-chair of the firm’s Healthcare Practice and Committee on Racial and Ethnic Diversity. Chris specializes in advising private equity sponsors and their portfolio companies in a wide variety of transactions, including leveraged buyouts, mergers and acquisitions, recapitalizations, growth equity investments, strategic transactions, joint ventures, and general corporate matters.
George Davis – Davis is a partner in the firm’s Business Law department and Tax practice. George represents financial and strategic clients with respect to federal income tax matters across a variety of industries on taxable and tax-free mergers, acquisitions and divestitures, joint ventures, real estate transactions, and restructurings.
