The Implications of the TCJA Expiration for Section 1202

Join us on August 27 for an in-depth review of the TCJA individual and estate tax planning provisions, upcoming sunsets, and crucial tax planning opportunities. This webinar will provide valuable insights and strategies for navigating potential increases in income taxes and transfer taxes, and filing complexities for 2024 and 2025.

Under the Tax Cuts and Jobs Act (TCJA), the imposed flat corporate tax rate of 21% had many business owners considering whether to organize their businesses as C Corporations instead of pass-through entities. The lower corporate tax rate also made a lesser-known provision of the Internal Revenue Code relevant in a way that it hadn’t previously been. Taxpayers who could meet the parameters of Section 1202 were afforded the lower corporate tax rate, as well as a potential gain exclusion on the sale of their corporate stock – of up to $10 million or 10 times their aggregate adjusted basis in such stock.

As the TCJA provisions are set to expire at the end of 2025, Section 1202 should once again be on taxpayers’ radars as a significant tax planning opportunity.

Sunsetting Provisions

While the TCJA introduced substantial changes to the tax landscape, not all of those changes were permanent. Notably, the deduction for Qualified Business Income (QBI) under Section 199A will sunset at the end of 2025 unless Congress extends it. Section 199A permits individuals, trusts and estates that are owners of pass-through businesses to deduct 20% of their QBI in determining their taxable income. This means the highest effective rate on qualifying income earned through a pass-through entity may be lowered from the maximum individual income tax rate of 37% to an effective rate of 29.6%. With the top individual income tax rate set to return to a pre-TCJA 39.6%, the expiration of Section 199A would mean owners of pass-through entities could be subject to a rate of nearly 40%.

A permanent change under the TCJA is the corporate tax rate reduction (35% to 21%), which will not sunset with the QBI. As a result, and as the Congressional Budget Office has acknowledged (perhaps nervously), if Section 199A is allowed to sunset, the disparity between the pass-through rate of nearly 40% and the corporate rate of 21% will lead many taxpayers to consider converting to a C Corporation – possibly in significant numbers.  

Section 1202

Section 1202 permits noncorporate taxpayers an exclusion of up to 100% of their gain derived from the sale of qualified small business stock (QSBS) held for longer than five years. The requirements of Section 1202 are numerous, but some of the most salient requirements are as follows:

• Stock is QSBS only if it is stock of a domestic C Corporation and was acquired by the taxpayer directly from the corporation in exchange for money, non-stock property or services (i.e., the “original issuance” requirement)
• The “aggregate gross assets” of the issuing C Corporation must not have been in excess of $50 million immediately after or any time before the original issuance
• At least 80% (by value) of the corporation’s assets must have been used in the active conduct of a qualified trade or business for substantially all of the taxpayer’s holding period

The amount of gain eligible for exclusion is limited to the greater of $10 million or 10 times the taxpayer’s aggregate adjusted basis of the QSBS sold. The percentage of eligible gain excluded depends on when the QSBS was issued. The exclusion percentage is 50% for QSBS issued from August 11, 1993 to February 17, 2009; 75% for QSBS issued from February 18, 2009 to September 27, 2010; and 100% for QSBS issued after September 27, 2010.

The combination of the 100% gain exclusion plus the reduction in the corporate tax rate to 21% has made Section 1202 incredibly popular and led many taxpayers to choose to organize their businesses as a C Corporation as opposed to a pass-through entity. If Section 199A does sunset, many taxpayers may turn to operating as a C Corporation – especially if they can take advantage of Section 1202 on a sale of their business.

Who Should Consider Section 1202?

Taxpayers planning to exit their businesses, who already operate as C Corporations, should consider the benefits of Section 1202. Further, taxpayers that operate their businesses as pass-through entities can take advantage of Section 1202 if they convert their operations to a C Corporation structure, after taking carefully planned steps to do so. Lastly, private equity funds or other investors can find tax savings under Section 1202’s gain exclusion provisions upon an exit, so long as their acquisition structures permit them to utilize it.

The requirements for qualification under Section 1202 are numerous and fact intensive. For additional information on the expiration of TCJA and the use of Section 1202, please reach out to your Sikich advisor or directly contact Greg Lohmeyer at greg.lohmeyer@sikich.com and Mary Griffin at mary.griffin@sikich.com.

Register for our webinar covering individual and estate tax planning updates here.

About our Authors

Greg Lohmeyer, J.D., LL.M., is a tax director in Sikich’s transaction advisory services practice, where he specializes in mergers & acquisitions and other strategic transactions. Greg’s impressive background includes leading tax due diligence efforts, identifying and implementing tax structuring opportunities, reviewing tax provisions in transaction documents, and leading post-merger integration activities.

Mary Griffin, CPA, is a tax director with Sikich, who performs tax due diligence and structure consulting for merger & acquisition transactions. Mary also works extensively on tax compliance and related consulting for corporations and partnerships for a variety of industries, including manufacturing and distribution and service businesses. In addition, she provides tax and financial consulting services to individuals.