Private Equity Transactions and 1202 Stock

Normally, when we think of private equity owned entity structures, some type of flow-through structure comes to mind. Private equity owned structures are often set-up as flow-through entities because of the flexibility that flow-through agreements provide and the potential for a single layer of tax.

However, for private equity firms targeting middle-market companies, there might be advantageous tax benefits of structures that include C-Corporations (in addition to the 21% tax rate).

IRC Sec. 1202 (Sec. 1202) provides 100% gain exclusion of the greater of $10,000,000 or ten times aggregate basis of qualified small business stock (QSBS).This gain exclusion can provide a meaningful tax savings for structures that include QSBS. As a result, Sec. 1202 is worth a look, as private equity firms structure acquisitions of their portfolio companies.

The requirements to qualify for the Sec. 1202 gain exclusion include:

  • The shareholder must be a non-C Corporation shareholder and have held the QSBS for more than five years.
  • At least 80% of the corporation’s assets must be employed in an active trade or business (other than certain service-type businesses such as accounting, law, and financial services) during substantially all the time the stock was held by the shareholder.
  • The aggregate gross assets of the issuing company up to the time of, and immediately after, the stock issuance is no greater than $50 million.  “Aggregate gross assets” means the amount of cash and the aggregate adjusted bases of the other property held by the corporation.  For this purpose, the adjusted basis of any property contributed to the corporation shall be its fair market value at the time of the contribution.
  • The issuing company must be a domestic corporation which is a C corporation for tax purposes.
  • The stock was acquired by the shareholder at its original issuance by the corporation in exchange for money or other property or as compensation for services provided to the corporation.

As with any detailed requirements in the tax code, the devil is in the details, including when you look at the requirements under Sec. 1202. However, for the acquisition of entities that fit the profile of a qualified small business or if you can structure into the profile, the exercise of analyzing these requirements and considering the potential tax benefits of Sec. 1202 and QSBS might be well worth the effort.

About Schneider Downs Private Equity Firm Services

Schneider Downs provides all the traditional audit and tax services needed by private equity firms and their portfolio companies, as well as specialized services including accounting advisory, investment valuations, equity incentive structuring, benefit plan analysis, operational efficiency and risk assessments, cybersecurity and technology solutions. To learn more, visit our dedicated Private Equity Firm Services page. 

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