This rule, if executed correctly, could allow you to save up to 100 percent of your capital gains on the sale of your company.
As explained by Paul J. Valentine, a tax attorney at Jennings, Strouss and Salmon, PLC, the 1202 exclusion provides that if you contribute a qualified company to a C-corporation, and hold the company's stock for five years or more, then the greater of $10 million or 10 times the initial value are not subject to capital gains when you sell.
In layman's terms, this requires you to create a new C-corporation, and "contribute" the equity from your existing company to this new entity.
After waiting a minimum of five years, you can then take advantage of ridiculously advantageous tax shields, excluding up to 10 times the base value from tax. Instead of paying the long-term capital gains tax on the total value of your sale, you might only pay long-term capital gains on the base value. In a growing company, this five-year-old basis could be a small fraction of the sales price.
For example, if your company is valued today at $2 million, and you sell it five years later for $22 million, you would pay tax on the initial $2 million, and not a penny on the remaining $20 million. If tax rates stay roughly where they are today, your effective federal tax rate on the sale would drop from 20 percent to 2 percent.
If this is such a good deal, why are you just now hearing about it?
While the well-intended Congress wanted entrepreneurs to take advantage of it back when it was established, the corporate tax rate was substantially higher. As such, the "double-taxation" of becoming a corporation made this conversion a much riskier bet. Furthermore, at the time, the 1202 rule did not provide a 100 percent exclusion on gains, as it does now. Even with the change to a 100 percent exclusion in 2010, the rule continued to collect dust until Trump lowered the corporate tax rate in December 2017.
And now, it's go-time.
The Conversion Process
Becoming a C-Corporation on paper sounds relatively easy. With the help of our lawyer, it only cost a few thousand dollars to file in Delaware, and create all the necessary corporate bylaws. However, as we became a new entity, we required a new EIN. This then sent us down a rabbit hole of new bank accounts, new accounting "books," new payroll, new insurance--new everything. Be sure to consider the ramifications prior to changing your entity.
After the legal conversion occurred, we were advised to have our initial company independently valued by a certified appraiser. Our attorney recommended one that was familiar with the process. The valuation is critical; if the number ends up too low, your "10X gain cap" might be smaller than ideal. Conversely, if your valuation is too high, you will pay additional tax on this basis when you sell down the road.
The Risk in Waiting
Converting to C-Corporation currently is economically advantageous. However, corporate tax rates could change, making the burden of operating within a C-Corporation more expensive, or Congress could change the exclusion.
We felt the risk of either of these events was relatively small, given the huge upside.
The Fine Print
There are a few restrictions to consider prior to converting. The 1202 conversions provide benefit only if your company performs a sale of equity. Asset sales do benefit from this tax treatment. Furthermore, if your company has $50 million or more in assets during any period of the five years, your company does not qualify.
To confuse matters, not every company type is eligible. Namely, businesses where people are the primary asset (such as investment firms, law firms, consulting firms, sports teams, etc.) are excluded, as are real estate investment vehicles. Additional company types, such as companies involved in farming and the operating of a hotel, motel, or restaurant, are also excluded. Be sure to double-check your company's eligibility first.
Note: Listen to Your Lawyers and Accountants
Let me close by saying that I am not an accountant or a lawyer. Please consult with professional advisors prior to converting. The decision to elect the 1202 conversion is a big one, with potentially huge upside.
Thanks to changes in the corporate tax rate, it might be the right time to consider this for your exit strategy.