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How Startups Benefit from Section 1202 & Section 1045 of the US Tax Code

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  • How Startups Benefit from Section 1202 & Section 1045 of the US Tax Code

    Few tax accountants outside of Silicon Valley seem to know about Section 1202 & Section 1045 of the US Tax Code, which provides extremely significant tax savings to entrepreneurs starting new businesses and creating saleable equity value.

    In a nutshell, Section 1202 enables Qualified Small Business Stock (QSBS) to be exempt from from capital gains taxes, for gains up to $10 million or 10 times the original investment, whichever is great. Both founders and investors are eligible. The business must be structured as a C Corporation, and must not have assets greater than $50 million at the time of issuance.

    Section 1045 is similar to Section 1031 (a popular tool for real estate investors to defer capital gains by plowing sale proceeds immediately into a new investment), except instead of real estate, the asset class is QSBS, i.e. startup stock. Both businesses must be structured as C Corporations. You must have been invested in the first venture for at least 6 months, and once you sell you must roll over your gains into a new QSBS within 60 days. If you do so, your gains are deferred, and you pay no capital gains tax!

    Pretty sure by the way this is what Elon Musk did time after time, i.e. rolling over gains from selling PayPal into SpaceX etc. The tax code in this instance actually incentivizes the American Dream!

    References:
    https://www.thetaxadviser.com/issues...ttractive.html
    https://www.wsj.com/articles/startup...on-11554663796

    "There is no specific language in either Sec. 1202 or 1045 that indicates the two sections are mutually exclusive. Therefore, it would be reasonable to conclude that a taxpayer who exceeds the dollar limits of Sec. 1202 could use Sec. 1045 to defer the excess gain."
    Last edited by aslan; 04-09-2019, 09:38 PM.

  • #2
    Also, don't forget about Section 1244 of the Tax Code which allows investors in small businesses to claim an ordinary vs capital loss on the sale of qualifying small business stock. Investors can claim a $50,000 loss per year, or $100,000 per year if married filing jointly. Any losses on top of those are subject to capital loss rules and rates, so it may make sense to get rid of a failed startup's stock over multiple years.

    Keep in mind the gross assets test for Section 1244 is more strict. The total amount of money and property received by the small business must not exceed $1 million at the time that stock is issued.

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