Taxable gain exclusion boosts after-tax ROI on qualified investments

Private equity groups and their investors are taking notice: The Section 1202 gain exclusion allows non-corporate sellers of qualifying C-corporation stock investments to exclude all or a portion of the gain on the sale of their stock from their taxable income. The gain exclusion can mean a significant boost in net after-tax return on qualifying investments.

As private equity funds begin turning over C-corporation portfolio company investments made five or more years ago, some are including Section 1202 gain exclusion planning in their exit transactions. Similarly, when new C-corporation acquisition targets are identified, funds are structuring transactions to qualify for the gain exclusion to help investors maximize their value going forward.

As with any favorable tax rule, there are criteria for both investors and investments to meet in order to qualify for the gain exclusion, and there are limitations. To qualify, the stock must meet several requirements, including original issuance from a C corporation to non-corporate taxpayers such as individuals, trusts, partnerships, pass-through entities, and more.

For private equity groups and investors who might qualify, the exclusion presents several strategic areas of opportunity.

The stock must have been held for at least five years — beginning on or after September 27, 2010 to qualify for the 100 percent gain exclusion (for investments prior to this date other exclusion percentages ranging from 50 percent to 100 percent apply based on the date the investment was made) — and the corporation's gross assets must not have exceeded $50 million between the inception of the Section 1202 provision (August 11, 1993) and the date the stock was issued. The gain exclusion is limited to the greater of either $10 million or 10 times the taxpayer's basis in the stock at the time it was issued.

Not all private equity groups or investors will qualify, nor will all investments. Investors focused on larger companies with assets over $50 million or holding periods shorter than the five-year threshold won't qualify. Also, gains in excess of the dollar limitations won't be eligible.

But for private equity groups and investors who might qualify, the exclusion presents several strategic areas of opportunity.

First, for recently closed C-corporation exit transactions that are still reporting for 2016 or 2017, be sure to check whether any of those transactions qualify. You may not have had Section 1202 in mind when making the acquisition, or the exit, but it could be a rewarding exercise now.

Second, review C-corporation portfolio companies you plan to turn over in the not-too-distant future for their eligibility for the Section 1202 exclusion. What you find may impact your thinking about how to structure the exit transaction, although — good news — there are fewer requirements on the exit. Still, if you've got a multi-tiered structure, for example, you'll want to be sure you're selling the right piece of the structure to qualify.

Third, non-corporate investors looking at making new acquisitions that involve a C corporation should look at Section 1202 criteria and consider structuring the transaction on the front end in ways that enable the potential gain to qualify for exclusion on the exit.

When considering accretive, tuck-in acquisitions, private equity groups may also want to consider which entity acquires the new targets. Since these bolt-on acquisitions tend to be smaller, they may qualify for 1202 treatment even if the original C-corporation acquisition does not.

Since the Section 1202 provision was made permanent in 2015, it's even more important to incorporate it into your transaction planning going forward. Section 1202 can represent significant tax savings and increase after-tax ROI, but it's complex, with a lot of details to consider. As always, if you have questions, feel free to give us a call.