Section 1202 comes with some problems—first and most obviously uncertainty, and the exclusion depends on criteria often difficult to predict in the early years of a company. Stock can drop in value or the company's worth can suddenly break the $50 million ceiling. Some say the potential of 1202 has also been hampered by the combination of a formerly high federal corporate tax rate and taxation of dividends distributed by the corporation to its shareholders (the “double taxation” of C corp profits). Tax reform has lowered the corporate rate, however, making 1202 more attractive.
The exclusion is also a consideration for choice of entity when starting a business. Most small businesses set up as corporations will also become Subchapter S corporations to avoid double taxation, according to Vento, rendering them ineligible for 1202.
“If your primary purpose for entering this business is to create value so that it can be sold off within five or more years, then foregoing Subchapter S status could be the most advantageous from a [1202] point of view,” Vento said. “This is especially true if you don’t anticipate large profits from the business for the first few years,” which will keep the company’s worth under the criteria ceiling.
Audits of 1202 treatments require strong backup, such as evidence of when the stock was acquired—receipts, cancelled checks, stock purchase confirmations and so on—as well as copies of the stock prospectus and financial statements.
“Usually the companies are small at the time, so they may not have financial statements,” Pon said, adding that during a recent 1202 audit, he successfully used the tax returns of the corporation for relevant years.
“Take a look at state tax law” regarding 1202, Pon added. “Some states conform [to the federal exclusion] and many do not.”