Sec. 1202 can benefit investors in an S corporation.

• Author: Deats, Richard G.

The enactment of new Sec. 1202 represents an attempt by Congress to encourage new investments in certain small C corporations that engage in manufacturing, certain types of high technology and other businesses that are not service or finance oriented. Congress sought to provide this encouragement by permitting 50% of the capital gain recognized on the sale of qualifying stock in such corporations to be excluded from tax.

While Sec. 1202 is intended to benefit new investments in C corporations, there may be opportunities in which existing investments in corporations can be structured to make the most of such benefits. One such opportunity may be available to S shareholders seeking an additional infusion of capital.

The benefits of Sec. 1202 are limited to individuals who sell qualified small business stock either directly or through a passthrough entity (i.e., a partnership, S corporation, regulated investment company or common trust fund). Individuals are generally required to have held the stock for at least five years, and have acquired it at the time it was originally issued by the corporation. if qualified small business stock is sold by a passthrough entity, the entity must have acquired the stock when it was originally issued, and must have held the stock for at least five years for Sec. 1202 to provide any benefits to the owners of the entity. In addition, although the benefits of Sec. 1202 may be available on a proportionate basis to the owners of the passthrough entity, the owner must have held his interest in the entity at the time it acquired the qualified stock; Sec. 1202 benefits are then available only to the extent of the owner's smallest interest in the entity during the entity's holding period.

The comparative advantages of

investing in S and C corporations

One of the primary benefits an S corporation can offer investors in a start-up business that a C corporation cannot is the flowthrough nature of the S corporation with respect to income and losses. S shareholders can offset the corporation's losses against their other income while most income is subject to tax only once (at the shareholder level). About the only advantage a C corporation can offer investors is the potential future benefit of Sec. 1202. Getting the best of both worlds One common scenario is an emerging S...