This article was originally published on November 8, 2021 on TechCrunch.com. Written by Peyton Carr.
The tax code contains many provisions that encourage investments in the technology startup ecosystem and small businesses. A powerful one is qualified small business stock (QSBS) or Section 1202 stock, which offers the opportunity to eliminate capital gains tax completely if certain requirements are met.
You can learn more about those requirements here, one being that stockholders must meet a five-year holding period. However, not everyone can time when to sell their company. The fact that many acquisitions happen prior to five years leaves some founders and angel investors short of qualifying for powerful tax savings.
In comes Section 1045.
What is Section 1045?
Section 1045 allows a founder or stockholder whose company has been sold prior to the five-year holding period to defer the capital gain by rolling the sale proceeds into a replacement QSBS. It also acts on a standalone basis, deferring gain on the initial sale of the original qualified small business stock.
Benefits and Opportunities
A 1045 rollover means founders, entrepreneurs, tech executives, and angel investors get to take advantage of multiple tax benefits and opportunities they would otherwise miss.
Extended Tax Deferral
With a 1045 rollover, the stockholder can defer taxes on the sale of the original QSBS. Under the right circumstances, tax can be deferred until the replacement QSBS is sold.
If the combined holding period is five years and other requirements (discussed below) are met then no federal capital gains taxes are due. But if the requirements are not met, then taxes will be due on the sale of the replacement QSBS.
This is even more impactful given President Biden’s tax plan, which does not intend to make any changes to the 1045 exclusion.
Shortened Holding Period
Typically, the holding period for all taxable exchanges will begin the day after the exchange. However, the holding period for the replacement QSBS includes the holding period of the original QSBS, allowing for the clock to continue ticking. This means a 1045 rollover, in turn, shortens the next QSBS holding period requirement.
QSBS Exclusion Stacking
Stockholders have the opportunity to multiply—or “stack”—the benefit of a 1045 rollover by spreading the QSBS exclusion to more than one new investment. This is accomplished by rolling the sale proceeds from one QSBS into multiple replacement QSBS companies, gaining the benefit each time.
Specifically, Section 1045 allows for a $10 million exclusion per company. By rolling proceeds into more than one company, the seller qualifies for the $10mn exclusion multiple times over, stacking the benefit in their favor.
Section 1045 Rollover Requirements
To qualify for the tax-deferred rollover of QSBS gain into a replacement QSBS under Section 1045, certain requirements need to be satisfied. Fundamentally, the original company must qualify for QSBS, and the new company must meet the requirements of QSBS both at the time of rollover and after the rollover is complete. In addition to that, you’ll need to pay close attention to timelines and other key qualifying measures.
Section 1045 Rollover Timeline
When it comes to meeting the 1045 rollover requirements, timing is key.
It’s important to note that the Section 1045 election is made on the tax return for the year in which the initial qualified business stock is sold—not when it’s rolled over into a new investment—even if the process extends into the following year. But you can’t delay for long. You only have 60 days from the date of sale of the original QSBS to roll the gain into a new QSBS investment.
Further, not only must the original qualified small business stock be owned for more than six months prior to the sale, but the replacement QSBS must also meet requirements for at least six months to qualify for the deferral on the original QSBS sale. To avoid missteps, you’ll need to pay attention to the calendar.
The 100 Percent Rule
In order to defer 100 percent of the tax, you must roll 100 percent of sale proceeds into the new QSBS. Just rolling the gain isn’t an option.
So if you want to realize the full benefit, you have to be willing to go all-in with the new investment. If you roll less than 100 percent of the proceeds, you only defer a pro-rata portion of the gain.
Section 1045 rollover requirements might seem restrictive. But by diving deeper, you’ll see that what could’ve been a heavy tax burden now opens you up to a whole new world of potential opportunities.
Section 1045 QSBS Strategies for Startup Founders
Now that you know more about Section 1045, you might be wondering if this is something that would be beneficial for you to leverage. It depends on your circumstances, big-picture financial plan, timing considerations, and your willingness to implement advanced tax and business investment strategies.
Below we highlight the most relevant Section 1045 strategies for founders, entrepreneurs, tech executives, and angel investors.
Invest in QSBS Startups
As someone involved in your own startup, the natural next step could be to invest in other QSBS startups. After all, you’re already familiar with the scene, current trends, and have your finger on the pulse of where technology is headed. You’re clearly positioned to use the valuable insights you’ve gained to your advantage.
So if you have a desire to invest in QSBS startups, you’ll need to know how to proceed.
At the most basic level, you’re simply rolling your sale proceeds into buying stock in one or multiple QSBS startup companies.
For example, let’s say you’ve been running your startup for three years, the stock has taken off, and your company is being acquired. Congratulations! The original QSBS was $5 million, but you’ve made significant gains that could be swallowed by a huge tax bill. So you decide to do a 1045 exchange and reinvest into multiple new QSBS eligible startups. By stacking the benefit— with $10 million in exclusions for each company—you’ll see tax savings on your proceeds for a total exclusion of $30 million.
Tip: If you already have investments lined up, this could be a good strategy. But don’t rush to invest just to meet the 1045 rollover requirements. We always tell our clients not to let the tax tail wag the investment dog.
Acquire One or More QSBS Companies
If your startup or the one you invested in early is being acquired, you’ve proven yourself and are likely feeling confident. Maybe you don’t just want to invest in a new venture but you’d like to acquire a controlling stake in a company or multiple companies yourself.
If you are going to use your 1045 rollover to acquire one or more QSBS companies, you’ll need to implement the strategy within 60 days. However, the strategy does allow more time to actually find and make your acquisition. Here’s how.
A newly formed C-corp must be created, and you would need to roll the proceeds of the original QSBS into the new company. This newly formed C-corp can then acquire a new QSBS eligible company.
Keep in mind that in order for QSBS to apply—however long it takes this newly formed “acquisition” C-corp to find a target—the total holding period of the actively engaged new company must be at least 80 percent of the holding time period, including the search timeframe.
For example, let’s say it takes eight months to acquire a company. To meet the 80 percent requirement, the holding period of the actively running QSBS company must be 32 months.
Tip: It’s possible to leverage multiple C-corp entities for diversification and stack the QSBS to claim multiple $10 million exclusions or 10 times basis exclusions, as mentioned above.
Start a New QSBS Company
You don’t have to take your proceeds and invest them into someone else’s big idea. With your experience and track record, maybe it’s time to make a move on your next big idea. For founders looking to jump right into another venture soon after an exit, this self-funding, serial entrepreneur strategy could be the ticket.
Keep in mind, you’ll need to tack on the holding period, get a new $10 million exemption, and defer the gain. And remember the 100 percent rule: If you only roll part of your sale proceeds, you only get to defer a pro-rata portion of the tax. Are you ready to go all-in?
To implement this strategy, you’ll need to form a new C-corp to start a new QSBS company and roll your sale proceeds into the company.
Tip: This strategy can also serve as a layer of protection for you. If the business fails, you have the option to wind down the company and possibly qualify for QSBS to exclude the original gain for any funds returned.
It may come as a surprise that the tax code is written in your favor, but the idea is to encourage business growth, innovation, and entrepreneurship. You’re playing a vital role in the economy. So if you’re worried about taxes eating up the proceeds of your buyout and hard-earned gains, think again. You have a variety of options to stay in the game, fund your fellow founders, or step back and use the insights you’ve acquired to put your money to work for you.
Before implementing any of these strategies, be sure to work closely with counsel to review all of your financials and ensure you are protecting your interests.
The information and opinions provided in this material are for general informational purposes only and should not be considered as tax, financial, investment, or legal advice. The information is not intended to replace professional advice from qualified professionals in your jurisdiction.
Tax laws and regulations are complex and subject to change, and their application can vary widely based on the specific facts and circumstances involved. Any tax information or advice in this article is not intended to be, and should not be, used as a substitute for specific tax advice from a qualified tax professional.
Investment advice in this article is based on the general principles of finance and investing and may not be suitable for all individuals or circumstances. Investments can go up or down in value, and there is always the potential of losing money when you invest. Before making any investment decisions, you should consult with a qualified financial professional who is familiar with your individual financial situation, objectives, and risk tolerance.