You might have heard of tax free rollovers. And you might be familiar with Section 1031 of the Internal Revenue Code, which allows you to rollover your gain on the sale of investment or commercial real estate if you buy a new property within a certain amount of time. But have you heard of Section 1045 exchanges?
1031 exchanges are for real estate.
1045 exchanges are for startup company stock.
If you are in startup land, you should know about 1045 exchanges.
Section 1045 of the Internal Revenue Code does for “qualified small business stock” what Section 1031 does for real estate. Here is what IRC Section 1045 says:
“In the case of any sale of qualified small business stock held by a taxpayer other than a corporation for more than 6 months and with respect to which such taxpayer elects the application of this section, gain from such sale shall be recognized only to the extent that the amount realized on such sale exceeds (1) the cost of any qualified small business stock purchased by the taxpayer during the 60-day beginning on the date of such sale, reduced by (2) any portion of such cost previously taken into account under this section.”
What this means is, if you sell qualified small business stock which you have held for more than 6 months, you can rollover your gain by buying more qualified small business stock. What a great deal.
Get Familiar with Section 1202
If you are a founder or angel investor and you are not familiar with qualified small business stock (QSBS) under Internal Revenue Code section 1202, we would also recommend that you become familiar with the potentially significant benefits of excluding up to $10 million of gain on the ultimate disposition of the QSBS so long as it was held at least 5 years. With certain exceptions, QSBS means any stock acquired on original issuance by the taxpayer from a domestic C corporation after August 10, 1993 that meets the following requirements: (1) the aggregate gross assets of the corporation must not have exceeded $50 million at the time of and immediately after the issuance of the stock; and (2) at least 80% of the value of the corporation’s assets must have been used in an active trade or business. IRC Section 1202.
The Beauty of Section 1045
What can you do if you have stock that otherwise qualifies as QSBS, but you have the good fortune of reaching an exit event before 5 years has passed? Maybe you aren’t quite ready to buy a small island in the Strait of Juan de Fuca, and plan to move on to your next venture like so many serial entrepreneurs. You could roll it over under Section 1045.
You Must Be a C Corporation
Section 1045 permits founders and angel investors to move money from one business venture to the next without having to pay tax on appreciation in the first business venture. Because the benefit of Section 1045 applies only to stock in C corporations, it should be taken into consideration by entrepreneurs in choosing the form of their business ventures.
If you form as an S corporation, you will not be able to access the benefits of Section 1202 or Section 1045 with respect to your founders’ stock.
Need help finding and hiring the right lawyer for your startup? We break down the best practices for picking a lawyer in our blog post, The Startup’s Guide to Hiring a Lawyer.