Background
Section 1202 of the Internal Revenue Code offers a powerful tax incentive for investors in qualified small businesses: the potential to exclude up to $10 million — or 10 times their adjusted basis — from capital gains tax. Despite being on the books for over three decades, this provision is still underutilized, largely due to its complexity and lack of detailed IRS guidance.
Challenge
A New York-based advisor reached out to MGO for a second opinion. Their client, a company founder, had recently undergone a recapitalization transaction involving a conversion of common to preferred shares and a partial redemption. A tax attorney had advised the client to claim a $5.8 million gain exclusion.
The situation raised several key questions under Section 1202:
- How and when did the client acquire their shares?
- Does the company meet the definition of a “qualified small business”?
- Has anyone calculated the actual gain eligible for exclusion?
Approach
MGO conducted a deep-dive analysis of the transaction and the company’s qualification status under Section 1202. The team verified the business met IRS criteria for a Qualified Small Business. We also walked the client through the full implications of the LLC-to-C corporation conversion and confirmed the funding event had triggered a significant step-up in basis. This meant that instead of being capped at $10 million, the client was eligible for a 10 times basis exclusion — resulting in a $100 million gain exclusion shared between the founder and his business partner.
Additionally, the team evaluated the structure of past and future share sales — including those involving preferred shares. As a result, the client was able to exclude all gains from the reported transactions and still retain $26 million in gain exclusion potential for future stock sales.
Value to Client
MGO transformed a narrowly scoped tax filing into a massive win:
- $100 million in total gain exclusion identified
- $0 in capital gains tax on current transactions
- $26 million in future tax exclusion potential preserved
By leveraging in-depth knowledge of Section 1202, MGO helped the client turn a limited exclusion into a far more advantageous result.
Don’t Miss Out on 1202 Opportunities
If you or your clients hold shares in a small business, don’t leave money on the table. Our professionals can help you evaluate 1202 eligibility, calculate your true gain exclusion, and build tax strategies that protect your wealth. Reach out to our team today to explore your options.