ESOPs provide many tax advantages for both sellers and the ESOP-owned company. In addition to all of the ESOP-specific benefits, sales to ESOPs can also potentially qualify for gain exclusion under Section 1202 of the Internal Revenue Code.
Benefits of Section 1202
Section 1202 provides significant tax benefits for sellers of qualified small business stock (QSBS). Under this provision, individuals selling QSBS held for more than five years may be eligible for an exclusion of up to 100% of the capital gains realized from the sale. The application of Section 1202 to ESOP sales involves several considerations:
- QSBS Eligibility: For stock to qualify for Section 1202 benefits, it must meet specific criteria, including being issued by a qualified small business that satisfies certain asset and business activity requirements. Only domestic C-corporations can be qualified small businesses.
- Holding Period: To benefit from Section 1202, the stock must be held for at least five years before the sale to the ESOP.
- Tax Exclusion: Under Section 1202, eligible sellers may exclude a portion or all of the capital gains realized from the sale of qualified small business stock. The percentage of exclusion depends on various factors, including the timing and nature of the sale.
- Limits and Considerations: There are limitations on the amount of capital gains that can be excluded under Section 1202. Additionally, the application of this provision involves nuanced rules and conditions that may affect the amount and timing of the tax benefits.
- Consultation and Compliance: Given the complexities of tax laws and the specific requirements of Section 1202, seeking advice from tax professionals or advisors familiar with both ESOPs and the Section 1202 tax regulations is crucial to ensure compliance and maximize potential tax benefits.
In summary, while Section 1202 can offer significant tax benefits for qualified small business stock held for at least five years, its application to ESOP sales involves meeting specific criteria and navigating complex rules. Owners considering the sale of qualified small business stock to an ESOP should seek professional guidance to assess eligibility and leverage potential tax advantages effectively.
Learn More About ESOPs
If you are interested in learning more about ESOPs, please check out bwesop.com. Our ESOP team would also be happy to provide a free initial consultation about whether an ESOP may be a fit for you and your business.