A recent issue of the New York Times contained an article about some LinkedIn employees who were granted shares with a value of $0.12 per share in 2003, which increased in value to $90.00 per share after the company went public in 2011.  Based on a little-used section of the Internal Revenue Code (Sec. 1202), these employees were able to exclude all or much of the gain from taxable income when they later sold the shares. 

Code Sec. 1202 allows employees in “qualified small business companies” to avoid capital gains taxes, the 3.8 percent net investment tax, and the alternative minimum tax on the sale of shares they purchase or receive as compensation.  The maximum amount excludible by an employee on the sale of his/her shares is the greater of $10,000,000 for all years, or 10 times the employee’s tax basis on shares sold in any year.

Each of the following requirements must be met in order for gain on the sale of stock to be eligible for the exclusion from income under Code Sec. 1202:

• The company must be a U.S. company taxed as a C corporation.  S corporations and partnerships are not eligible.  Along with the recent cut in the corporate tax rate, this is another potential advantage of C corporations.
• The aggregate gross assets of the company through the date of issuance of the stock must be $50,000,000 or less.
• At least 80% of the assets of the company must be used in the active conduct of one or more qualified trade or businesses, which does not include professional services, financial services, farming and mining, and hotel, motel and restaurant businesses.
• The stock must be acquired by the employee directly from the company in exchange for money, property, or services.  Hence, stock bonuses and other compensatory grants to employees will qualify.  Although the employees will be taxed on the value of shares they receive in exchange for services ($0.12 per share in the LinkedIn example), any gain above that amount will be eligible for tax-free treatment.
• The stock must be held by the employee for at least five years.  Stock acquired on exercise of an option will qualify, but the five-year period does not start until the option is exercised.

The percentage of gain excludible under Sec. 1202 was less than 100 percent before 2010, which will complicate the calculation for shares acquired before 2010.  In addition, not all states follow the federal rules in their treatment of qualified small business stock.

Sec. 1202 can provide a tremendous tax benefit to employees who receive stock in early-stage companies, and an effective tool for companies to attract and retain key employees.  If you have any questions about this topic or any other employee benefits topics, please contact Charles Berquist (cberquist@bestlaw.com) or Libby Davydov (edavydov@bestlaw.com).