The Advantages of Structuring an Investment with Section 1202
Investing in an operating company can be complex and requires careful structuring to improve returns. One strategy gaining traction within the realm of buy-side private equity investments is leveraging Internal Revenue Code Section 1202. This provision offers a range of benefits that may significantly enhance the overall profitability of investments in portfolio companies.
Understanding Section 1202
Section 1202 — also known as the Qualified Small Business Stock (QSBS) provision — was introduced to incentivize investment in small businesses. Under this provision, eligible investors can potentially exclude a significant portion of their gains from the sale of qualified small business stock. To qualify for these benefits, the stock must meet specific criteria, including being issued by a qualified small business and held for a minimum period.
Section 1202 benefits
Gain exclusion
One of the most significant advantages of using Section 1202 is the potential for the exclusion from federal income tax gains realized from selling qualified stock. By structuring a private equity investment in a portfolio company to meet the requirements of Section 1202, investors may reduce their tax liabilities and boost their after-tax returns.
Long-term investment incentives
Section 1202 encourages long-term investment in small businesses by providing increasing levels of tax incentives based on the duration the stock is held. This can align the interests of investors with the growth and success of the portfolio company over an extended period.
Enhanced returns and increased cash flow
By taking advantage of the tax benefits offered by Section 1202, investors can potentially enhance their overall returns on investment in a portfolio company. Similarly, by using a C corporation structure as required by Section 1202, investors may increase their cash flow due to the favorable C corporation rates where any excess cash is used for growth or reinvestment or accelerated debt payments. The tax savings realized through this provision may significantly boost an investment’s profitability.
Risk mitigation
Structuring a private equity investment using Section 1202 may also help mitigate risks associated with taxation, providing investors with a level of certainty regarding their potential tax obligations. This can contribute to a more stable and predictable investment environment.
Attractiveness to investors
Leveraging Section 1202 can make an investment in a portfolio company more attractive to potential investors seeking tax-efficient investment opportunities. This can help broaden the pool of investors interested in participating in the private equity transaction.
How we can help
CLA can work with you on structuring your investment in a portfolio company. We can help you assess whether QSBS investments as part of your structure provides increased benefits, which may include increased cash flow, decreased tax administrative costs, enhanced overall profitability, or investment return.
By taking advantage of the gain exclusion, long-term incentives, enhanced returns, risk mitigation, and attractiveness to investors provided by Section 1202, investors can position themselves for greater success in the complex and competitive world of private equity investments.
Craig Arends is a principal at CLA and is the managing principal of CLA's private equity practice. Craig brings a concentration of experience in providing accounting and transaction structuring advice for leveraged recapitalizations, purchase accounting and SEC reporting, assessing quality of earnings, and GAAP accounting. He has far-reaching experience with critiquing financial models and reviewing target companies' financial performance to identify cost reductions and/or operating efficiencies Craig has more than 30 years of experience in public accounting serving public companies, private equity groups, and companies, including a term as principal in charge of a Big Four Capital Markets Group in Moscow, Russia. He has led financial accounting due diligence projects for private equity investor groups and venture capital funds, primarily in the technology, communications, and manufacturing industries, as well as assisting with Foreign Corrupt Practice Act matters ranging from investigation of payments made, validation of compliance with corporate policies, and review of proposed transactions to ensure compliance. When not working, Craig enjoys watching any sports, but his most favorite are baseball, football and soccer.
Comments are closed.