As promised, we continue to briefly comment on OBBBA changes that impact flow-through entities and closely held businesses. (See last week’s email communication entitled “Integrating the New OBBBA SALT Cap with PTE Workaround Statutes.”) We now want to pass on to you the changes to §1202, the Code section that provides for a 100% gain exclusion on the sale of qualifying C corporation stock held for five years or more:
1. The minimum §1202 gain exclusion is increased from $10,000,000 to $15,000,000, effective for stock issuances after July 4, 2025. For sales in taxable years beginning after 2026, the $15,000,000 exclusion is adjusted for inflation. Note that this change does not impact the 10x §1202 basis gain exclusion, if such amount is greater than $15,000,000 (as adjusted for inflation).
2. For stock issuances after July 4, 2025, there is a new 50% §1202 gain exclusion for stock held for at least three years, but less than four years and a 75% gain exclusion for stock held for at least four years, but less than five years. The gain that is not eligible for exclusion because of the 50%/75% limitations is taxed at a 28% capital gains rate and is subject to the 3.8% net investment income tax, but is not an AMT preference item (although 7% of gain that qualifies for the gain exclusion for §1202 stock issued on or before September 27, 2010, remains a tax preference item).
3. The $50,000,000 gross asset limitation contained in §1202(d)(1)(A) is increased to $75,000,000 (as adjusted for inflation) for stock issuances after July 4, 2025.
Do any of these changes impact the choice of operating in flow-through entity format vs. C corporation format (where §1202 potentially is the driving force)? Our view is probably not to any significant degree. There are many factors that drive the entity choice decision, with perhaps two of the most significant being (1) whether there will be dividend pressure during operations, because, if so, income will be taxed at an effective tax rate as high as almost 40% vs. 29.6% for the “active” flow-through business owner, and (2) how much of a discount will be demanded by a buyer of stock, who will not receive a basis step-up in the corporation’s assets as a result of the stock purchase. What perhaps might change the thought process is where there is going to be a disposition, for example, just after a three-year holding period (which now would allow for a 50% gain exclusion), and dividend pressure is not expected to arise until the years immediately following the “quick” disposition.
We certainly will be discussing OBBBA and the entity choice issue at our fall and winter Tax Planning Forum and Fundamentals of Flow-Through programs, as well as other OBBBA changes impacting flow-through entities. Registration for all our virtual and in-person programs is open, and you may want to register now to take advantage of our early-bird discount that expires on July 31st.