Section 1202 Bill Would Help Emerging Small Companies and Encourage Economic Growth and Job Creation

 – September 18, 2018
Section 1202 Bill Would Help Emerging Small Companies and  Encourage Economic Growth and Job Creation

In an effort to promote investment and job creation in New Jersey, the New Jersey Society of CPAs urges lawmakers to follow the lead of the federal government and the vast majority of states in offering what is known as Internal Revenue Code “Section 1202” tax incentives to targeted New Jersey-based businesses owners who are willing to make a long-term commitment to investing in small and medium-sized New Jersey-based companies.

Most states follow the federal government’s lead and provide section 1202 incentives for qualified business owners. Of the 43 states that have a personal income tax, all but six of them provide some form of section 1202 incentives, including New York, Connecticut, Delaware and Massachusetts.

Background on Section 1202 Tax Incentives

In 2015, the United States enacted legislation that made permanent a federal capital gains tax incentive for owners of Qualified Small Business Stock (QSBS). Section 1202 of the IRS code lays out all the detailed particulars of what qualifies as QSBS stock, but broadly speaking it is originally issued C corporation stock held for at least five years in a corporation with no more than $50 million in assets when the stock is issued. Adopting a modified version of section 1202 in New Jersey, as most other states have done, would help spur investment in New Jersey-based biotech, tech, manufacturing and distribution companies. These are typically companies that face difficulty finding initial investors because of the long-term commitment investors must make with little prospect of profits for the first few years.

The federal section 1202 tax incentives apply to investments made in years prior to 2016, but under S2265 the tax breaks would be limited to companies established no earlier than the date of enactment. Because no shareholder can receive any capital gains tax benefits from S2265 without holding the QSBS stock for at least five years, New Jersey would not experience any loss in tax revenues for at least five years. After five years, when the tax break is granted, we believe that tax revenues lost on providing the tax incentive would be more than offset by taxes collected by the state due to the increased economic activity that section 1202 would spur. In the long run, providing section 1202 incentives should increase tax revenues for New Jersey.

Due to a lack of access to tax data, it is very difficult for our state taxation experts to provide a definitive estimate of what the annual cost of the incentives to the state after five years would be. Nonetheless, they believe it would most likely be under $25 million. And, of course, that loss should be more than offset by taxes collected by the state due to the increased economic activity that section 1202 would spur.

Under S2265, only shareholders in New Jersey-based businesses would be permitted to take advantage of section 1202. That ensures that this tax incentive generates economic activity and job creation in New Jersey. (We suggest using some language from the definition of “New Jersey emerging technology company” that’s in New Jersey's Angel Investor Tax Credit Act, P.L. 2013, c. 14, as the basis for defining what businesses qualify as New Jersey-based.)

What Is QSBS?*

Like all things in tax, the IRS definition of qualified small business can get complicated, and it changes depending on the section of the tax code in question. For our purposes, we’ll be focusing on Section 1202 of the Internal Revenue Code (IRC). To qualify as QSBS under Section 1202:

  • The stock must be in a domestic C corporation (not an S corporation or LLC, etc.), and it must be a C corporation during substantially all the time you hold the stock.
  • The corporation may not have more than $50 million in assets as of the date the stock was issued and immediately after.
  • Your stock must be acquired at its original issue (not from a secondary market).
  • During substantially all the time you hold the stock, at least 80 percent of the value of the corporation’s assets must be used in the active conduct of one or more qualified businesses.

To elaborate on the last point, active conduct means a qualified business can NOT be an investment vehicle or inactive business. It can NOT be, for example: a service business in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services; a banking, insurance, financing, leasing, investing or similar business; a farming business; a business of operating a hotel, motel, restaurant or similar business.

*Excerpted from Qualified Small Business Stock Is an Often Overlooked Tax Windfall, by Toby Johnston, Wealth Front Knowledge Center website, Feb. 17, 2016.

What Tax Incentives Does Section 1202 Provide?

If an investor holds stock qualifying as QSBS for at least five years when it’s sold, then the investor would be exempt from New Jersey capital gains taxes on a maximum of the greater of $10 million or 10 times the taxpayer’s adjusted basis in the stock (which is usually not more than $10 million.)

The federal section 1202 tax incentives apply to investments made in years prior to 2016, but under our proposal the tax breaks would be limited to companies established no earlier than the date of enactment of our proposal.

Conclusion

New Jersey should join the federal government and 37 other states, including many of our neighboring states, in offering section 1202 tax incentives. This will help generate economic growth and create jobs for New Jerseyans. There would be NO loss of tax revenues to the state for at least five years and we believe the maximum amount of the annual loss in revenues after year five would be $25 million. Overall, that loss should be more than offset by taxes collected by the state due to the increased economic activity that section 1202 would spur. In the long run, providing section 1202 incentives should increase tax revenues for New Jersey.