The capital gains problem at exit

At sale, federal long-term capital gains rates of 20 percent combine with the 3.8 percent Net Investment Income Tax and, in many states, an additional 5 to 13 percent in state capital gains tax. For a California seller realizing a $20 million gain, the headline tax bill before structuring is $7 to $8 million. The numbers are similar for New York and New Jersey sellers. For a Florida or Texas seller, the federal-only exposure is still roughly $4.8 million.

The exit-tax outcome is determined years before the closing date. Whether the deal is structured as an asset sale or a stock sale, whether the selling entity is a C corporation, S corporation, or LLC, whether the shares qualify for the Section 1202 QSBS exclusion, and whether proceeds flow through a charitable remainder trust or a Section 1042 rollover all change the after-tax outcome dramatically. None of those decisions can be made well at the negotiating table. Each has to be set up in advance.

Section 1202 Qualified Small Business Stock

Section 1202 is the most powerful single tax provision available to founders and early investors in qualifying C corporations. For stock acquired after September 27, 2010 and held for at least five years, Section 1202 allows each shareholder to exclude up to the greater of $10 million or 10 times the original basis from federal capital gains tax at sale. The exclusion is per shareholder, per issuer. With deliberate structuring through trusts and family transfers, the per-issuer cap can be multiplied across multiple shareholders.

The qualification rules are specific. The issuing entity must be a domestic C corporation with gross assets not exceeding $50 million at issuance. The corporation must operate a qualified trade or business. The holding period clock starts at issuance, not at incorporation.

We evaluate Section 1202 qualification at the entity-formation stage and at the restructuring stage when the original entity choice was different. For companies organized as LLCs or S corporations approaching a sale window, a deliberate conversion to C corporation status can be the difference between a fully taxable exit and a substantially exempt one. The conversion has its own consequences and must be modeled carefully against the holding period requirement.

Section 1042 ESOP rollover

An ESOP sale transfers the company to a qualified retirement trust held for the benefit of employees. The selling shareholder receives proceeds in cash or as a promissory note from the ESOP. Section 1042 allows the selling shareholder, if conditions are met, to roll proceeds into a Qualified Replacement Property portfolio of U.S. operating-company securities and defer capital gains tax indefinitely. With proper planning, the deferral can extend through the seller’s lifetime.

ESOP exits work best when the company has consistent free cash flow, employee continuity is a priority, and the post-sale management team can operate the business independently. ESOP setup typically requires 12 to 18 months of preparation covering valuation, plan design, trustee selection, financing, and the Section 1042 election strategy.

Installment sales and Charitable Remainder Trusts

When Section 1202 and Section 1042 are not available, the work shifts to spreading the gain over multiple tax years and routing proceeds through structures that defer or eliminate tax at the structure level. An installment sale spreads the gain across the payment schedule, with each year’s gain taxed at that year’s rate.

A Charitable Remainder Trust takes a different approach. Appreciated business interests are contributed to the trust before sale. The trust sells the interest tax-free and pays the seller a stream of income over a fixed term or lifetime. The remainder passes to a designated charity. CRTs are well-suited to charitably inclined sellers and to situations where additional taxable proceeds would be inefficient given the seller’s other income.

Asset sale vs. stock sale

Buyers generally prefer asset sales. They receive a stepped-up basis in the acquired assets, can selectively assume liabilities, and amortize a portion of the purchase price. Sellers generally prefer stock sales: capital gains treatment on the entire proceeds, no double-tax exposure for C corporations, and preservation of Section 1202 QSBS qualification.

A Section 338(h)(10) election bridges the two. It treats a stock sale as an asset sale for tax purposes, giving the buyer the asset-sale outcome while preserving the stock-sale legal mechanics. The economic value of the election can be quantified and shared between the parties through purchase price adjustment. We model the value of the election on both sides and advise on which structure produces the highest after-tax outcome for our client.

Pre-sale entity restructuring

Most exit-tax strategies require entity-level decisions made years before sale: a Section 1202 QSBS conversion, a state-of-domicile relocation, the creation of family limited partnerships for valuation discounting, the establishment of grantor trusts for Section 1202 stacking, and the seasoning of S corporation status for built-in gains tax avoidance. None of these can be retrofitted at the last minute.

Our exit work routinely begins three to seven years before the contemplated sale. By the time a letter of intent arrives, the tax architecture is already in place. The negotiating leverage shifts to deal terms rather than scrambled tax positioning.

When this work makes sense

Best suited for owners of businesses with current or projected enterprise value of $5 million or more, considering a sale, succession, or recapitalization within the next two to seven years. Section 1202 demands a five-year holding period. ESOP transactions require 12 to 18 months of preparation. Entity restructuring decisions take effect over multiple tax years. The work is designed to be in place well before the sale becomes imminent.