The Small Business Stock Gain Exclusion: Understanding Section 1202
Steve Kenney, Tax Shareholder
September 29, 2023
Investing in small businesses and startups might feel risky, but the potential for substantial returns has always attracted entrepreneurs and venture capitalists. The U.S. government acknowledged the significance of promoting investment in these industries and implemented a tax incentive called Section 1202, also known as the Small Business Stock Gain Exclusion.
Under this provision, taxpayers may exclude a portion of their capital gains from selling qualified small business stock (QSBS). This exclusion can result in substantial tax savings, making it an attractive option for investors. In this article, we will delve into the intricacies of the Section 1202 Stock Exclusion, exploring what it is, how it works, and the eligibility criteria for this tax advantage.
What is Section 1202?
Section 1202 isn't new. It was originally enacted in 1993 to encourage long-term investment in startups and small businesses by exempting capital gains on the sale of stock in these entities from taxation. However, before 2013, the maximum long-term capital gains rate was 15%, and the effective tax rate on Section 1202 gains was 14%, giving taxpayers little incentive to claim the exclusion. However, with the increase in LTCG rates to a maximum of 23.8% in 2013 and subsequent changes made by the Tax Cuts and Jobs Act, Section 1202 has gained more attention as a valuable tax benefit.
The exclusion allows individuals to exclude up to 100% of their gain from the sale of qualified small business stock, with certain limitations. The percentage of exclusion depends on when the stock was acquired. For stock acquired after September 27, 2010, and held for at least five years, the exclusion is generally 100% of the gain. However, the exclusion percentage may vary for stock acquired before that date.
The gain exclusion has a maximum of $10 million or ten times the original investment in the stock, whichever is greater. For example, if you invested $2 million, the exclusion could increase to $20 million (ten times your basis).
Qualifying for the Small Business Stock Gain Exclusion
Stockholders must meet certain eligibility requirements to qualify for the Small Business Stock Gain Exclusion under Section 1202.
The gain exclusion under Section 1202 is available to non-corporate stockholders, including individuals, trusts, and pass-through entities such as partnerships or S corporations.
The stock in question must be issued directly by the corporation to the investor, not acquired on the secondary market. This requirement emphasizes the significance of fostering investment in startups and growing companies. However, a taxpayer may obtain the stock as a gift or as an inheritance who acquired the stock at the original issuance.
The investor must hold the qualified small business stock for at least five years to be eligible for the Section 1202 exclusion. This stipulation encourages long-term investment and commitment to the business.
For the stock to be eligible, the corporation issuing it should qualify as a domestic C corporation. S corporations are not eligible, but an LLC that has opted for C corporation taxation can be eligible. Additionally, the corporation must be based in the United States, but its activities or subsidiaries can be domestic or international.
Qualified Trade or Business
The business must operate as a "qualified" trade or business, excluding certain service-oriented businesses like professional service firms The focus is encouraging and rewarding companies contributing to economic growth and job creation.
Gross Assets Test
The gross assets of the corporation must not exceed $50 million at any time between August 11, 1993, and immediately after the stock issuance. This criterion ensures that the tax benefit primarily helps small enterprises.
At Least 80% Use in Active Business
During most of the taxpayer's holding period, at least 80% of the corporation's assets must be used in the active conduct of one or more qualified trades or businesses. This safeguards against the misuse of the provision for tax avoidance purposes.
To encourage investment in small business corporations, Congress aimed to prevent misuse of Section 1202 investment for stock redemptions. To achieve this, they established broad criteria to disqualify stock issued around stock redemptions, which can inadvertently affect otherwise qualifying stock. Any substantial redemptions within a year before or after stock issuance, even as small as 5%, can lead to disqualification, with stricter rules applying to related parties and exceptions for specific cases like death, disability, or service termination.
Additionally, the date you purchased the stock can affect the amount of gain eligible for exclusion. If stock was acquired before 2010, You may only be able to exclude 50% or 75% of the gain, depending on the purchase date. The exact details are beyond the scope of this article. Given the complexities and potential tax implications involved, we recommend consulting with a CPA to ensure you comply with regulations.
Let's explore two fact patterns to illustrate how Section 1202's Small Business Stock Gain Exclusion can be applied in real-life scenarios.
Example 1: Qualifying for Section 1202's Gain Exclusion
John is an individual investor who acquires 10,000 shares of common stock in a qualified small business for $100,000. After five years, he sells the stock for $2 million, resulting in a gain of $1.9 million. Assuming John meets all the criteria for Section 1202's gain exclusion, he can potentially exclude 100% of the gain from federal capital gains tax.
Example 2: Limitations on Section 1202's Gain Exclusion
Sarah is a corporate investor who purchases 5,000 shares of qualified small business stock for $500,000. After the five-year holding period, she sells the stock for $1.5 million, generating a gain of $1 million. Unfortunately, as a corporate stockholder, Sarah is not eligible to claim Section 1202's gain exclusion. While she may still benefit from the favorable capital gains tax rates, she cannot take advantage of the additional tax savings provided by the exclusion.
If you are a small business owner or investor, it is worth exploring the potential benefits of the Section 1202 Stock Exclusion. By understanding this tax provision and engaging in strategic tax planning, you can maximize your tax savings and contribute to the growth of startups and small businesses. If you have questions about navigating the intricacies involved in the exclusion, please contact us.
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