What is IRC Section 1202?
As an incentive for non-corporate taxpayers to invest in small businesses, Section 1202, Small Business Stock Capital Gains Exclusion, allows for the exclusion of gains associated with Qualified Small Business (QSB) stocks. Section 1202 was initially enacted with the purpose of promoting investments in new ventures and small businesses by allowing taxpayers to exclude 50% of the gain in select small businesses, however, as capital gain rates changed, the Section 1202 exclusion was increased from 50% to 75%, and subsequently to an exclusion of 100%, effective for QSB stocks acquired after September 27, 2010.
Defining Qualified Small Business Stock
Among the limitations for Section 1202, stock eligible for this exclusion must be Qualified Small Business stock as defined by the Internal Revenue Code (IRC). This means that not all small business stocks are qualified for the exclusion. In order for small business stock to qualify under Section 1202, the stock must meet the following requirements:
- C Corporation Requirement - at the date of its issuance of the stock, the corporation (issuer) must have been a C corporation and the stock must be issued after August 9, 1993.
- Aggregate Gross Assets Requirement - the issuer must meet the gross assets test, where:
- At all times from August 10, 1993 thru the date of issuance, the aggregate gross assets of the corporation (and any of its predecessor) must not exceed $50 million. Once a corporation reaches the $50 million gross asset threshold, it can no longer issue QSB stock, even if the gross assets fall under the $50 million threshold in subsequent years.
- Immediately after the date of issuance, the aggregate gross assets of the corporation must not exceed $50 million. Contributions in connection with the issuance of the stocks should be taken into account when determining the aggregate gross assets.
- Active Business Requirement - at least 80% of the corporation’s assets were used for the active conduct of one or more qualified businesses. Section 1202 defines assets that are used in a qualified trade or business as assets used for the purpose of the active business requirement if they are held for the reasonable working capital of a qualified trade of business or held for investment if it is reasonably expected to be used within two years to finance research and experimentation in a qualified trade or business or increase working capital needs in a qualified trade or business.
Excluding the Gain from Qualified Small Business Stocks
If you have QSB stock, you’re a step closer to being allowed to exclude the gain from income. However, the following must be considered before the gain exclusion can be applied:
- The taxpayer must have acquired the QSB stock directly by the issuer in exchange for money or property, other than stock, or as compensation of services performed for the issuer. There are limited exceptions for stock received as a gift, at death, or as a distribution from a partnership, however, generally the original purchaser of the QSB stock must be the seller claiming the Section 1202 exclusion.
- The QSB stock must be held for more than five years and the holding period begins at the date the stock is issued.
- The issuer must remain a C corporation during substantially all of the taxpayer’s holding period of the QSB stock.
- Taxpayers are limited to total gain exclusions based on the greater of:
- A cumulative limitation of $10 million of excludable gain per issuer, or
- The annual limitation of 10 times the issuer’s aggregate adjusted basis of the QSB issued by the corporation and disposed of by the taxpayer during the taxable year.
- The amount of exclusion taxpayers are allowed is based on the date the stock was acquired.
- QSB stock acquired from August 10, 1993 to February 17, 2009 is allowed an exclusion of 50% of the gain.
- QSB stock acquired from February 18, 2009 thru September 27, 2010 is allowed an exclusion of 75% of the gain.
- QSB stock acquired on or after September 28, 2010 is allowed an exclusion of 100% of the gain.
- Section 1202 exclusions are disqualified if any of the following applies:
- The issuer purchased stock from the holder or related party at any time during the four-year period beginning two years before the issuance of the stock, or
- During the two year period beginning on the date one year before the issuance of the stock, the issuing corporation made one or more purchases of its stock within an aggregate value exceeding 5% of the aggregate value of all its stocks as of the beginning of such two year period.
The Section 1202 capital gain exclusion can be confusing as qualification rules can be complicated and recordkeeping can be arduous, however, the exclusion can be exceedingly advantageous to investors of these qualified small business stocks. As with all tax records, proper documentation should be retained to document the eligibility of the small business corporation and the necessary support to substantiate the exclusion on your tax return. In many instances, obtaining the information and QSB stock certification from the corporation at the time of issuance will allow taxpayers to avoid possible difficulties in the future.
As always, our CPAs at Mason + Rich are ready to answer any additional questions. Feel free to call us at 603-224-2000.