Section 1202 exclusion has been saving individuals and small businesses since as far back as August 1993. However, findings have shown that little is known about this tax incentive.
You sure don’t want to miss out. So, let’s delve right into it.
(Qualified Small Business Stock Gain Exclusion)
When Section 1202, a portion of the Internal Revenue Code, was enacted in 1993, the objective was simple: to encourage investment in small businesses. As a result, individuals can avoid paying taxes on up to 100 percent of the taxable gain recorded on selling qualified small business corporation stock (QSBS) under this exception.
Though typically referred to as a small business tax incentive, even a large business can qualify as a ‘small business‘ under the exclusion.
Under current law as of the writing of this article, the gain exclusion creates a markedly effective tax rate savings of up to 23.8% for federal income tax purposes.
Due to future changes, an increase in federal long-term capital results in a corresponding rise in the tax benefit under section 1202.
A shareholder’s date of investment in the corporation determines the amount of the gain excludible by shareholders. The good news is, many states follow the federal treatment, meaning there are even more significant savings.
Many taxpayers were oblivious of this tax-saving strategy until recently when tax changes have helped showcase the immense benefits of this exclusion to selling shareholders. The advantages became more apparent as it became evident that possible rises in capital gains tax rates on the horizon would amplify those advantages.
Take Ted Andrews, for example. Ted was issued stock in Firestone Inc. on February 1, 2010, for $2million in cash. On July 1, 2015, Ted sold the stock for $22 million, realizing a $20 million gain.
Now, assuming the stock qualifies for Section 1202, Ted would exclude 100% of up to $20 million of his gain–in other words, the greater of $10 million or ten times of his initial investment of $2 million. Since Ted’s entire $20 million gain would be excluded from his income, Ted would pay $0 tax.
If Ted does not qualify for Section 1202, he would have paid 23.8 percent on his total gain, culminating in a $4,760,000 tax burden. Not to mention that Ted’s state applies a 5% tax rate to capital gains, costing him another $1 million. Whereas, if he were qualified for Section 1202, the state would follow the federal Section 1202 treatment, and he’d have saved that $1 million as well.
By using section 1202, Ted saved almost $6 million in tax on a $22 million transaction.
As bounteous as its benefits may appear, Section 1202 lays down requirements a person must meet to qualify for the exclusion. These requirements are not simple, especially when there’s not enough guidance from the Internal Revenue Service (IRS) to clarify notable gray areas in this subject and how taxpayers can navigate the rules.
We discuss these requirements below.
Requirements to Qualify for Section 1202 Exclusion
There are eight essential requirements that a stock must meet to qualify for Section 1202 benefits. These requirements are broadly divided into shareholder-level requirements and corporation-level requirements.
Eligible shareholders include all non-corporate shareholders, including individuals, estates, and trusts. These shareholders must hold the stock directly or indirectly.
For instance, in a case where a shareholder is an S corporation or partnership, the gain may apply, but there are additional requirements that must be met before the non-corporate owners of the pass-through entity can be eligible to claim the exclusion benefits.
However, it must be stated that generally, partnerships often create additional challenges capable of reducing the ultimate benefits to the partners unless the partnership is deliberate about preserving the Section 1202 qualification.
The stock’s holding period is more than five years before its disposal, beginning from when it was issued.
For example, stock issued in exchange for a non-cash property starts on the exchange date even if the holding period for general tax purposes carries over.
In evaluating if a shareholder has completed the five-year threshold, a shareholder might ride on past holding periods if the stock was obtained as a gift, inheritance, partnership distribution, or through a specific stock exchange or conversions.
Original issuance of stock
The taxpayer must have bought the stock after the beginning date of August 10, 1993. In addition, the stock must be acquired directly from the corporation rather than from a shareholder.
Also, the stock needs to be issued as part of the initial corporation. Stocks issued as compensation for services rendered to the corporation satisfy this requirement.
The corporation must be eligible as at the date of issuance of the stock, and throughout the taxpayer’s holding period. Except for a few specified restrictions, an eligible corporation is any domestic C corporation (IC-DISC, former DISC, RIC, REIT, REMIC, or cooperative). Meanwhile, an S corporation is ineligible, although an LLC that has consented to be taxed as a C corporation is.
Furthermore, though the activity of the corporation in question or its subsidiaries can be domestic or international, the corporation must be domiciled in the US.
$50 million gross assets cap
The corporation’s assets should not have had a tax basis of more than $50 million at any point between August 11, 1993, and the day the stock was issued. This analysis is run at the time of stock issuance. Once the asset criteria are fulfilled, it is not reevaluated for that stock again. As a result, stock issued when the corporation’s assets have a tax basis of less than $50 million continues to qualify, even if the corporation’s assets later surpass $50 million.
However, measuring this test on a tax basis opens up even more opportunities. For instance, a corporation can be worth significantly more than $50 million while qualifying to issue small business stock if it boasts a significant tax basis in its assets encumbered by substantial liabilities.
This evaluation admits that assets contributed to a corporation in exchange for stock are measured by their fair market value when they receive the property.
True to its objective of encouraging investments in small business corporations, the US government sought to prevent situations where capital invested in section 1202 is issued to find redemption of other shareholders. As such, stock issued shortly before or after stock redemption is disqualified from the exclusion gain. Most taxpayers fail at this requirement.
Though typically beginning from 5% redemption, the threshold drops to 2% where related, in which case the testing period extends to two years.
Some exceptions apply in determining the size of the stock and the likelihood of it triggering disqualifications and permitting redemptions of any size in the circumstances such as termination of services, disability, or death.
Qualified trade or business requirement
The corporation in question must be engaged in (or performing activities to start up) a ‘qualified‘ trade or business. This includes any business other than the following:
- Personal services like health, law, engineering, architecture, accounting, performing arts, consulting, or businesses where the principal assets of the trade are skills or reputation of one of its employees;
- Financials like banking, insurance, leasing, investing, franchising, leasing;
- Farming like gardening, growing, and other similar businesses;
- Oil, gas, and mining;
- Hospitality like a hotel, motel, restaurant; and
- Real estate
There is limited guidance on how these terms should be interpreted, thereby leaving too much to the discretion of IRS and taxpayers, often making this exclusion slippery and slope.
Active business requirement
A corporation must use a minimum of 80% of its fair market value in the active conduct of an eligible business or trade. This must be during substantially all of the taxpayers’ holding period of the stock.
A corporation may fail this requirement if:
- stock (or securities in other corporations in which the corporation controls less than 50%) make up at least 10% of the corporation’s net assets; or
- a minimum of 10% m gross assets are real property that is not used to conduct qualified business.
You may be starting a new business, contemplating an exit strategy, or have already sold your stock; you will need all of the details to benefit from the Section 1202 exclusion.
With Section 1202, you will be saving money that you can reinvest into your long-term growth financial health & wealth!
Headed by Shauna A. Wekherlien (CPA, Masters in Taxation, and Certified Tax Coach), Tax Goddess Business Services®s P.C. is a tax and accounting firm that specializes in tax reduction, audit assistance, and accounting services. As a top 1% CPA in the US, what sets us apart from other CPA’s is our cutting-edge system in which our team of professionals, we are a team of experienced tax professionals who will work with you to develop a customized plan to reduce your taxes while creating the most-effective financial plan possible. Over the past twenty years, we have helped individuals and business owners from across the US keep more of their hard earned income by saving a total of $423,984,402 and counting. You can book a free consultation here to discuss all tax related queries and get expert advice from our tax professional. Book here Also, our YouTube channel is a goldmine for tax updates and tax reduction strategies. Watch clients' success stories here. Subscribe to our newsletter to stay updated with the secret strategies that we share.