Section 1202 of the Internal Revenue Code, often referred to as the Qualified Small Business Stock (QSBS) Gain Exclusion, is a powerful tax incentive designed to encourage investment in small businesses. For small business owners and investors, it can mean substantial tax savings when selling certain types of stock in qualifying companies.
What Does IRS Section 1202 Entail?
Section 1202 allows non-corporate taxpayers (such as individuals, trusts, and estates) to potentially exclude up to 100% of the capital gains realized from the sale of qualified small business stock (QSBS) from federal income tax, provided certain requirements are met. The exclusion applies to the greater of $10 million or 10 times the taxpayer’s original investment (basis) in the stock. This can translate into millions of dollars in tax savings for founders, early employees, and investors in eligible businesses.
Key Requirements for Section 1202
To benefit from Section 1202, several criteria must be satisfied:
- C Corporation: The business must be a domestic C corporation when the stock is issued and throughout the holding period.
- Original Issuance: The stock must be acquired at its original issuance (directly from the company) in exchange for money, property (excluding other stock), or as compensation for services.
- Active Business: At least 80% of the company’s assets must be used in the active conduct of a qualified trade or business during substantially all of the shareholder’s holding period.
- Gross Assets Limit: The company must have $50 million or less in gross assets at all times before and immediately after the stock is issued.
- Holding Period: The stock must be held for more than five years before it is sold.
- Qualified Trade or Business: Certain businesses are excluded, such as those in health, law, engineering, architecture, financial services, hospitality, and a few others.
What Does Section 1202 Mean for Small Business Owners?
1. Major Tax Savings
If a small business owner or investor sells QSBS after holding it for more than five years, they may exclude up to 100% of the gain from federal capital gains tax-up to $10 million or 10x their investment, whichever is greater. This can result in effective tax savings of up to 23.8% (the typical capital gains tax rate).
2. Incentive for Investment and Growth
Section 1202 encourages investment in small businesses by offering a significant tax break to founders, employees, and investors. This can make it easier for small businesses to attract capital and talent, fueling growth and innovation.
3. Strategic Planning Opportunities
Small business owners considering forming or converting to a C corporation may do so to take advantage of Section 1202. Proper planning is essential, as the rules are complex and there are many nuances (such as the timing of stock issuance, business activities, and asset tests).
4. Not All Businesses Qualify
Section 1202 does not apply to all businesses or types of stock. Service businesses (like law firms, accounting, health, and consulting), financial institutions, farms, mining companies, and hospitality businesses (like hotels and restaurants) are generally excluded. Only C corporation stock issued directly by the company qualifies.
5. State Tax Treatment May Vary
While many states conform to the federal exclusion, not all do. Business owners should consult with tax professionals to understand the state tax implications.
Example
If a founder invests $1 million in a qualifying C corporation and sells the stock after six years for $12 million, up to $10 million of the gain could be excluded from federal tax under Section 1202. This would save the founder over $2 million in federal taxes compared to a typical capital gains scenario.
Bottom Line
Section 1202 offers a unique and substantial tax advantage for small business owners and investors in qualifying C corporations. By planning ahead and ensuring compliance with the requirements, small business owners can leverage this provision to attract investment, reward early stakeholders, and potentially realize significant tax-free gains upon a successful exit. However, the rules are complex, so professional tax advice is highly recommended.