Small Business Stock Gains Exclusion: Section 1202

Section 1202, or the Small Business Stock Gains Exclusion, allows capital gains from certain small business stocks to be excluded from federal tax.

To qualify for Section 1202, the qualified small business stock (QSBS) must have been acquired after September 27, 2010, and have been held for more than five years.

In 2015, the Protecting Americans from Tax Hikes (PATH) Act was passed. This Act renewed some expired tax provisions and permanently extended others. 1202 was made permanent by this Act.

Before 2009, Section 1202 excluded only 50% of capital gains from gross income, and in 2009 that exclusion rate was increased to 75%. The current rate is 100% and is there to provide an incentive to non-corporate taxpayers to invest in small businesses. The maximum amount of gain that any investor can exclude under Section 1202 is limited to the greater of $10 million or 10 times the adjusted basis of the stock. Adjusted basis refers to the material change to the recorded initial cost of an asset or security, to calculate this, you simply take the purchase price and then add or subtract any changes to its initial recorded value.

Requirements of Section 1202

Not all small business stocks are qualified for tax breaks under the IRC.

· It is a small business stock if it was issued by a domestic C-corporation other than a hotel, restaurant, financial institution, real estate company, farm, a mining company, or business related to law, engineering, or architecture.

· It was originally issued after August 10, 1993, in exchange for money, property (not including stocks), or as compensation for a service rendered.

· On the date of the stock issue and immediately after, the issuing corporation had $50 million or less in assets.

· The use of at least 80% of the corporation’s assets is for the active conduct of one or more qualified businesses.

· The issuing corporation does not purchase any of the stock from the taxpayer for four years beginning two years before the issue date.

· The issuing corporation does not significantly redeem its stock within two years beginning one year before the issue date. A significant stock redemption is redeeming an aggregate value of stocks that exceed 5% of the total value of the company’s stock.

State taxes that follow the federal tax will also exclude capital gains of small business stock. Ensure that you check to see if your state is one of them.

Please reach out to the professionals at the Center for Financial, Legal, and Tax Planning, Inc., at (618) 997-3436 for more information.