Section 1202 provides notable tax benefits for individuals and entities that are not classified as corporations. These benefits extend to various parties, such as founders, investors, and private equity groups. This provision allows for the exclusion of capital gains derived from the sale of qualified small business stock (QSBS) held for more than five years. Recent changes, including the Tax Cuts and Jobs Act and potential tax rate increases, have increased the relevance and popularity of Section 1202. Here’s what you need to know about this tax-saving opportunity.
Section 1202 allows for the exclusion of up to 100% of capital gains from the sale of QSBS, subject to certain limitations. The exclusion percentage depends on the date of QSBS issuance, ranging from 50% to 100%. The original-issuance requirement, active-trade-or-business requirement, and asset size limitation must be met for stock to qualify as QSBS.
While Section 1202 was underused in the past due to the higher tax rate on nonexcludable gains, recent developments have made it more attractive. The reduction in corporate tax rates and potential rate increases for high-income individuals under the Biden administration have sparked interest in utilizing Section 1202 for tax savings.
For investors and private equity groups, Section 1202 can offer significant benefits. By structuring acquisitions and investments properly, it’s possible to exclude all or a substantial portion of the gain from stock sales. Private equity funds, through partnerships, can allocate the gain exclusion at the partner level, providing individual partners with substantial tax savings.
What are the main points to understand about Section 1202?
- Section 1202 exempts certain capital gains from federal taxation for small business stock.
- Non-corporate taxpayers are encouraged to invest in small enterprises under this section of the tax code.
- Not all shares of small companies are eligible for these exemptions.
- The maximum amount of gain that can be deducted under Section 1202 is either $10 million or 10 times the stock’s adjusted basis, whichever is greater.
What are the eligibility criteria for Section 1202?
- Qualified Small Business Stock: The stock must be issued by a qualified small business (QSB). A QSB is a domestic C corporation that meets certain active business requirements and has total gross assets of $50 million or less at the time of issuance of the stock.
- Original Issuance: The stock must be acquired directly from the QSB either at its original issuance or through an underwriter.
- Holding Period: The stock must be held for at least five years. The holding period begins on the date of acquisition and ends on the date of the sale or exchange of the stock.
- Exclusion Amount: The exclusion under Section 1202 allows for the exclusion of a percentage of the gain realized from the sale or exchange of QSBS. The applicable exclusion percentage depends on the acquisition date of the stock:
- For stock acquired between August 10, 1993, and February 17, 2009: The exclusion percentage is generally 50%.
- For stock acquired between February 18, 2009, and September 27, 2010: The exclusion percentage is generally 75%.
- For stock acquired on or after September 28, 2010: The exclusion percentage is generally 100%.
- Limitation on Exclusion: The amount of gain that can be excluded under Section 1202 is subject to certain limitations. The exclusion is limited to the greater of $10 million or 10 times the taxpayer’s basis in the QSBS.
What are the challenges of Section 1202?
Acquisitions present unique challenges when it comes to utilizing Section 1202. Here are some of the key challenges associated with applying Section 1202 in the context of acquisitions:
- Maintaining QSBS Status: To qualify for the tax benefits of Section 1202, the acquired stock must meet specific requirements, including the original-issuance requirement. This means that stock acquired through a secondary purchase (shareholder to shareholder) generally does not qualify as QSBS.
- Complex Asset Valuation: Section 1202 includes a limitation based on the aggregate gross asset basis of the corporation, which must not have exceeded $50 million at any time on or after August 10, 1993.
- Stock Redemption Implications: Stock redemptions by the corporation can impact on the QSBS status of the redeemed stock as well as the remaining stock held by other shareholders. If a corporation redeems more than a de minimis amount of stock from a shareholder or its related parties during specific periods, it can jeopardize the QSBS status of the remaining stock.
- Choice of Entity Considerations: Choosing the appropriate entity structure for the acquisition is crucial. While C corporations are eligible for Section 1202 benefits, they may be subject to double taxation, which can offset the potential tax advantages. Partnerships and S corporations, on the other hand, pass through income to shareholders or partners, potentially allowing for more favorable tax treatment.
- Compliance and Planning: Section 1202 has specific qualification requirements and limitations, and ongoing compliance and planning are necessary to ensure the continued eligibility for the tax benefits. Changes in business activities, additions of nonqualified trades or businesses, and other factors can jeopardize the QSBS status and the availability of gain exclusion.
How can we help?
It’s important to note that the application of Section 1202 in acquisitions can be complex, and the specific challenges may vary depending on the circumstances of each transaction. Seeking the guidance of experienced tax professionals and advisors with expertise in Section 1202 is highly recommended to effectively navigate these challenges and maximize the potential tax benefits while ensuring compliance with the relevant regulations. You can get the best tailored advice through our wide network alliances, please get in touch with us here.