Through a series of bills enacted over the past several years, Congress has attempted to incentivize taxpayers to invest in small businesses by creating generous tax benefits. One of the most lucrative benefits, although often overlooked by investors and tax advisors, is provided by Section 1202 of the Internal Revenue Code (“IRC”) which generally can provide for a complete exemption from federal income tax on gains from the sale of stock in a U.S. corporation.
Although many incentives are temporary, there are still opportunities for investors to make small business investments that can be completely exempt from federal income taxes on a following sale. Section 1202, which allows for exclusion on gains from the sale or exchange of Qualified Small Business Stock (QSBS), is frequently overlooked yet may be one of best planning opportunities for business owners and investors in the tax code. A Caroprese accountant can help investment professionals effectively and efficiently utilize Section 1202. Here is what every investor needs to know about this tremendous opportunity.
Section 1202 Background and QSBS Basics
Section 1202 allows for noncorporate taxpayers to exclude from gross income at least 50% of the gain recognized on the exchange or sale of QSBS held more than five years. A QSBS is normally only issued by a qualified small business, as defined within Section 1202. Generally, this is a domestic C Corporation that has gross assets less than $50 million and reports to the IRS and stockholders. The $50 million threshold is when the corporation qualifies as a QSBS, not when the taxpayer sells the stock, giving companies the opportunity to grow.
Enacted in 1993, Section 1202 was in effect before a 1997 reduction brought the maximum capital gain rate for noncorporate taxpayers to 20%. That rate was further reduced to 15% in 2003 before being raised back to 20% in 2013 for taxpayers in the 39.6% income tax bracket.
The exclusion percentage can vary depending on when qualifying stock was acquired. The exclusion percentage is 75% for stock acquired after February 17, 2009 and on or before September 27, 2010. Qualifying stock acquired after September 27, 2010 and before January 1, 2014 can be excluded 100%. For any exchange or sale of certain empowerment zone stock acquired after December 21, 2000 and sold before 2015, 60% can be excluded.
One of the strongest advantages of Section 1202 stock is the ability to roll over gains. This remains despite the Jobs and Growth Tax Relief Reconciliation Act of 2003, which eliminated nearly all tax rate benefits related to the Section 1202 gain exclusion.
A capital gains taxation greater than $10 million or 10 times the taxpayer’s aggregate adjusted basis in the stock can be taken excluded. For example, for a $40 million basis, the excludable amount would be $400 million. This limit applies on a per-issuer basis, with lower limits for married individuals who file separately. When the exclusion is applied in later years, gain excluded under Section 1202 is allocated equally between married individuals filing jointly.
For most taxpayers, QSBS is a capital asset, and thus subject to capital gains tax rates. Most Section 1202 eligible taxpayers are also subject to a lower effective tax rate than would have been the case if Congress did not provide for partial gain exclusion for QSBS.
Taxpayers cannot be entitled to both the reduced capital gains rates and the partial gain exclusion under Section 1202. The taxable portion of the gain is taxed as it normally would be and subject to a maximum rate of 28% on capital gains. This leaves 14% as the maximum effective rate on the gain from the sale of QSBS.
The partial exclusion is not allowed when modifying income for calculating a noncorporate taxpayer’s net operating loss deduction (Sec. 172(d)(2)(B)). When calculating a taxpayer’s long-term capital gain or loss, gain excluded under Section 1202 is not applicable. Gain excluded is also not considered investment income for purposes of the investment interest limitation.
Requirements for Qualified Small Businesses
The requirements for meeting the Qualified Small Business definition are complex. However, it is likely that a large number of startup companies and venture-backed businesses should meet the requirements. It is important to note though that there are specific types of businesses that will not qualify. In general, businesses where the principal asset is the reputation or skill of its employees will generally not qualify. For example, banks are excluded, as well as insurance, financing, investing, leasing and other similar businesses. Businesses operating hotels or restaurants as well as farming businesses are generally excluded, as are those featuring the performance of services in law, health, performing arts, athletics, consulting, financial services, architecture, and brokerage.
This rule is not absolute, however, as companies seemingly built on skill and reputation have previously qualified because their activities were defined as having involved the development of assets to create value for customers rather than offering expert services. How a company can frame its assets matters when being considered for qualified small business status.
For the purposes of Section 1202, a qualified small business may be:
- a C corporation that is neither a domestic international sales corporation (DISC) nor a former DISC.
- a regulated investment company
- a cooperative
- a real estate mortgage investment conduit
- a real estate investment trust
Qualifying businesses cannot possess portfolio stock or securities with a value exceeding 10% of its total assets in excess of liabilities. Generally, they also cannot own property that is unused when conducting a qualified trade or business possessing a valued at more than 10% of its total assets.
For QSBS, when the stock is issued, the issuing corporation must be a qualified small business and maintain that status throughout the time the taxpayer holds stock. To qualify as QSBS, the stock must meet the following:
- Stock must be issued after August 10, 1993.
- Must be issued by a U.S. C corporation that, at the time of issuance, has no more than $50 million in gross assets. The $50 million threshold refers to the amount of cash plus aggregate adjusted bases of other property held by the business.
- To be eligible for a tax-free rollover under Section 1045 (which will be discussed in detail later), stock must be held for more than six months and more than five years to qualify for gain exclusion.
- Stock must be held by a taxpayer other than a corporation (noncorporate).
- Must be acquired by the taxpayer on original issuance, however, there are exceptions.
- The issuing corporation must use at least 80% of its assets in an active trade or business. This cannot include certain personal services and types of businesses. If a corporation uses assets in research, experimental, startup, or in-house research activities connected with a future trade or business, the corporation is considered to have used those assets in the active conduct of a qualified trade or business.
Rights to computer software are treated as active conduct of a trade or business. Any assets held for the company’s working capital needs are also considered used in active conduct of a trade or business. This is true as well for assets held for investment purposes which are expected to be utilized in two years for financing of experimentation and research. Only half of working capital assets will be considered used in active conduct of a qualified trade or business for companies that are at least two years old.
If a corporation’s stock is to be QSBS, its aggregate gross assets must not be more than $50 million from after August 10, 1993 and before stock is issued (Sec. 1202(d)(1)(A)). After issuing stock, the corporation’s aggregate gross assets cannot exceed $50 million. Because of this, amounts received in stock issuance are considered (Sec 1202(d)(1)(B)).
There are consequences if any company moves in and out of these requirements. For example, once a corporation moves past the $50 million asset threshold, it will never be able to issue QSBS. However, if a corporation met the $50 million threshold when the stock was issued but then moves past that limitation, qualifying QSBS stock will not lose its classification.
Specialized small business investment companies (SSBIC) are considered to meet the requirements for the active business test. SSBICs are corporations licensed by the Small Business Administration under Sec. 301(d) of the Small Business Act of 1958, P.L. 85-699, as in effect on May 13, 1993.
Temporary 100% Exclusion
Several years ago, a major addition to Section 1202’s exclusions rules was enacted, allowing a 100% exclusion percentage on QSBS acquired after September 27, 2010 and before January 1, 2011. This was enacted with The Small Business Jobs Act of 2010, P.L. 111-240.
The application of 100% exclusion was extended by a year by The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, applying to qualifying stock acquired before January 1, 2012.
Two years later, The American Taxpayer Relief Act of 2012 (ATRA), P.L. 112-240, retroactively extended the 100% exclusion of the gain from the sale of QSBS for two more years, applying to stock acquired before January 1, 2014. The five-year holding period and other requirements have not been changed.
Section 1045 Rollovers
In 1997, The Taxpayer Relief Act of 1997, P.L. 105-34, enacted Section 1045, permitting rollover treatment for sales of QSBS occurring after Aug. 5, 1997. Section 1045 first only applied to individual taxpayers, but the IRS Restructuring and Reform Act of 1998 P.L. 105-206, changed the rule to apply to taxpayers other than corporations.
Section 1202’s gain exclusion and Section 1045’s gain rollover both only apply to QSBS (Sections 1045(b)(1) and 1202(c)). Section 1202(c) defines QSBS for both provisions.
Under Section 1045, if sales proceeds are invested in QSBS within 60 days of the sale, gain on sales of QSBS held longer than six months cannot be taxed.
Section 1397B further gives taxpayers the option to rollover capital gain from the sale or exchange of qualified empowerment zone assets bought after December 21, 2000. The purchase, however, must be held for more than one year where the taxpayer uses proceeds to buy other qualifying empowerment zone assets in the same zone in a span of 60 days from the original zone asset. The basis in the QSBS acquired by any deferred gain must also be reduced by the taxpayer.
Section 1045 allows the deferral of gain from the sale of QSBS where replacement QSBS is acquired. Within 60 days of a sale, taxpayers can defer gain on acquiring QSBS. Taxpayers utilizing Section 1045 rollover benefits are required to make an election on or before the due date for filing the tax return for the tax year QSBS is sold. Only with written consent from the IRS (which must be obtained by way of a request for a private letter ruling) can a Section 1045 election be revoked.
Taxpayers and QSBS
To benefit from QSBS rules, a taxpayer does not need to own stock directly, as nonrecognition of gain can be made through an S corporation, partnership, common trust fund, or regulated investment company if the following apply:
- All eligibility requirements with respect to QSBS are satisfied.
- When the taxpayer acquired the qualifying stock and afterward, a taxpayer sharing in the gain held the interest in the passthrough entity.
- Qualifying stock was held by the entity for more than five years.
Stock is eligible if it is acquired by the taxpayer after December 31, 1992 at the original issuance in exchange for money, compensation for services to the company, or property other than stock.
A few years ago, another incentive for small business investment was enacted by way of The American Recovery and Reinvestment Act of 2009, P.L. 111-5. This raised the Section 1202 exclusion from 50% to 75% for gain from the exchange or sale of QSBS acquired after February 17, 2009 and before January 1, 2011 and held for more than five years (Sec. 1202(a)(3)). The 60% exclusion remained concerning the sale or exchange of certain empowerment zone stock.
An important note: Partners, participants and shareholders cannot exclude gain received from a company if their share in the entity’s gain exceeded their interest in the entity when the company acquired the stock.
Reporting and Penalties
Reporting plays a role in Section 1202, as the Treasury can require taxpayers to submit reports to carry out the provision’s purpose. If taxpayers do not file reports correctly as required by Sec. 1202(d)(1)(C) in relation to gain exclusion, a penalty of $50 can be levied for each report where there was a failure. Failing to report because of intentional disregard or negligence of rules and regulations (Sec. 6652(k)) can increase the penalty to $100.
Takeaways and Considerations
QSBS is not significantly beneficial to every taxpayer it was intended to help, with the capital gain tax rates reduction permanently extended for taxpayers under the 39.6% threshold. Section 1202 stock, however, is worthy of a deeper look for investors if for no other reason than The American Tax Relief Act’s 100% gain exclusion extension coupled with tax preference items for AMT purposes being inapplicable.
With the help of a Caroprese accountant, taxpayers can diligently analyze and contrast how a QSBS investment may be to their benefit. Contact a Caroprese tax expert for more information on the potential tax windfall from Section 1202 investments.