Section 1202 Stock, Exclusion, Requirements Checklist

section 1202

When Congress enacted the IRS Section 1202, the gain exclusion aimed to encourage those small business owners to have a healthy flow of capital. In fact, many of them struggle to attract equity financing and it leads to the increase of the gain exclusion percentage to 100% that was implemented way back in 2010. However, many taxpayers are not aware of the tax benefits and incentives for the sellers of eligible C corporations and the updates in the tax laws in the past few years that can definitely provide huge benefits to the selling shareholders. Hence, if you want to know more about it, check the complete details below of how Section 1202 works and its stock, exclusion, requirements, and checklist. 

What Is Section 1202 (a.k.a. Qualified Small Business Stock Gain Exclusion)? 

Small Business Stock Gains Exclusion is also called Section 1202. It’s a portion of the IRC or Internal Revenue Code that provides the statutory basis for QSBS exclusion. This particular law allows capital gains to be excluded from the small business stock federal tax. However, the law is applicable to the eligible small business stock held for more than 5 years and acquired after the 27th of September in 2010. 

In general, for those individuals who invest in startup businesses, Section 1202 will allow them to exclude their capital gains from their total income taxes up to $10 million. Or, it’ll be ten times their stock basis as long as their shares have been held for five years. But both the company and the shareholder should meet the set of requirements for them to apply the exclusion. 

Moreover, FATCA or the Foreign Account Tax Compliance Act was enacted by Congress to get rid of tax evasion in the United States. The law is targeting those U.S. citizens who have foreign financial accounts and didn’t comply with the tax rules. Besides that, FATCA is part of the Hiring Incentives to Restore Employment Act or HIRE, which is a law that provides business owners with incentives to hire unemployed individuals. 

In addition, the said law requires any U.S. citizen to report and include their foreign financial accounts and other foreign financial assets in their return. In fact, the law doesn’t only affect U.S. citizens but also involves those offshore financial institutions. It’s because FATCA also requires those foreign financial institutions and non-financial foreign entities to report their account holders’ foreign financial assets to the IRS. 

section 1202 stock

Requirements of Section 1202

Under the Internal revenue Code, not all people who have small business stock are eligible for the said tax exclusion. A particular business stock will be qualified based on the guidelines below.

  • It was initially issued in exchange for cash, as compensation for the offered services, or for a particular property excluding stocks after the 10th of August in 1993. 
  • The assets of the corporation or company have been used for the qualified businesses’ active conduct of at least 80%. 
  • The domestic C corporation issued the business stock, instead of the restaurant, real estate company, financial institution, hotel, a mining company, or any businesses that are related to architecture, engineering, or the law. 
  • The corporation that issued the business stock didn’t purchase any of the taxpayer’s stock at the beginning of two years and during the four-year period before the date of its issuance. 
  • Within two years starting a year before the issuance date, the corporation should not redeem its stock, the redemption of the stocks’ total value that exceeds 5% of the company’s stock aggregate value. 
  • The corporation that issued the business stock should have at least $50 million of assets or less on the issuance date and immediately after that. 

Taxpayers of the United States should find help and assistance from a tax professional to know how their states recognize the realized profits from the qualified small business stocks sales. Besides that, your capital gains from small business stock will also be excluded from state taxes if they conform to the federal taxes.

Sample Calculation

To have a better understanding of how this law applies to your qualified small business stock, here’s a concrete sample scenario:

James issued stock in a particular corporation on the 2nd of February in 2011, and that was in exchange for cash worth $2.5 million. After that, James decided to sell his stock on the 2nd of June in 2016 for $20 million with capital gains amounting to $17.5 million. So if the said stock of James is eligible for tax deductions based on Section 1202 guidelines, it means that he would have up to $20 million tax exclusion of his capital gain. Since the aggregate amount of the capital gains is $17 million, James won’t pay any taxes for that at all. 

However, if there’s no Section 1202 treatment applied, James would end up paying 23.8% of his capital gain. It’ll result in dealing with a huge amount of income taxes. Besides that, since James held the stock for five years, there will 5% tax rate for his total capital gain. But after Section 1202 treatment has been applied, he would no longer pay any taxes at all. 

The same thing goes for other tax benefits. There will be tons of requirements and the process may take longer and a bit complicated if you want to get your small business stock be eligible for Section 1202. So it’ll still be best to get assistance and help from a tax professional. 

Requirements to Qualify for Section 1202 

As mentioned earlier, for you to qualify for Section 1202, you have to meet a set of requirements. With that, here’s an overview and some details you need to know about those requirements and guidelines that you need to always keep in mind. 

Shareholder Level Requirement

Who is an eligible shareholder?

Those non-corporate shareholders are the eligible shareholders and that includes estates, trusts, and individuals. For instance, if a particular S corporation or partnership is the shareholder, the capital gains may still be eligible for tax deductions but there will be additional requirements that need to be met upon filing the return to the IRS. 

Holding Period

The holding period will begin on the date when the said stock was issued and it also needs to be held for more than five years before you sell it. Besides that, if the issued stock was in exchange for a non-monetary asset or property, then the holding period based on Section 1202 will still start on the exact date when the exchange happened, even though the holding tax period carries over for tax purposes in general. Moreover, if the issued stock was from the exercise of stocks warrants or options or for debt conversion, in times like these, the holding period will start after the said exercise or conversion.

Date of Issuance of Stock

To be eligible for Section 1202, the stock must be acquired after the 10th of August in 1993. Besides that, you have to purchase it from a particular company instead of acquiring it from other shareholders and it should not also be issued in the initial corporation. In addition, your stock qualifies for Section 1202 if you’ve acquired it as compensation for the services you offered to the corporation. However, if you’ve received it in exchange for other stock, it may still be eligible but there will be another set of requirements that you also need to meet. 

Corporate Level Requirement

Eligible Corporation

When the stock is acquired during the holding period of the taxpayers, the corporation will become eligible for Section 1202. Any domestic C corporations will be qualified other than those with limited exemptions, such as former DISC, REIT, RIC, IC-DISC, and many others. Moreover, the S corporation won’t be eligible but an LLC as a C corporation and elected to be taxed will still be qualified for Section 1202. 

Gross Asset Limitation

From the 11th of August of 1993 to the date after the stock has been acquired by a corporation, there should not have a tax basis for the total assets of more than $50 million. Besides that, there will be a particular test to be used to evaluate the issued stock and if the results show that it meets the requirements, there will be no other tests for reevaluation after the stock acquisition. 

So even if the assets of the corporation exceed $50 million after acquiring the stock, it’ll still qualify for Section 1202 as long as it was less than $50 million at the time of stock issuance. Moreover, a corporation can’t issue QSBS if it has a low equity value and has a tax basis amount for its assets restricted by liabilities. In addition to that, the fair market value will be used to measure the assets contributed as an exchange for a stock to the corporation. 

Stock Redemption Limitation

Congress always encourages people to make investments in small business corporations. Because of that, it doesn’t want people to use the capital invested for Section 1202 to finance other shareholders’ redemptions. So to prevent it from happening in the future, issuance after or before any stock redemption, Congress has a wide net to disqualify stock. 

Moreover, during the year before or after the stock issuance, any redemptions that happened at this time will disqualify the stock for Section 1202. In addition, the threshold will decrease by 2% and there will be 2 years of extension for the testing period when the related parties get involved. However, the law has some exceptions to apply to identify if the redeemed stock amount may trigger disqualification for Section 1202. 

Qualified Trade and Business Requirement

The corporation should have activities to start a business or get engaged in an eligible trade from a particular industry. It could be in the industry of farming, hospitality, real estate, oil, gas, and mining, and many others. However, when it comes to the technical definition and interpretation of these terms, there’s limited guidance to it. That’s why there’s a need to seek help and assistance from tax professionals. 

Active Business Requirement

There should be active conduct of eligible business or trade where the corporation has to use the fair market value of its assets for at least 80%. In fact, during the entire holding period of the stock, the taxpayer should meet this particular requirement. In addition, to support any research or support the need of the business, the assets of the corporation can be a working capital up to 50%. 

However, any corporation may become ineligible for Section 1202 if its gross assets that include real property are not used for any active conduct of an eligible business and if its assets that include securities or stock are 10% or more, where the said corporation doesn’t own more than 50% of it. 

Per-Issuer Limitation on Gain Exclusion

The tax savings you can get under Section 1202 also have limitations. In fact, the gain to be excluded from your total income taxes is limited per taxpayer and per stock issuer. It’ll be more than $10 million, but it’ll become $5 million if a married couple is filing individually. Besides that, it’ll also be at ten times the total adjusted basis of the taxpayer in the QSBS sale during the tax season. 

Options, Warrants, and Convertible Debt

One of the questions that a lot of people keep on asking is to know if the warrants, options, and convertible debt will qualify for Section 1202. They won’t qualify with the instrument itself, but they may become eligible for the exclusion when the particular instrument is converted or exercised to the original stock that has been issued. That’s why it’s always important to measure every criterion of QSBS on the actual date of exercise or conversion. It’s because the holding period of five years will start on that particular date. 

How to Benefit from QSBS

To determine the status of QSBS, there are tons of information to check and other details to gather, resulting in finding more opportunities and benefits you can definitely enjoy.  Besides that, the guidelines and statute of Section 1202 provide people with an opportunity to have an open interpretation and broader application. So for better understanding, please take a look at the sample scenario below. 

A Private Equity Fund wants to buy a particular stock from a C corporation in the country amounting to $35 million with the assets tax basis adjustment of $12 million. So to proceed with the stock acquisition, the Fund creates Holdings as the acquisition platform. After that, the Fund will pay for the stock issued in Holdings, and it’ll then buy that stock from the C corporation. 

In this particular situation, you may say that the C corporation didn’t issue the said stock and the Fund actually bought the current stock from the seller. But there will be a significant reason in business that will make you create Holdings that will result in issuing the original stock issuance in exchange for cash. Besides that, due to the parent-subsidiary look-through guideline of Section 1202, the requirements for active business or trade should be met. In addition, the scenario above doesn’t have anything to prevent it from qualifying for the exclusion based on the guidelines of Section 1202. So this particular scenario is an example where you can significantly benefit from QSBS. 

Proposed Reduction

Based on the guideline stipulated in Section 1202, a particular stockholder will be entitled to $2, 380, 000 of total savings from federal income taxes in the country if he or she has an aggregate amount of capital gains amounting to $10 million from disposing of the QSBS after applying the Section 1202 treatment. So with the capital gain tax exclusion, there will be no alternative minimum tax and no investment income tax incurred. It’ll be the capital gains rate of 20%, the investment tax rate of 3.8, and another tax rate of 0%. 

However, with the amended guidelines stipulated in Section 1202, the same stockholder who claims the capital gain exclusion of 50% will still be eligible for $1, 590, 000 savings from federal income taxes. It’ll be the capital gain rate of 25, investment income tax of 3.8%, and an additional tax of 3% over $5 million and a blended tax rate of 15.9%. So there will surely be a $790, 000 reduction in the aggregate amount of the federal incomes taxes if a particular stockholder has earned capital gains of $10 million from QSBS with 50% capital gain exclusion. 

Factors to Consider When Making a Choice of Entity Decision

The possible savings from taxes that are associated with the QSBS investment can be reduced by the proposed tax legislation. Besides that, the incentive you may get from venture start-up investment may also decrease by that tax legislation. However, there will still be a few benefits you’ll surely enjoy that are associated with a C corporation instead of choosing LP/LLC for venture start-ups or an S corporation. 

Moreover, from a tax point of view, a C corporation is an efficient business entity if the profits and revenue are used to reinvest into a particular business. Besides that, if Section 1202 treatment is applied, the stockholders may enjoy a few benefits with their investment through the sales of stock. 

In addition to that, the path still remains unclear with the draft legislation of the Ways and Means Committee at this early stage of the process. So there will be a tendency that the various proposed changes to the tax laws can still be abandoned or modified overtime during the said legislative procedure. On top of that, before you can claim for the exclusion from Section 1202, you should hold the stock you’ve acquired today for five years. 

Then, after a few years, several changes must have been made to the particular percentage of the capital gain exclusion as well as the percentage of the gain exclusion today can be changed up to a hundred per cent exclusion of return in the next administration of the country. 

section 1202 exclusion

IRC Section 1202 Qualified Small Business Stock Checklist

To take advantage of Section 1202 or to verify if the stock is QSBS, there’s a basic checklist of the requirements for qualification to help tax experts and business owners consider their business to structure or restructure in the future. So go ahead and check some of them below. 

  • While holding QSBS, you must satisfy the active business requirement. The C corporation issuing the stock that fails to meet the requirements for active business during the holding period will lose its status. Keep in mind that too much passive investment or non-operating cash can blow even blow the QSBS treatment. 
  • Those who can issue QSBS: The one that can only issue QSBS is a domestic C corporation. The S corporation can’t do the same thing but it can be converted to a C corporation to have the ability to issue QSBS. Besides that, in the exchange of QSBS, the S corporation can give a contribution of its assets to the C corporation. 
  • The QSBS status can be blown by holding too much non-operating real estate.
  • It can block the QSBS qualification or blow the QSBS status during the holding period when the engagement in the business activities which are not eligible for business or trade. 
  • Those who can hold QSBS: A trust, individual, single-member LLC, partnership, S corporation, common trust fund, or the regulated investment company can hold QSBS, but the C corporation can’t do the same thing. 
  • While holding QSBS, you must satisfy the active business requirement. The C corporation issuing the stock that fails to meet the requirements for active business during the holding period will lose its status. Keep in mind that too much passive investment or non-operating cash can blow even blow the QSBS treatment. 
  • Issuance of QSBS in exchange for service, property, or cash:  QSBS may retain its status even after converting it to other stock from the same company or issuer. Besides that, partnerships that hold QSBS can distribute it to other partners. 
  • You have to ensure that the issuing corporation has a plan if you want to take advantage of the Section 1202 benefits. 
  • You should also have enough knowledge about the mechanics of a rollover of the sales proceed of QSBS under Section 1045 as a QSBS holder. 
  • The ultimate QSBS seller is the original QSBS holder: To take advantage of Section 1202, the taxpayer should continue to hold and sell the QSBS. However, there are exceptions for QSBS transferred at death, gifted QSBS, and even QSBS transferred between individuals or entities in partnerships. 
  • The requirement of a five-year holding period: Those QSBS gains held for more than the five-year period can be eligible for Section 1202. 
  • The C corporation can issue QSBS with total gross assets note exceeding $50 million. The amount of cash and total adjusted bases of the property that a corporation holds constitute the aggregate gross assets. 
  • The benefits of Section 1202 are limited to $10 million for each taxpayer for every C corporation issuer. 
  • It’s always crucial to qualify for QSBS status to have a well-maintained record. 
  • Obtaining the QSBS status can be interfered with by stock redemptions: There are various stock redemptions that can make a particular stock ineligible for Section 1202 treatment. 
  • It can blow the QSBS status when holding too much portfolio stock. If there’s more than 10% of the asset value that consists of a corporation’s stock not eligible as subsidiaries, the corporation won’t be able to meet the requirement of the active business.

FAQs

How do you qualify for Section 1202 exclusion?

To qualify for Section 1202 exclusion, you need to meet a particular set of requirements. Besides that, under the Internal revenue Code, not all people who have small business stocks are eligible for the said tax exclusion. A particular business stock will be qualified based on the guidelines discussed above.

What is Section 1202 Qualified Small Business Stock?

Small Business Stock Gains Exclusion is also called Section 1202. It’s a portion of the IRC or Internal Revenue Code that provides the statutory basis for QSBS exclusion. This particular law allows capital gains to be excluded from the small business stock federal tax. However, the law is applicable to the eligible small business stock held for more than 5 years and acquired after the 27th of September in 2010. 

What is Qualified Small Business Stock Exclusion?

Section 1202 or the Small Business Stock Gains Exclusion provides investors with an opportunity to exclude some or the entire gain that has been realized from a QSBS sale. The said exclusion will be provided as long as the requirements are met. However, there may be some limitations depending on the situation and some factors to consider during the application of Section 1202 treatment. 

Can LLC qualify for 1202?

According to the guidelines stipulated in Section 1202, a qualified small business means any domestic C corporation. However, it doesn’t clearly say that Section  1202 treatment is available for LLC taxed as a C corporation. 

Can an LLC Taxed as C Corporation Qualify for QSBS?

For LLC, it will be possible to convert it to a C corporation that wil allow investors or non-corporate partners to be eligible for QSBS. Besides that, the fair market value of the LLC interests can be used to calculate the possible tax exclusion at the time of conversion.

Does Section 1202 apply to redemptions?

Stock redemptions may be eligible for the gain exclusion as long as the rules regarding the amount of the redeemed stock and the timing should be observed carefully to avoid voiding the treatment of Section 1202 for the said redeemed stock of the shareholder or the entire stock of a particular corporation. 

What disqualifies QSBS?

When the company’s gross assets are more than $50 million, it’s one way that the QSBS is not applicable to the stock or shares issued by the corporation. Hence, if you’re raising greater than $50 million, you’ll be disqualified to take advantage of the benefits that the QSBS offers.

What is a pass-thru entity?

A pass-thru entity is also called a flow-through entity. It’s a particular structure of a business in which the income it generates is treated as the personal income of the owners. So when the income of the business is subject to the owner’s personal income and corporate tax, it’ll help avoid getting double taxes. 

What is a special basis rule?

Section 1202 allows the stockholders to exclude the gains on the QSBS sale that has been held for five years and capped at ten times the basis of the initial investment or greater than $10 million. Besides that, the basis of the tax adjustment of the property you’ve contributed to the stock issuer is the fair market value at the time of the contribution. 

Conclusion

Taxpayers should have enough knowledge about the benefits of Section 1202, especially those who seek more tax savings and additional funds. That’s why you have to know all of the necessary information about the exclusion, requirements, and even the checklist. Hence, always remember everything discussed above and come back to this article whenever you have any confusion about Section 1202 in the future. 

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