When the 2017 Tax Cuts and Jobs Act (TCJA) dropped the corporate tax rate to 21 percent, it triggered a new wave of interest in a somewhat obscure provision of the Internal Revenue Code, Section 1202, which could enable shareholders of qualifying businesses to avoid paying federal income tax on the gains they realize from the sale of their stock.
Section 1202 Basics
Section 1202 was enacted in 1993 as an incentive for taxpayers to start or invest in certain businesses. It originally allowed taxpayers to avoid paying capital gains taxes on 50 percent of the gains they received from the sale of qualified small business stock (QSBS). The business had to be structured as a C corporation and meet various other qualifications, and only individual, noncorporate shareholders were eligible for the exclusion.
The exclusion amount grew over the years—to 75 percent in February 2009 and 100 percent in September 2010. Congress made the 100 percent exclusion permanent in 2015; however, the law that was in effect at the time the company issued the stock determines the exclusion amount. Thus, the 100 percent exclusion applies only to qualifying stock issued after Sept. 27, 2010, and stock issued before 1993 is ineligible. Eligible shareholders now include pass through entities such as partnerships and S-Corps.
Qualifications and Limitations
When the TCJA made C corporation status more attractive, interest in Section 1202 grew dramatically. But, in addition to being structured as a C corporation, a business must meet certain additional requirements to qualify for the QSBS exclusion:
- Size limitations. The aggregate gross assets of the corporation from 1993 up to the date of issuance and immediately thereafter cannot exceed $50 million If the company grows beyond $50 million afterward, all original shares are eligible but not subsequent stock issues. This provision has been a boon to early investors in many fast-growing start-ups.
- Eligible industries. The QSBS exclusion is not available to service businesses where the company’s principal asset is the reputation or skill of its employees or owners. The statute specifically rules out service companies in health, law, architecture, engineering, accounting, actuarial science, performing arts, consulting, athletics, and the financial or brokerage industries. It also excludes banking, insurance, financing, leasing, and farming businesses, as well as hotels, motels, restaurants, and companies eligible for oil or gas depletion allowances.
- “Active business” test. The corporation must use at least 80 percent of its assets in the active conduct of its business. Passive “income-generating assets” such as investment real estate and securities cannot each exceed 10 percent of total assets.
The shareholder must also meet certain tests:
- Holding period. A taxpayer must hold the stock for a minimum of five years before selling. When converting a pass-through entity to a C corporation, the five-year requirement begins at the time of incorporation.
- Original issue. The QSBS exclusion applies only to stock originally issued by the company—not stock purchased from other shareholders or in a secondary market. The stock can be acquired for money, property or compensation for services.
The law limits the taxpayer’s excluded gain to either a lifetime limit of $10 million per issuer or an annual limit of 10 times the adjusted basis of the taxpayer’s stock—whichever is greater. Because this applies to each shareholder individually, some business owners have maximized the benefit by choosing to give—not sell—shares of stock to their children. This allows parents and children to benefit from the gain exclusion.
With the potential to reduce or eliminate capital gains taxes on certain stock sales, business owners and investors should familiarize themselves with Section 1202 fundamentals before buying, selling, or incorporating a qualifying business. Unfortunately, for California tax reporting there is no conformity.
Please contact us to learn more about how Section 1202 stock can benefit you.