Section 1202 Offers Attractive Tax Treatment for Capital Gains on Qualified Small Business Stock

By Jyothi Chillara, CPA, Principal

Section 1202 of the Internal Revenue Code is gaining greater interest from shareholders and investors in start-ups and small businesses. It offers favorable tax treatment for capital gains to those holding qualified small business stock (QSBS). A qualified small business (QSB) is an active C corporation with assets of less than $50 million at the point of or immediately after the issuance of stock.

According to IRC Section 1202, QSBS holders may have gains of 50 percent to 100 percent excluded from their tax obligations, depending on the date the stock was acquired. The exclusion is generally limited to either $10 million or 10 times the taxpayer’s basis in the stock, whichever is greater.

The latest amendment to Section 1202 provides for 100% exclusion of capital gains if the acquisition of the QSBS was made after September 27, 2010. The qualifying capital gains also are exempt from the 3.8% net investment income (NII) tax that applies to most investment income.

Previously, Section 1202 was underutilized as a tax strategy because the non-excludable portion of the Section 1202 capital gain was taxed at 28%, much higher than the lower tax rates available for capital gains from the sale of non-qualified business stock. With the change to the 100% gain exclusion for QSBS, the 28% tax rate became a moot issue.

Recently, the Biden administration announced that it is considering raising the long-term capital gains tax rate to 39.6% from 20% for taxpayers with taxable income in excess of $1 million. With the addition of the NII tax of 3.8%, high-net-worth taxpayers would be taxed at a total rate of 43.4%. With the 100% exclusion offered by Section 1202, QSB founders, shareholders and investors could realize considerable federal tax savings. The Biden administration has not proposed making any changes to Section 1202 as it is encouraging small business start-ups to help spur growth in the economy.

Some frequently asked questions about Section 1202 include the following:

Q. What are the requirements for qualified small business stock to qualify for Section 1202 tax exclusion?

To qualify, the QSBS must be:

  • Issued by a domestic C corporation that must meet a $50 million aggregate-assets requirement and an active trade or business requirement. The issuing entity must remain a C corporation for substantially all of the shareholder’s holding period.
  • Issued by a corporation that uses at least 80 percent of its assets (by value) in the active conduct of a qualified trade or business.
  • Acquired on original issuance for money, property (not including stocks), or as compensation for services
  • Held by a natural (non-corporate) taxpayer.
  • Issued after August 10, 1993, and held for more than five years.

Q. What kinds of companies can be considered as qualified small businesses?

Businesses that are considered QSBs include domestic C corporations in the technology, manufacturing, retail and wholesale sectors. Businesses in farming, mining, hospitality, restaurants, personal services and financial services sectors do not qualify. Section 1202 also states that disqualified businesses include “any trade or business involving the performance of services in the fields of health, law, engineering, accounting…where the principal asset of such trade or business is the reputation or skill of one or more of its employees.” 

Q. Should I factor in Section 1202 tax benefits when deciding which legal entity is right for my start-up company?

Many factors should be considered when deciding whether to establish a new business as an S corporation, a C corporation or as a limited liability corporation (LLC). It’s best to consult with your legal and tax advisors to carefully review relevant factors and determine which legal entity is most appropriate for your particular situation.

Q. Should I convert my S corporation (or LLC) to a C corporation so that I can take advantage of Section 1202 tax benefits?

The decision of which type of legal entity is best for your business is a complex one, encompassing many considerations and factors. It’s best to consult with your tax and legal advisors to determine the best path to follow.

Q. What kinds of records should I keep on my QSBS holdings to take advantage of Section 1202?

Supporting documentation is important as evidence that the issued stock meets the requirements of QSBS, especially if an audit should arise in the future. Founders have access to the company balance sheet showing the date and year the stock was issued. Investors should retain records showing the date of the stock issuance and acquisition. The company’s articles of incorporation provide evidence that it is a C corporation.

If you have additional questions about QSBS and Section 1202, or other tax issues, please contact us or call us at (408) 377-8700.