If you’ve invested in a small business and sold the stock after holding it for more than five years, you may be able to exclude a percentage of your gain under Internal Revenue Code (IRC) Section 1202. This federal tax benefit can provide investors with significant tax savings, resulting in potentially up to 100% of the gain being excluded.
But first, you must qualify. You own qualified small business stock if you meet all of the following requirements:
- The stock must be issued by a domestic C Corporation with no more than $50 million of adjusted basis in gross assets up to the time of issuance and immediately after;
- The stock must be issued by a corporation that uses at least 80% of its assets (by value) in an active trade or business, other than in certain personal service corporations and certain other excluded activities;
- You must have purchased the issued stock after August 10, 1993;
- You must be a non-corporate taxpayer;
- You must have acquired the stock in original issuance or acquired it in a certain nontaxable transfer such as a gift or inheritance of original issuance stock; and
- You have held the stock for more than five years.
If you qualify, you may take advantage of the 1202 exclusion but should be aware that there are specific parameters and limitations:
- In general, you may be able to exclude different amounts of the gain depending on when you acquired the stock:
- 50% if acquired before February 18, 2009
- 75% if acquired from February 18, 2009 through September 27, 2010
- 100% if acquired after September 27, 2010. (The Protecting Americans from Tax Hikes or PATH Act passed in December 2015 made permanent the 100% exclusion of gain on the sale or exchange of qualified small business stock.)
- The eligible gain is limited to the greater of $10 million ($5 million married filing separately) or 10 times your tax basis in the stock.
- Taxpayers may NOT take both the Section 1202 gain exclusion and the benefits of lower capital gains rates (15% and 20%) currently available. If you choose to take the exclusion on a portion of the gain from the sale of your qualified small business stock, the remaining taxable portion of the gain is subject to a capital gain tax rate of 28%. For higher-earning taxpayers, the non-excluded portion also could be subject to the Net Investment Income tax, adding on another 3.8% of tax.
- There could be state tax ramifications of this exclusion. Not all states, such as California for example, follow the rules of Section 1202 so the gain may be taxable to your state of residence.
Let’s look at an example to help illustrate how Section 1202 works. An individual taxpayer purchases 10,000 shares of original issuance common stock in an active domestic C Corporation with less than $50 million of adjusted basis in gross assets on May 30, 2000. She purchases the stock for $1 per share, or $10,000 in total investment. In 2016, the taxpayer's shares were sold for $2 per share, or $20,000 total.
- Does the taxpayer meet the requirements of owning qualified small business stock? Yes. Her gain would be eligible for the 50% capital gain exclusion because the stock was purchased with an original issuance date before February 18, 2009.
- How much can the taxpayer exclude? This taxpayer is eligible to exclude $5,000 of the gain [($20,000-$10,000) x 50%]. Note: The exclusion amount is limited to the greater of $10 million dollars or 10 times the basis of the taxpayer's stock, which in this case is $100,000. As a result, the taxpayer is eligible to exclude the full $5,000 of the $10,000 gain.
- What does the taxpayer owe on the remaining $5,000 not excluded from the gain? The remaining $5,000 is taxed at the top capital gain tax rate of 28% instead of the more favorable 15% or 20% tax rates. This taxpayer will owe tax of $1,400 ($5,000 x 28%) on this transaction.
Overall, the taxpayer paid an effective federal tax rate of 14%. This is obviously a basic example. The larger the gain, the larger the potential savings. And if certain facts slightly change, such as if the taxpayer purchased the stock on December 1, 2010, in the same scenario she would be able to exclude the full 100% of the gain from her taxable income.
Section 1202 is a significant federal tax benefit that anyone investing in small businesses should consider.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.