The Section 1202 Small Business Stock Gain Exclusion
Section 1202 of the Internal Revenue Code allows non-corporate taxpayers to exclude from federal income tax 100% of the gain on the sale of certain qualified small business stock (QSBS), limited to the greater of $10 million or 10 times the adjusted basis of the investment. Unlike in prior years, this creates possible opportunities for non-corporate taxpayers who dispose of QSBS in a taxable transaction to potentially exclude the entire gain for federal tax purposes. Assuming all applicable requirements are met, the 0 percent federal income tax rate would apply to gains from sales of QSBS acquired at any time after September 27, 2010.
Before February 18, 2009, this provision of Section 1202 excluded 50% of capital gains from gross income. To stimulate the small business sector, the American Recovery and Reinvestment Act increased the exclusion rate from 50% to 75% for stocks purchased between February 18, 2009 and September 27, 2010. For small business stocks that are eligible for the 50% or 75% exclusion, a portion of the excluded gain is taxed as a preference item that incurs an additional 7% tax called Alternative Minimum Tax (AMT). AMT is usually imposed on individuals or investors who have tax exemptions that allow them to decrease the income tax paid.
The latest amendment to Section 1202 provides for 100% exclusion of any capital gains if the acquisition of the small business stock was after September 27, 2010. Also, the treatment of no portion of the excluded gain is a preference item for AMT purposes. The capital gains that are exempt from tax under this section are also exempt from the 3.8% net investment income (NII) tax applied to most investment income.
Qualified small business stock (QSBS) is the stock—or shares—of a qualified small business (QSB), as defined by the Internal Revenue Code. A qualified small business is an active domestic C Corporation whose gross assets, valued at original cost, do not exceed $50 million on and immediately after its stock issuance.
Several requirements must be satisfied before those benefits can be realized, and even if those requirements are met, there are important limitations on the amount of gain that can qualify for the 0 percent rate. These requirements and limitations are further discussed below.
The general requirements for qualifying for the 0 percent federal tax rate on gains from the sale of QSBS include the following:
The Internal Revenue Code (IRC) Section 1202 defines a qualified small business (QSB), and only certain types of companies are eligible. For example, companies in the hospitality industry, personal services, the financial sector, farming, and mining are not eligible. Those that are eligible include companies in the technology, retail, wholesale, and manufacturing sectors.
Example of Qualified Small Business Stock (QSBS) Taxation
If someone invested $1.5 million in a tech startup on October 1, 2010, and held that investment for five years, they could sell their QSBS for up to $16.5 million (10 x their original investment of $1.5 million) + $1.5 million, without owing capital gains tax. Once they deduct their initial investment, they have a $15 million capital gain, none of which is taxable on their federal income tax.
Similarly, an investor who put $500,000 into the same tech startup would be able to sell their shares for up to $10.5 million ($10 million + $500,000), with no tax on their capital gain of $10 million. However, if the investor’s proceeds from the sale totaled $20 million, a 28% capital gains tax would be applied to the additional $10 million gain.