Article Highlights:
- Gain Exclusion Benefits of Sec 1202 QSBS
- Qualifications for Sec 1202 QSBS
- Limitations of Sec 1202 QSBS
- Holding Period Requirements
- Determining the 5-Year Holding Period
- Investor Exclusion Limits
- Rollover Possibilities
- Active Business Requirement
- AMT Ramifications
- Application to Pass-Through Entities
- Making the Election
- Example of Sec 1202 QSBS Benefits
The Internal Revenue Code (IRC) Section 1202, often referred to as the Qualified Small Business Stock (QSBS) provision, offers a significant tax incentive for investors in small businesses. Enacted in 1993, this provision aims to stimulate investment in small businesses by allowing non-corporate taxpayers to exclude a portion of the gain realized on the sale of QSBS. This article delves into the myriad aspects of Sec 1202, including its benefits, qualifications, limitations, holding periods, investor exclusion limits, rollover possibilities, active business requirements, Alternative Minimum Tax (AMT) ramifications, and application to pass-through entities, and the intricacies of Form 8949 reporting.
- Gain Exclusion Benefits of Sec 1202 QSBS – The primary benefit of Sec 1202 is the potential to exclude up to 100% of the gain from the sale of QSBS, depending on when the stock was issued. This exclusion can significantly reduce the tax burden on investors, making it an attractive option for those looking to invest in small businesses. The exclusion percentages are as follows:
- 50% Exclusion: For stock issued after August 10, 1993, and before February 18, 2009.
- 75% Exclusion: For stock issued after February 17, 2009, and before September 28, 2010.
- 100% Exclusion: For stock issued after September 27, 2010.
- Qualifications for Sec 1202 QSBS – To qualify for Sec 1202 benefits, the stock must meet several stringent requirements:
- Eligible Shareholder: The stock must be held by a non-corporate shareholder, such as an individual, trust, or estate. Partnerships and S corporations can also qualify, but additional requirements apply for non-corporate owners of these entities.
- Original Issuance: The stock must be acquired at its original issuance directly from the company, not from another shareholder. This includes stock received as compensation for services or in exchange for non-cash property.
- Qualified Small Business: The issuing corporation must be a C corporation with aggregate gross assets not exceeding $50 million at the time of stock issuance.
- Active Business Requirement: The corporation must use at least 80% of its assets in the active conduct of a qualified trade or business.
- Limitations of Sec 1202 QSBS – Despite its benefits, Sec 1202 has several limitations:
- Investor Exclusion Limits: The exclusion cannot exceed the greater of $10 million or 10 times the taxpayer’s adjusted basis in the QSBS.
- State Limitations: Some states do not conform to the federal QSBS exclusion, potentially subjecting the gain to state taxes.
- Excess Buybacks: Excessive buybacks of shares by the issuing corporation can disqualify the stock from QSBS treatment.
- Holding Period Requirements – To benefit from the Sec 1202 exclusion, the stock must be held for an uninterrupted period of more than five years before it is disposed of. The holding period generally begins on the date the stock was issued. However, if the stock was issued in exchange for non-cash property, the holding period starts on the exchange date. For stock issued from the conversion of debt or the exercise of stock options or warrants, the holding period begins at the conversion or exercise date.
For example, if you acquired QSBS on June 1, 2019, you will need to hold the stock until at least June 2, 2024, to meet the five-year holding requirement. The holding period begins on the date the stock was issued, and any interruptions or breaks in ownership could disqualify the stock from meeting this requirement.
- “Tack on” to the Holding Period – In certain situations, a shareholder can “tack on” previous holding periods to meet the five-year requirement. This applies if the stock was inherited, received as a gift, or acquired in a distribution from a partnership. For example, if a shareholder inherits QSBS from a decedent who held the stock for three years, the heir only needs to hold the stock for an additional two years to meet the five-year requirement.
- Investor Exclusion Limits – The exclusion limits under Sec 1202 are designed to prevent excessive tax benefits. The exclusion is capped at the greater of $10 million or 10 times the taxpayer’s adjusted basis in the QSBS. This means that investors with a large basis in the stock may be able to exclude more than $10 million of gain. Additionally, spreading sales over multiple years can allow investors to utilize the exclusion in each year.
- Rollover Possibilities – Sec 1202 allows for the deferral of gain through a rollover to another QSBS within 60 days. This provision enables investors to reinvest in another qualified small business without immediately recognizing the gain, thereby deferring taxes and potentially benefiting from future exclusions.
- Active Business Requirement – To qualify for Sec 1202, the issuing corporation must meet the active business requirement, which mandates that at least 80% of the corporation’s assets be used in the active conduct of a qualified trade or business. Certain businesses, such as those involved in personal services, financial services, and hospitality, are excluded from being considered qualified trades or businesses.
- AMT Ramifications – The Alternative Minimum Tax (AMT) implications of Sec 1202 depend on the QSBS exclusion percentage:
- 50% and 75% Exclusions: 7% of the excluded gain is treated as a preference item for AMT purposes.
- 100% Exclusion: No AMT preference applies.
- Application to Pass-Through Entities – Sec 1202 benefits can extend to pass-through entities like partnerships and S corporations, but specific conditions must be met:
- The stock must be QSBS in the hands of the partnership or S corporation.
- The partner or shareholder must have been a partner or shareholder from the date the entity acquired the stock through the date of distribution.
- The partner’s or shareholder’s share of the distributed stock cannot exceed their interest in the entity at the time the stock was acquired.
- Claiming the Exclusion – An individual elects to exclude gain from the sale of QSBS by reporting the sale on IRS Form 8949, Sales and Other Dispositions of Capital Assets, when filing their tax return for the sale year. If not all of the gain qualifies for the exclusion, the remaining gain is not eligible for the regular advantageous long-term capital gains rate. Instead, the excess gain is taxed at a maximum rate of 28%. Should the QSBS exclusion not apply because the stock is sold after being held more than one year but before meeting the required five-year holding period, the entire gain qualifies to be taxed at the regular capital gains rate.
- Example of Sec 1202 QSBS Benefits
Consider an investor who acquired QSBS in a C corporation for $1 million in 2013 and sold it for $15 million in 2023. Since the stock was held for more than five years and issued after September 27, 2010, the investor can exclude 100% of the $14 million gain from federal taxes, subject to the $10 million exclusion limit. If the investor’s basis was higher, say $2 million, the exclusion could be up to $20 million (10 times the basis).
Sec 1202 QSBS offers a powerful tax incentive for investing in small businesses, with the potential to exclude up to 100% of the gain from federal taxes when the stock is sold. However, navigating the complexities of Sec 1202 requires a thorough understanding of its benefits, qualifications, limitations, holding periods, and reporting requirements. By meeting the stringent criteria and leveraging strategic planning opportunities, investors can maximize the tax advantages of QSBS and support the growth of small businesses.
Contact this office for additional information or assistance benefiting from this tax incentive.
If you have any questions, please contact our office at (503) 224-5321. Isler Northwest LLC is a firm of business advisors and CPAs in Portland, Oregon. Our service goal at Isler Northwest is to earn our clients’ trust as their primary business and financial advisor.
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