IRS Section 1202: Don’t Miss This Tax Exclusion

By Paul West, Managing Partner, CFP^®, CAP^®, CExP

Business owners: do you know that the first $10,000,000 of business sale proceeds could be tax-free? Owing no federal income tax after selling stock may seem far-fetched, but in some instances it’s possible.

IRS Section 1202 allows for a federal income tax gain exclusion – in some instances – from the sale of small business stock. And though there is a wide variety of exclusions and requirements, Section 1202 may be available to an individual stockholder selling qualified small business stock (QSBS) that was acquired after 9/27/2010 and held for more than five years – though additional qualifications and restrictions apply.

• The date of 9/27/2010 is when the 100% exclusion was enacted.
• Stock acquired before 2/18/09 has a 50% exclusion.
• After 2/17/09, but before 9/28/10, the exclusion is 75%.

For the 50% and 75% exclusion sales, 7% of the excluded gain is added back alternative minimum tax (AMT) income. There is no AMT adjusted for the 100% exclusion QSBS.

Qualified Businesses

Also commonly referred to as the Small Business Stock Gains Exclusion, Section 1202 restricts which companies can fall under the umbrella of a qualified business designation.

• The company must be a C corporation within the United States.
• The company’s assets may not exceed $50,000,000 before or after the stock is issued.
• The company cannot be a holding company.
• The company must issue the stock in exchange for certain assets or services provided by the individual.
• The company cannot be in any of the following industries:
  1. • Banking
  2. • Insurance
  3. • Farming
  4. • Financing or Leasing
  5. • Mining
  6. • Hotel or Motel
  7. • Restaurant

As with many income tax breaks, there are a variety of instances in which the above exclusions may or may not apply. Deciphering whether or not your proceeds qualify is best left to the professionals – but it’s such a potentially valuable exclusion that it should be explored if you think there is a chance you might qualify.

Section 1045

Section 1045 transactions allow you to rollover the proceeds from QSBS (held for more than six months) sale into another 1202 stock under a 1045 transaction, which basically keeps the ball rolling and maintains the holding period of the original investment, which is particularly important with the 5-year rule in place for Section 1202 stock.

Looking Ahead for Future Tax Breaks

Small businesses can strategically use Section 1202 as a method for attracting investors who want to reap the biggest benefits down the road. It’s a method for raising capital for the company without fear of capital gains for the investor.

Companies may also consider using stock at start-up to attract and reward key employees.

Do you qualify for Section 1202?

It’s important to note that not all states comply with Section 1202, so plan accordingly.

Section 1202 can be confusing and is subject to a variety of regulations and qualifications. Connect with one of our Exit Planning Specialists to discuss your options in exploring this or other lesser-known exemptions.