Section 1202

DEFINITION of 'Section 1202'

A section of the Internal Revenue Code which provides for capital gain from select small business stock to be excluded from federal tax. Section 1202 of the Internal Revenue Code (IRC) only applies to qualified small business (QSB) stock that has been held for more than five years.

Also called the Small Business Stock Gains Exclusion.

BREAKING DOWN 'Section 1202'

The Protecting Americans from Tax Hikes (PATH) Act of 2015 was passed by Congress and signed into law by President Barack Obama. The PATH Act was introduced to renew some expired tax provisions for a couple more years and to permanently extend some tax benefits. One of the tax breaks that was made permanent by the Obama administration is the Small Business Stock Gains Exclusion found in Section 1202 of the Internal Revenue Code (IRC).

Section 1202 provides an incentive for non-corporate taxpayers to invest in small businesses. The capital gains exemption from federal income tax on the sale of small business stock is the underlying purpose of this IRC section. A small business stock that has been held for at least five years before it is sold will have a portion or all of its realized gains excluded from federal tax. The provision of Section 1202 prior to February 18, 2009 excluded 50% of capital gains from gross income. In order to stimulate the small business sector, the 2009 Stimulus Act increased the exclusion rate from 50% to 75% for stocks purchased from February 18, 2009 to September 27, 2010. For small business stocks that are eligible for the 50% or 75% exclusion, a portion of the excluded gain is treated as a preference item which incurs an additional 7% tax called Alternative Minimum Tax (AMT). AMT is normally 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% of any capital gain to be excluded if the small business stock was acquired after September 27, 2010. In addition, no portion of the excluded gain is treated as a preference item for AMT purposes. Capital gain that is exempt from tax under this section is also exempt from the 3.8% net investment income (NII) tax that is applied to most investment income. The amount of gain that any investor can exclude under Section 1202 is limited to a maximum of the greater of $10 million or 10 times the adjusted basis of the stock. The taxable part of a gain from selling a small business stock is taxed at a maximum rate of 28%. Consider a taxpayer who is single and has $410,000 in ordinary taxable income which places him in the highest tax bracket. He sells qualified small business stock that he acquired on September 30, 2010 and realized a profit of $50,000. He can exclude 100% of his capital gains which means the federal tax due on his gain is $0. Assuming he purchased the stock on February 10, 2009 and after 5 years, sells it for a $50,000 profit. His federal tax due on capital gains would be 28% x (50% x 50,000) = $7,000.

However, not all small business stocks are qualified for tax breaks under the IRC which defines a small business stock as qualified if:

  1. Issued by a domestic C-corporation other than hotels, restaurants, financial institutions, real estate companies, farms, mining companies, and businesses relating to law, engineering, or architecture
  2. Originally issued after August 10, 1993 in exchange for money, property not including stocks, or as compensation for a service rendered
  3. The issuing corporation had $50 million or less in assets on the date the stock was issued and immediately after
  4. At least 80% of the corporation’s assets are used in the active conduct of one or more qualified businesses. Number 1 above lists a number of qualified businesses
  5. The issuing corporation does not purchase any of the stock from the taxpayer during a four-year period beginning two years before the issue date
  6. The issuing corporation does not significantly redeem its stock within a two-year period beginning one year before the issue date. A significant stock redemption is defined as redeeming an aggregate value of stocks that exceed 5% of the total value of the company’s stock

State taxes that conform to federal tax will also exclude capital gains of small business stock. Since not all states correlate with federal tax directives, taxpayers should seek guidance from their accountants on how their states treat realized gains from the sale of qualified small business stocks.