What is 'Section 1202'

Section 1202, also called the Small Business Stock Gains Exclusion, is a portion of the Internal Revenue Code (IRC) that provides for capital gains from select small business stock to be excluded from federal tax. Section 1202 of the IRS Code only applies to qualified small business (QSB) stock acquired after September 27, 2010, that is held for more than five years.

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 renews some expired tax provisions for a couple of years and permanently extends some tax benefits. One tax break, made permanent by the Obama administration, is the Small Business Stock Capital 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 held for at least five years before selling will have a portion or all of its realized gains excluded from federal tax.

Section 1202 Capital Gains Exclusions

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. 

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 portion of a gain from selling a small business stock has an assessment at the maximum tax rate of 28%.

Consider a taxpayer who is single and has $410,000 in ordinary taxable income. This income places him in the highest tax bracket. He sells qualified small business stock acquired on September 30, 2010, and has a realized profit of $50,000. The taxpayer may exclude 100% of his capital gains, meaning the federal tax due on the gains is $0. Assume the taxpayer purchased the stock on February 10, 2009, and after five years sells it for a $50,000 profit. Federal tax due on capital gains would be 28% x (50% x 50,000) = $7,000.

Definition of a Qualified Small Business

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

  1. It was issued by a domestic C-corporation other than a hotel, restaurant, financial institution, real estate company, farm, a mining company, or business relating to law, engineering, or architecture.

  2. It was originally issued after August 10, 1993, in exchange for money, property not including stocks, or as compensation for a service rendered
  3. On the date of stock issue and immediately after, the issuing corporation had $50 million or less in assets.
  4. The use of at least 80% of the corporation’s assets is for the active conduct of one or more qualified businesses. Number 1 above lists some eligible companies.
  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 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 profits from the sale of qualified small business stocks.

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