Section 1202 of the IR Code & Tax Breaks for Small Businesses

What Is Section 1202?

Section 1202, also called the Small Business Stock Gains Exclusion, is a portion of the Internal Revenue Code (IRC) that allows 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 stock (QSBS) acquired after Sept. 27, 2010, that is held for more than five years.

Key Takeaways

  • Under Section 1202, capital gains from certain small business stocks are excluded from federal tax.
  • This portion of the tax code provides an incentive for non-corporate taxpayers to invest in small businesses.
  • Not all small business stocks qualify, however.
  • The amount of gain excluded under Section 1202 is limited to a maximum of $10 million or 10 times the adjusted basis of the stock.

Understanding 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.

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.

Amendments to Section 1202

Before Feb. 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 Feb. 18, 2009, and Sept. 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 Tas (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 Sept. 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 the greater of $10 million or 10 times the adjusted basis of the stock sold by the taxpayer during the year. The taxable portion of a gain from selling a small business stock has an assessment at the maximum tax rate of 28%.

The exclusion amount varies depending on when the stock was acquired:

  • 50% gain exclusion for QSBS acquired between Aug. 11, 1993, and Feb. 17, 2009
  • 75% gain exclusion for QSBS acquired between Feb. 18, 2009, and Sept. 27, 2010
  • 100% gain exclusion for QSBS acquired on or after Sept. 28, 2010

Requirements of Section 1202

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

  • It was issued by a domestic C-corporation other than a hotel, restaurant, financial institution, real estate company, farm, mining company, or business relating to law, engineering, or architecture.
  • It was originally issued after Aug. 10, 1993, in exchange for money, property not including stocks, or as compensation for a service rendered.
  • On the date of stock issue and immediately after, the issuing corporation had $50 million or less in assets.
  • The use of at least 80% of the corporation’s assets is for the active conduct of one or more qualified businesses.
  • 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.
  • 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.

Example of Section 1202

Consider a taxpayer who acquired qualified small business stock on Jan. 1, 2012, for $200,000. On June 1, 2017, (more than five years later) they sold the stock for $300,000, realizing a $100,000 gain. The taxpayer can exclude 100% of their capital gains, meaning the federal tax due on the gains is $0.

However, if the taxpayer had acquired the stock on February 1, 2009, and sold it for a profit after five years, they could exclude only 50% of their capital gains.

What Is the Section 1202 Exclusion?

Section 1202 allows capital gains from qualified small business stocks to be excluded from federal tax. Among other rules, the stock must be held for at least five years in order to exclude the gains. This special tax treatment is designed to incentivize investors to invest in small businesses.

How Is Section 1202 Stock Taxed?

Section 1202 lets you exclude capital gains from the sale of qualified small business stocks acquired after Sept. 27, 2010, and held for at least five years. The maximum gain that can be excluded is the greater of $10 million or 10 times the adjusted basis of the stock.

Which Businesses Are Excluded From Section 1202?

The Section 1202 exclusion only applies to capital gains from qualified small business stocks of companies engaged in a qualified trade or business (QTB). For the purpose of the exclusion, a QTB does not include a trade or business engaged in in accounting, actuarial science, architecture, athletics, banking, brokerage services, consulting, engineering, farming, financing, health, insurance, investing, law, leasing, performing arts, or any business operating a hotel, motel, restaurant, or similar business.

The Bottom Line

The Section 1202 exclusion is intended to incentivize non-corporate taxpayers to invest in small businesses. While the potential for significant tax savings exists, qualifying for the exclusion can be complicated. It's a good idea to consult with a qualified tax attorney who has a solid understanding of QSBS planning.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a qualified financial and/or tax professional to determine a suitable investment strategy.

Article Sources
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  1. U.S. Code. "26 USC §1202."

  2. U.S. House of Representatives. "Protecting Americans From Tax Hikes Act of 2015," Pages 32-33.

  3. U.S. Congress. "H.R. 1—American Recovery and Reinvestment Act of 2009," Sec. 1241.

  4. Internal Revenue Service. "Instructions for Form 6251 (2020)."

  5. U.S. Congress. "Small Business Jobs Act of 2010," Page 124 Stat. 2555.

  6. Internal Revenue Service. "Topic No. 559 Net Investment Tax."

  7. Internal Revenue Service. "Topic No. 409, Capital Gains and Losses."

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