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.

RELATED TERMS
  1. Tax Preference Item

    Tax preference item is a type of income, normally tax-free, that ...
  2. Tax Base

    A tax base is the amount of assets or income that can be taxed.
  3. Section 1341 Credit

    A tax credit available for taxpayers who are repaid in a later ...
  4. Section 1256 Contract

    Section 1256 Contract is a type of investment defined by the ...
  5. Tax Benefit

    A tax benefit is an allowable deduction on a tax return intended ...
  6. Income Tax

    An income tax is a tax that governments impose on income generated ...
Related Articles
  1. Taxes

    How the GOP Tax Bill Affects You

    Here's how the new tax bill changes the taxes you file in 2018.
  2. Small Business

    Tax Savings Opportunities for Small Businesses

    Small business owners shouldn't overlook these potentially substantial tax incentives.
  3. Taxes

    Capital Gains Tax Cuts For Middle Income Investors

    Find out how TIPRA plans to slash taxes for those in the 10-15% tax bracket.
  4. Taxes

    Are You Missing Out On These Tax Exemptions?

    To lower your tax bill, make sure that you're taking all the exemptions that apply to you.
  5. Financial Advisor

    The Impact of 2015 Tax Extender Bill on Savers

    The passage of the PATH legislation at the end of 2015 gives advisors more clarity on how to help clients with tax and financial planning.
  6. Taxes

    Taxes in California for Small Business: The Basics

    Understand the tax implications of running a small business in California, and learn which state taxes apply based on business type.
  7. Taxes

    The History of Taxes in the U.S.

    America's first citizens enjoyed few to no taxes. Then taxes were added, increased and occasionally repealed to give us our current tax regime.
  8. Managing Wealth

    How Trump Tax Plans Will Aid Wealth Building for the 1%

    President-elect Trump's proposed tax plan includes tax breaks that may offer some generous benefits to higher-income earners.
  9. Taxes

    Taxes in New York for Small Business: The Basics

    Learn how small businesses are taxed in New York, and understand how tax rates vary based on whether the business is an S corporation, LLC or partnership.
Trading Center