Do You Qualify To Sell Your Business Tax-Free?
Section 1202 of the Internal Revenue Code (IRC), also called the Small Business Stock Gains Exclusion, 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 acquired after September 27, 2010, held for more than five years.
Key Takeaways
- Under Section 1202, capital gains from select small business stocks are excluded from federal tax.
- It 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 ten times the stock's adjusted basis.
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 IRC section's underlying purpose. 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.
Special Considerations
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.
The latest amendment to Section 1202 provides for 100% exclusion of any capital gains if the small business stock acquisition 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 exempt from tax under this section are also exempt from the 3.8% net investment income (NII) tax applied to most investment income.
The Section 1202 gain exclusion is limited to the greater of $10 million or ten times the stock's adjusted basis.
Requirements of Section 1202
Not all small businesses are qualified for tax breaks under Section 1202. 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, a mining company, or business relating to law, engineering, or architecture.
- It was originally issued after August 10, 1993, in exchange for money, property not including stocks, or as compensation for a service rendered.
- On the stock issuance date 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 taxpayer's stock during the four years beginning two years before the issue date.
- The issuing corporation does not significantly redeem its stock within two years, beginning one year before its issuance. A significant stock redemption is any redemption that exceeds 5% of the total value of the company.
State taxes that conform to federal tax will also exclude capital gains of small business stock.
Chapman Associates does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction.
