Like many valuable tax incentives, the requirements to qualify for Section 1202 are complex, and there are pitfalls for the unwary. Scant guidance from the Internal Revenue Service creates challenges for taxpayers navigating the rules.
Requirements to qualify for Section 1202 gain exclusion
Stock must meet eight requirements to qualify for Section 1202 benefits. Some requirements apply to the shareholder, and some apply to the corporation.
Shareholder-level requirements
1. Eligible shareholder: The stock must be held, directly or indirectly, by an eligible shareholder. Eligible shareholders are all non-corporate shareholders, including individuals, trusts, and estates.
2. Holding period: The stock must be held for more than five years before its sale. Generally, the stock’s holding period begins on the date the stock was issued.
3. Original issuance of stock: The taxpayer must have acquired the stock on original issuance after August 10, 1993. Consequently, the stock must be purchased from the company rather than another shareholder.
Corporation-level requirements
4. Eligible corporation: The corporation must be eligible when the stock is issued and during substantially all of the taxpayer’s holding period. An eligible corporation is any domestic C corporation other than certain limited exceptions
5. $50 million gross assets limitation: The corporation must not have had more than $50 million of tax basis in its assets at any time between August 10, 1993, and the date the stock was issued.
6. Redemption transactions: Any “significant” redemptions in the year preceding or following a stock issuance can disqualify the stock from Section 1202.
7. Qualified trade or business requirement: The corporation must be engaged in a “qualified” trade or business. A qualified business is any business that is not one of the following.
- A business involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services
- A business whose principal asset is the reputation or skill of one or more employees
- A banking, insurance, financing, leasing, investing, or similar business
- A farming business (including the raising or harvesting of trees)
- A business involving the production of products for which percentage depletion can be claimed
- A business of operating a hotel, motel, restaurant, or similar business
8. Active business requirement: The corporation must use at least 80% of the fair market value of its assets in the active conduct of a qualified trade or business.
The preceding is a brief overview of Section 1202, the purpose of which is to create awareness, and it does not constitute tax advice. This provision of the tax code has many intricacies and complex requirements. Anyone considering benefiting from this exclusion should seek professional advice.
