Charles R. Kennedy, CPA, MBA
Vice President & Director of Tax Services

Investors who purchase “qualified small business stock” may be eligible for a substantial tax benefit when they sell if the company that issued the stock fits the requirements of Internal Revenue Code (IRC) Section 1202. 

Generally, a non-corporate taxpayer can exclude up to 100% of the gain realized on the sale or exchange of qualified small business stock held for more than five years, to the greater of $10 million or 10 times the investor’s basis.

Stock is not qualified small business stock unless, during substantially all of the taxpayer’s holding period for such stock, the issuing corporation satisfies certain active business requirements. Alternatively, if the stock has been held for less than five years, but for at least six months, the law generally permits a tax-free rollover of the gain on the sale if the proceeds are reinvested within 60 days.

The active business requirements for claiming the Sec. 1202 gain exclusion are crucial for business founders and investors seeking to exclude taxable gain on the sale of stock. Specifically, they include:

• The issuer of Qualified Small Business Stock (QSBS) must be a C corporation both when the QSBS is issued and when it is sold, and it must maintain its C corporation status for substantially all of the taxpayer’s QSBS holding period. An eligible C corporation cannot be a domestic international sales corporation or former domestic international sales corporation; a regulated investment company; a real estate investment trust; a real estate mortgage investment conduit, or a cooperative.
• During substantially all of the taxpayer’s QSBS holding period:

1. • • At least 80% (by value) of the corporation’s assets must be used in the active conduct of a trade or business, for such activities as start-up activities, research and experimentation and in-house research.
     • No more than 10% (by value) of the corporation’s assets can consist of stock or securities in non-subsidiary corporations.
     • No more than 10% (by value) of the corporation’s assets can consist of real estate not used in the active conduct of a trade or business.

The 80% requirement also includes working capital, investments expected to finance research and experimentation or increased working capital within two years. The corporation is treated as using these assets in the active conduct of a qualified trade or business without regard to whether it has any gross income from these activities.

However, after the corporation has existed for two years, no more than half of its assets can be working capital or investments held for future research or working capital.

Portfolio securities, which are stock or securities in a non-subsidiary corporation that are not investments meeting these criteria, cause the corporation to fail the active business test for any period during which they constitute more than 10% of its net worth .

Satisfying these requirements is essential for claiming the Section 1202 gain exclusion. Proper documentation and understanding of Section 1202’s rules are crucial for a successful defense during an IRS audit.

Additional qualifying attributes for corporations

Additional qualifying attributes for C corporations issuing QSBS include:

• The issuing corporation’s aggregate gross assets from inception to the date the stock is issued must be $50 million or less.
• With certain de minimis exceptions, the issuing corporation has not made any repurchases of stock from any of is investors within the two-year period starting one year prior to the date the stock was issued.
• With certain de minimis exceptions, the issuing corporation has not repurchased any stock from the taxpayer claiming the QSBS gain exclusion or related parties within a four-year period starting two years prior to the date the stock was issued.

Businesses excluded from QSBS issuance

For the purposes of Sec. 1202, certain types of businesses are excluded from the definition of “qualified trade or business” and, therefore, are not eligible to issue QSBS. They include such fields as accounting, engineering, consulting, financial services, brokerage services or any other trade or business where the principal asset is the reputation or skill of one or more employees. The rules also exclude businesses engaged in banking, insurance, financing, leasing, investing or similar businesses, farming, mining, oil or gas, and any business operating a hotel, motel, restaurant or similar business.

Additionally, if the issuing corporation owns more than 50% by value or voting power of another corporation, its pro rata share of that corporation’s assets and activities is attributed to the issuing corporation.

A corporation does not meet the qualified active business requirement for any period during which more than 10% of its assets’ total value (not reduced by liabilities) consists of real estate not used in the active conduct of a qualified trade or business. Owning, dealing in, or renting real property is not a qualified trade or business.

A corporation also fails the active business test during any period in which more than 10% of its net worth consists of stock or securities (other than working capital) of a corporation that is not a subsidiary.

There are exceptions to the active business requirement. The requirement is waived for specialized small business investment companies (SSBICs). An SSBIC is any corporation or partnership licensed by the Small Business Administration of the Small Business Investment Act of 1958 as in effect on May 13, 1993.

Sec. 1202 history

Sec. 1202 has been around for a while, having been enacted in 1993 as a tax incentive to drive the investment in and founding of small businesses in the U.S. But with the passage of the Tax Cuts and Jobs Act of 2017 – and its significant reduction of the federal tax rate for C corporations to 21% – the unique rules of Sec. 1202 make the C corporation entity structure more attractive for smaller companies that expect to issue stock to outside investors.

Moreover, the benefits of a Sec. 1202 QSBS investment go beyond the capital gains tax exclusion. An eligible stock sale also qualifies for a corresponding 100% exclusion from the alternative minimum tax (AMT) and a 100% exclusion from the 3.8% net investment income tax (NIIT).

The 100% exclusion applies only to QSBS that was purchased after September 28, 2010, and held for at least five years. Lower percentage exclusion rates (generally 50% or 75%) are available for QSBS issued prior to September 28, 2010. The amount of gain that is not excluded is generally taxed at a rate of 28% and is also subject to the NIIT. The excluded portion of any gain is treated as a preference item for AMT purposes.

Additional benefits

Since the tax incentives associated with QSBS can attract long-term investors, small businesses that issue this type of stock can see their growth and stability strengthened.

QSBS also can be issued in exchange for services, making it a useful tool for compensating employees of startups and other companies short of cash.

How investors qualify for Sec. 1202 treatment

To qualify for Sec. 1202 incentives, the investor must meet several criteria:

• The investor must not be a corporation, but may be an individual or pass-through business entity, including an LLC taxed as a partnership or S corporation.
• The stock must be acquired at its original issue and not on the secondary market.
• The stock must be purchased with cash or property, or accepted as payment for a service.
• The stock must be held for at least five years.
• With limited exceptions, QSBS must be sold by the same party who purchased it.

In summary

The tax benefits of Sec. 1202 are substantial for taxpayers who are interested in long-term investments in emerging companies. For more information about Qualified Small Business Stock, contact your G.T. Reilly advisor.