The qualified small business stock (QSBS) gains exclusion under Section 1202 of the tax code allows capital gains from specific holdings to be exempt from federal tax.
This has been an excellent opportunity for many years. Enacted in 1993, the Section 1202 exclusion was developed to encourage small business investment and expansion. The gain exclusion applies to the greater of $10 million or ten times the aggregate adjusted basis of the stock at the time of the issuance and is available for stock issued after August 10, 1993.
The amount of the exclusion has increased since its enactment. It now applies to 100% of stock issued after September 27, 2010 — creating an effective federal tax savings of up to 23.8% under current law. Any changes that increase the federal long-term capital gain tax rate will make investing in QSBS all the more attractive.
How does it work:
- The qualified small business must be incorporated as a domestic C corporation.
- The gross assets of the company must be no greater than $50 million in value at original issuance.
- The originally issued stock must be held for a minimum of five years in order to meet the exclusion.
- The business must have at least 80% of its activity as qualifying activity.
- The stock must be in a qualified industry — the code specifically excludes certain industries including some service businesses (accountants, doctors, attorneys), financial companies, energy production, farming, athletes and hospitality. Any person whose business is based on their reputation or skill will not qualify.
Exclusion Percentage:
The amount of the exclusion has increased since the enactment:
- 50% Exclusion – stock issuance before February 18, 2009
- 75% Exclusion – stock issuance before February 18, 2009 to September 27, 2010
- 100% Exclusion – stock issuance after September 27, 2010
Frequently asked questions:
Q: Are you able to hold an interest through a pass-through entity:
A: Yes, so long as the ultimate investor was in the pass-thru at the date of the original issuance and they are a qualifying investor: individual, trust or pass-through entity
- The gain allocated to the investor must be consistent with the % at original issue
Q: Do options qualify?
A: You must hold actual stock in the company, not options/convertible notes.
- Option holding period for ISOs is the date of exercise, RSUs is date of vesting if an 83b election was not made, and the date of election if it was made
Q: Is there an ability to rollover?
A: If you sell before the 5 year holding period is met you will be able to utilize a rollover opportunity under section 1045 if the proceeds from the sale of QSBS that was held for at least 6 months is rolled into a newly acquired QSBS within 45 days
Q: Will a trust with multiple beneficiaries qualify for multiple exclusions?
A: If nothing is done, the trust will qualify for one exclusion – the greater of ten times the adjusted basis or $10,000,000.
Solution: If state law permits, you can decant the present trust and form separate trusts for each beneficiary. The stock is now allocated proportionately to each new trust. Holding period and section 1202 eligibility does not change. You now have multiple 1202 exclusions.
If you believe your new or existing business would benefi t from the Section 1202 exclusion, please get in touch with our team to discuss.