There’s a lesser known and often under-utilized part of the Internal Revenue Code, Section 1202, that can offer a significant tax break for non-corporate taxpayers.
Known as the Small Business Stock Gain Exclusion, Section 1202 allows an exemption from federal tax for capital gains from certain small business stocks. It is important to note that the exclusion only applies to qualified small business stock purchased after Sept. 27, 2010 and held for at least five years.
Passed by Congress in 2015 as part of the Protecting Americans from Tax Hikes (PATH Act), Section 1202 was designed as an incentive for non-corporate taxpayers to invest in qualifying small businesses. The maximum exemption is capped at $10 million, or 10 times the adjusted basis of the stock.
To see the benefit of the Small Business Stock Gain Exclusion, take a single person earning $410,000 in taxable income. After five years they sell the stock they acquired in February 2009 and earn $50,000 in profit. In that instance, the taxpayer would have to pay a federal capital gains tax of 28 percent, or $7,000. Now, under the provisions of Section 1202, if they sell the same qualified small business stock they purchased on Sept. 30, 2010, they pay no capital gains tax.
The Obama administration made the tax break permanent in Section 1202 of the IRS code in 2015.
As stated by the IRS, only certain small business stocks are qualified for the exemption. To meet the Code’s definition, these are the requirements:
- the stock had to be 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
- the stock was originally issued after August 10, 1993, in exchange for money, property not including stocks, or as compensation for a service rendered
on the date of stock issue 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 stock from the taxpayer during a four-year period beginning two years before the issue date
- 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.
As with all financial matters, it is strongly advised that you consult a professional tax advisor to review your stock holdings to see if Sec. 1202 rules are applicable to any stocks in your portfolio. Our highly trained staff are happy to help.