Article Highlights: Sec1202 - Qualified Small Business Stock (QSBS) Exclusion Periods & Exclusion Percentages Maximum Exclusions Strategies Shareholder Qualifications Corporate Level Requirements Retaining QSBS Status Employee Benefits State Taxation Conversions of an Existing Business Rollovers IRC Sec 1202, Qualified Small Business Stock (QSBS) gain exclusion, provides a significant tax planning strategy. Sec 1202 was enacted in 1993 to encourage investment in small businesses. It allows individuals to avoid paying taxes on up to 100% of the taxable gain recognized on the sale of qualified small business stock (QSBS) of a C corporation. Whether a new business, or rethinking your existing business structure, Sec 1202 could be right for you. While this tax strategy is designed to be a benefit to small business owners, some larger businesses can qualify. The benefits of Sec 1202 are a permanent exclusion of gain rather than a deferral of gain like many other tax benefits. However, qualifying as QSBS can be complex so it’s important to seek professional assistance. The following is only an overview of the qualifications for this tax benefit. When Section 1202 was originally enacted it allowed 50% of the gain from selling QSBS to be excluded. It was not initially popular, and the exclusion was increased to 75% and then later to 100%. Thus, there are three time periods when the qualifying stock is purchased with the corresponding gain exclusions as illustrated in the following table: Stock Issued Sec 1202 Exclusion Beginning Date Ending Date Percentage 8/11/1993 2/18/2009 50% 2/19/2009 9/27/2010 75% 9/28/2010 Continuing 100% So, individuals acquiring QSBS qualified small business stock September 28, 2010, or later that was originally issued after August 10, 1993, can avoid paying taxes on up to 100% of the taxable gain recognized on the sale of the QSBS. And even though it’s framed as a small business tax incentive, a business can be quite large and still qualify as a “small business” for this purpose. If the QSBS was acquired after September 27, 2010, the qualified stockholder could permanently exclude up to $10 million of the gain on sale of the stock or 10 timestheir aggregate adjusted basis of the QSBS. Example: Assuming an exclusion of $10 million and based on a 23.8% federal tax rate (made up of the 20% capital gains tax rate plus the 3.8% net investment income tax) and a 6% assumed state income tax rate, a qualifying stockholder could potentially save $2.98 million ($10 million x 29.8%) in federal and state taxes. Of course, this is true only if the stockholder’s state also permits the gain to be excluded. For stock issued after August 10, 1993 and acquired between 1993 and 2010, the amount of gain that avoids taxation can be 50% or 75%, depending on when the stock was acquired. Maximum Exclusion for QSBS Acquired After Sept 27, 2010 (100% Exclusion) For stock issued after Aug. 10, 1993 and acquired after September 27, 2010, the gain exclusion is the greater of: 10 million - The $10 million is a cumulative limitation and is reduced by the amount of eligible gain excluded in previous sales of QSBS with respect to each corporation. 10X basis limitation - The 10X basis limitation allows a taxpayer to exclude up to 10 times their basis of the QSBS sold in a given tax year, regardless of the number of QSBS sales or the amount of gain the taxpayer previously excluded. Example: A QSBS holder, Sebastian, was originally issued the stock on January 15, 2016, in exchange for a cash payment of $3 million. Sebastian subsequently sold the stock on October 10, 2023, for $23 million, resulting is a $20 million gain. Since the stock is QSBS under Sec 1202, Sebastian can exclude the greater of $10 million or 10 times his initial basis of $3 million or $30 million (10 x $3 million). Thus, Sebastian can exclude the entire $20 million gain, paying no federal tax on the gain. Strategies – There are strategies based upon the circumstances of each sale that require careful consideration when applying either the $10M cumulative exclusion limitation or the 10X basis limitation. Basis Limitation Can Exceed $10M Cumulative Exclusion – A taxpayer who has a large basis in QSBS should consider the benefit of their QSBS basis when planning a sale. Using the 10X basis limitation on a sale of QSBS with high basis may provide a gain exclusion that exceeds the amount available under the cumulative limitation. The basis of any QSBS the taxpayer still owns or sold in previous years is not considered. This is significant when some shares have greater basis than others or are sold over time. Sales Over 2 or More Years – Taxpayers can use the $10M cumulative exclusion in year one and the 10X basis limitation in subsequent years. Or as an alternative, use the $10M cumulative exclusion on the sale of shares with a lower basis and the 10X basis limitation on higher-basis shares. Computing the Exclusion for QSBS Subject to the 50% or 75% Exclusion For QSBS stock subject to the50% and 75% exclusions, first, the $10 million cumulative limitation or the 10X basis limitation is applied to determine the amount of eligible gain resulting from the sale. Next, the actual amount of gain excludable is determined by multiplying that eligible gain by the appropriate 50% or 75% limitation. Seven percent of the 50% or 75% excluded Sec 1202 gain is treated as a tax preference for alternative minimum tax purposes. However, for dispositions of qualified Sec 1202 stock issued after September 27, 2010, and held for over 5 years, the excluded gain (100%) does not count as a preference item. (Code Sec. 1202(a)(4)) Requirements to Qualify for Section 1202 Gain Exclusion Stock must meet eight requirements to qualify for Section 1202 benefits. Following is an overview of each of these requirements. A. Shareholder-level Requirements 1. Eligible Shareholder - The stock must be held, directly or indirectly, by an eligible shareholder. Eligible shareholders are non-corporate shareholders including individuals, trusts, and estates. Suppose the shareholder is a partnership or S corporation. In that case, the gain may still qualify, but there are additional requirements that must be met for non-corporate owners of the pass-through entity to claim the benefits of Section 1202. Only U.S. taxpayers qualify for the Sec 1202 benefits. 2. Holding Period - The stock must be held for more than five years before it’s disposed. Generally, the holding period of the stock begins on the date the stock was issued. Suppose stock was issued in exchange for non-cash property. In that case, the Section 1202 holding period still begins on the exchange date even if the holding period for general tax purposes carries over. If the stock is issued from the conversion of debt or the exercise of stock options or warrants, the holding period doesn’t begin until the conversion or exercise. Additionally, some hedging transactions can disqualify stock from Section 1202 treatment. In determining whether a shareholder has met the five-year requirement, a shareholder can “tack on” previous holding periods if the stock was inherited, received as a gift, in a distribution from a partnership, or in certain stock conversions or exchange. 3. Original issuance of stock - The taxpayer must have acquired the stock on original issuance after Aug. 10, 1993. Consequently, the stock must be purchased from the company, rather than another shareholder. However, the stock doesn’t have to be issued as a part of the initial incorporation. Stock received as compensation for services provided to the corporation meets this requirement (see more on this later). However, stock that’s received in exchange for other stock can sometimes qualify, although it’s subject to additional requirements. In certain situations, stock can be treated as having been received at original issuance even when the shareholder is not the original owner of the shares. When stock is received via a gift, at death, or as a distribution from a partnership, the stock is treated as having been received by the transferee in the same manner as the transferor. Thus, if the stock was acquired by the transferor at original issuance, the transferee will be treated as having done the same. In other words, the holding period of the original owner is tacked on to the subsequent owner. For stock distributed from a partnership to a partner, to meet the definition of QSB stock in the hands of the partner: (1) the stock must have been QSB stock in the partnership's hands (ignoring the five-year holding period requirement), (2) the partner must have been a partner from the date the partnership acquired the stock through the date of the distribution, and (3) the partner cannot treat stock the partnership distributed as QSB stock to the extent the partner's share of the distributed stock exceeds the partner's interest in the partnership at the time the partnership acquired the stock.