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Gains on the Sale of Small Business Stock (Section 1202)

In order to stimulate investment in small businesses, the 1993 tax law introduced code section 1202, which says that you may exclude from taxable income up to 50 percent of the gain you realize on the sale of qualified small business stock.

In order to qualify for the exclusion, you must meet these criteria:

  • You are not a corporation.
  • You acquired the stock from a C corporation after August 10, 1993, in an original issue, in exchange for money or other property, or issued as compensation for services that were provided to the corporation.
  • On the date the stock is issued, the corporation was a qualified small business.
  • During substantially all the time the stock is held, the business meets the active business requirements of section 1202 (c). This requirement will be waived if the corporation qualifies as a "specialized small business investment company".
  • At all times after August 10, 1993, or after the inception of the company if later, and immediately after the issuance, the corporation's gross assets do not exceed $50 million.
  • At least 80 percent of the assets of the corporation are used by the corporation in the conduct of one or more qualified trades or businesses. A qualified business means any trade or business other than:
    any trade or business involving the performance of personal services in specified fields such as accounting, law, or medicine;
    any business involved in banking, financing, leasing, insurance, or similar businesses;
    any farming business;
    any business operating a hotel, motel, restaurant, or similar business;
    any business to which a deduction for depletion is allowed.
  • The corporation must be an eligible C corporation, which precludes a number of specialized corporations such as REITs, REMICs, DISCs, and cooperatives.
  • The corporation must not have purchased stock from you within two years before or after issuing stock to you. It cannot have purchased stock of greater than 5 percent of total stock outstanding from anyone within 1 year before or after issuing stock to you.
  • If the corporation is an Empowerment Zone Business the exclusion is increased to 60 percent.

Limits on the Amount of Gain You Can Exclude

For any corporation's stock, the maximum gain eligible for exclusion in any one year is $10 million less any gains excluded in previous years. Therefore, the maximum lifetime exclusion for any one issuer's stock is $5 million, 50% of $10 million ($6 million if the corporation is an Empowerment Zone Business).

In addition, you are limited to a gain that is not more than 10 times the adjusted basis of the stock.

The nonexcluded portion of the gain on sale is subject to tax at 28 percent (resulting in an effective rate of 14 percent (50% x 28%)) on the entire gain.

Also, 7 percent of the excluded gain is a preference item for purposes of calculating alternative minimum tax (AMT). A preference item is an item of income that is added back to your regular income for purposes of computing the alternative minimum tax, a parallel taxing system designed to make sure that higher income taxpayers pay at least a minimum amount of tax.

As you can see, there are a number of hurdles to overcome in order to exclude the gain. However if you think you may qualify, or want to structure your investment to make sure you qualify, you should consult a professional advisor with expertise in this area.

By Intuit Inc.

 

 
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