Article Highlights:
- Gain Exclusion Benefits of Sec 1202 QSBS
- Qualifications for Sec 1202 QSBS
- Limitations of Sec 1202 QSBS
- Holding Period Requirements
- Determining the 5-Year Holding Period
- Investor Exclusion Limits
- Rollover Possibilities
- Active Business Requirement
- AMT Ramifications
- Application to Pass-Through Entities
- Making the Election
- Example of Sec 1202 QSBS Benefits
Investors in small firms can benefit greatly from the Qualified Small Business Stock (QSBS) provision of Internal Revenue Code (IRC) Section 1202. Enacted in 1993, this provision permits non-corporate taxpayers to exclude a part of the gain achieved on the sale of QSBS in an effort to promote investment in small enterprises. This article explores the many facets of Section 1202, such as its advantages, requirements, restrictions, holding periods, investor exclusion limits, rollover potential, requirements for active businesses, implications of the Alternative Minimum Tax (AMT), application to pass-through entities, and the complexities of Form 8949 reporting.
Gain Exclusion Benefits of Sec 1202 QSBS
The main advantage of Sec. 1202 is that, depending on when the stock was issued, it may allow for the exclusion of up to 100% of the gain on the sale of QSBS. Those wishing to invest in small enterprises may find this exception to be an appealing choice because it can drastically lower their tax burden. The following are the exclusion percentages:
- 50% Exclusion: For stock issued after August 10, 1993, and before February 18, 2009.
- 75% Exclusion: For stock issued after February 17, 2009, and before September 28, 2010.
- 100% Exclusion: For stock issued after September 27, 2010.
Qualifications for Sec 1202 QSBS
To qualify for Sec 1202 benefits, the stock must meet several stringent requirements:
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- Eligible Shareholder: The stock must be held by a non-corporate shareholder, such as an individual, trust, or estate. Partnerships and S corporations can also qualify, but additional requirements apply for non-corporate owners of these entities.
- Original Issuance: The stock must be acquired at its original issuance directly from the company, not from another shareholder. This includes stock received as compensation for services or in exchange for non-cash property.
- Qualified Small Business: The issuing corporation must be a C corporation with aggregate gross assets not exceeding $50 million at the time of stock issuance.
- Active Business Requirement: The corporation must use at least 80% of its assets in the active conduct of a qualified trade or business.
Limitations of Sec 1202 QSBS
Despite its benefits, Sec 1202 has several limitations:
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- Investor Exclusion Limits: The exclusion cannot exceed the greater of $10 million or 10 times the taxpayer's adjusted basis in the QSBS.
- State Limitations: Some states do not conform to the federal QSBS exclusion, potentially subjecting the gain to state taxes.
- Excess Buybacks: Excessive buybacks of shares by the issuing corporation can disqualify the stock from QSBS treatment.
Holding Period Requirements
In order for the stock to qualify for the Sec. 1202 exception, it must be held continuously for a duration exceeding five years prior to being sold. Generally speaking, the holding period started on the day the stock was issued. The holding term begins on the exchange date, nevertheless, if the shares was issued in return for non-cash property. The holding period for shares issued as a result of debt conversion, stock option exercise, or warrant exercise starts on the date of conversion or exercise.
For instance, in order to fulfill the five-year holding rule, you must hold QSBS stock until at least June 2, 2024, if you purchased it on June 1, 2019. Any disruptions or lapses in ownership may prevent the stock from satisfying this criterion. The holding period starts on the day the stock is issued.
"Tack on"to the Holding Period
A shareholder may be able to "tack on" prior holding periods in some circumstances in order to fulfill the five-year requirement. This is true whether the stock was obtained through a partnership distribution, inherited, or received as a gift. To satisfy the five-year requirement, a shareholder who inherits QSBS, for instance, only has to hold the stock for an extra two years if the deceased owned it for three years.
Investor Exclusion Limits
The purpose of Section 1202's exclusion limitations is to prohibit undue tax advantages. The exclusion is limited to the higher of ten times the taxpayer's adjusted basis in the QSBS or $10 million. This implies that investors who own a sizable position in the stock could be able to exclude gains exceeding $10 million. Furthermore, investors may be able to take advantage of the exclusion in each year by distributing sales across a number of years.
Rollover Possibilities
Gains may be deferred under Sec. 1202 by rolling over to another QSBS within 60 days. By reinvesting in another eligible small business, investors can postpone taxes and potentially take advantage of future exemptions without having to recognize the gain right away.
Active Business Requirement
The active business condition, which stipulates that at least 80% of the company's assets be employed in the active conduct of a recognized trade or business, must be met by the issuing corporation in order for it to be eligible under Section 1202. Certain types of enterprises are not eligible trades or businesses; they include personal services, financial services, and hospitality.
AMT Ramifications
The Alternative Minimum Tax (AMT) implications of Sec 1202 depend on the QSBS exclusion percentage:
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- 50% and 75% Exclusions: 7% of the excluded gain is treated as a preference item for AMT purposes.
- 100% Exclusion: No AMT preference applies.
Application to Pass-Through Entities
Sec 1202 benefits can extend to pass-through entities like partnerships and S corporations, but specific conditions must be met:
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- The stock must be QSBS in the hands of the partnership or S corporation.
- The partner or shareholder must have been a partner or shareholder from the date the entity acquired the stock through the date of distribution.
- The partner's or shareholder's share of the distributed stock cannot exceed their interest in the entity at the time the stock was acquired.
Claiming the Exclusion
When submitting their tax return for the sale year, an individual can choose to exclude gain from the sale of QSBS by disclosing the sale on IRS Form 8949, Sales and Other Dispositions of Capital Assets. The portion of the gain that does not qualify for the exclusion is not subject to the ordinary favorable long-term capital gains rate. Rather, the excess gain is subject to a 28% maximum tax rate. The full gain is subject to capital gains tax at the standard rate if the QSBS exception is not applicable due to the stock being sold before the mandatory five-year holding period has passed but after the stock has been held for more than a year.
Example of Sec 1202 QSBS Benefits
Think about a buyer who paid $1 million for QSBS in a C company in 2013 and sold it for $15 million in 2023. Subject to the $10 million exclusion cap, the investor can deduct 100% of the $14 million gain from federal taxes since the shares was issued after September 27, 2010, and it was held for more than five years. The exclusion may be as much as $20 million (10 times the basis) if the investor had a greater basis, let's say $2 million.
Investing in small firms can yield significant tax benefits under Sec. 1202 QSBS, as investors may be able to deduct up to 100% of their gains from federal taxes upon selling their shares. To effectively navigate the intricacies of Section 1202, one must possess a comprehensive comprehension of its advantages, prerequisites, constraints, retention durations, and documentation obligations. Through adherence to the strict requirements and utilization of tactical planning prospects, investors may optimize the tax benefits associated with QSBS and bolster the expansion of small enterprises.
For further information or help taking advantage of this tax incentive, get in touch with this office.
