IRC Section 1202: Why Qualified Small-Business Stock Should Be on Your Radar

Qualified small-business stock (QSB stock) under Internal Revenue Code (IRC) Section 1202, also called the Small Business Stock Gains Exclusion, is an often-missed and material tax-savings benefit available to noncorporate shareholders of C corporations. Section 1202 allows capital gains from select C corporation QSB stock to be excluded from federal income tax. The 100% exclusion under Section 1202 applies to QSB stock acquired after Sept. 27, 2010, and that is held for more than five years. The amount of gain excluded by each shareholder under Section 1202 is limited to a maximum of $10 million or, if higher, 10 times the adjusted basis of such stock.

Section 1202 sets specific parameters to QSB stock as follows:

• On the date the stock was issued, and immediately thereafter, the issuing corporation had $50 million or less in assets and did not purchase any of the stock from the taxpayer during a four-year period beginning two years before the issue date and did not redeem 5% of its stock within a two-year period beginning one year before the issue date.
• The stock was issued by a domestic U.S. corporation engaged in a “qualified trade or business.” This would exclude businesses such as hotels, restaurants, financial investing or banking institutions, insurance operations, real estate companies, leasing, farming, or mining companies, or businesses relating to law, accounting, engineering, architecture, performing arts, or health. The use of at least 80% of the corporation’s assets must be for the active conduct of one or more qualified businesses.
• The stock must originally have been issued after Aug. 10, 1993, in exchange for money, property not including stocks, or as compensation for a service rendered.

Furthermore, the Section 1202 gain exclusion amounts vary, depending on when the stock was acquired:

• A 50% gain exclusion for stock acquired between Aug. 11, 1993, and Feb. 17, 2009 (50% exclusion).
• A 75% gain exclusion for stock acquired between Feb. 18, 2009, and Sept. 27, 2010 (75% exclusion).
• A 100% gain exclusion for stock acquired on or after Sept. 28, 2010.

State taxes that conform to the federal tax will also exclude capital gains of small business stock.

For QSB stock that is eligible for the 50% or 75% exclusion, a portion of the excluded gain may be taxed as a preference item that incurs an additional 7% tax via the Alternative Minimum Tax (AMT).

The 100%, or full, exclusion supercharges the income tax savings by providing for a 100% exclusion of any capital gains for small business stock acquired after Sept. 27, 2010. Also, no portion of the excluded gain is a preference item for AMT purposes, and the gains are also exempt from the 3.8% net investment income tax applied to most investment income.

Stacking

Under various provisions of Section 1202, a shareholder can generate additional exclusions in excess of the $10 million exclusion cap by making certain tax-free transfers or gift transfers to family members and/or trusts for their benefit. This is called “stacking.” Any transfers of QSB stock should be done with caution because certain types of transfers may permanently disqualify the stock from Section 1202 treatment.

A taxpayer who receives QSB stock from the original holder through a tax-free transfer or gift is treated as if he or she acquired the stock as of the original issuance from the corporation in the same manner as the transferor, so they can then tack on the transferor’s holding period along with the transferor’s carryover basis in the stock.

For example, if a founder transfers QSB stock outright to a spouse and four children by gift, the family unit consisting of six individuals (founder, spouse, and four children) will have exclusions totaling as much as $60 million ($10 million times six), as opposed to the founder’s single Section 1202 $10 million exclusion before he made the gifts.

Arguably, nothing prevents the founder from making gifts to friends outside the family unit, provided the transfers are not treated as compensation to the recipients. The limitations on this strategy may be the founder’s available annual gift tax exclusion and the remaining lifetime gift tax exemption amount, and, if applicable, state and federal gift taxes.

The Section 1202 exclusions can be further multiplied by making transfers to nongrantor trusts for the benefit of the same family members. Grantor trusts will not work in this scenario because a grantor trust is not treated as a separate taxpayer from the grantor, and each taxpayer only reserves one Section 1202 exclusion. Consider a gift of QSB stock to six additional irrevocable nongrantor trusts for the founder, spouse, and four children, thus creating 12 different taxpayers for total capital gain exclusions of $120 million (six individuals and six irrevocable trusts). This type of planning, however, is not without risk. IRC Section 643(f) will treat two or more trusts as one trust if you have substantially the same parties (i.e., the grantor and beneficiaries) and if your principal purpose of such trusts is the avoidance of tax. Therefore, careful planning is required.

Impact

Many clients may not be aware that their stock qualifies as QSB stock. Given the relatively recent adoption of the QSB stock rules, many advisers also are unfamiliar with this section of the IRC. Furthermore, C corporations have been increasingly rare since the 1990s. Whenever an adviser has a client with

C corporation stock, a Section 1202 analysis may be in order.

Consider a taxpayer who acquired QSB stock on Jan. 1, 2011, for $200,000. On Jan. 2, 2016, (more than five years after the acquisition of such stock) the taxpayer sold the stock for $10 million, realizing a $9.8 million gain. Under Section 1202, the taxpayer can exclude 100% of their capital gains, meaning the federal tax due on the gains is $0. If the taxpayer had acquired the stock on Feb.1, 2009, and sold it for a profit after five years, the taxpayer could exclude only 50% of the capital gains or $4.9 million under the Section 1202 50% exclusion.

Conclusion

The amount of gain that any taxpayer can exclude under Section 1202 is limited to the greater of $10 million or 10 times the adjusted basis of the stock sold by the taxpayer during the year. The taxable portion of a gain from selling QSB stock has an assessment at the maximum tax rate of 28%. Given the significant tax savings available to clients with C corporation stock, Section 1202 should be on your radar.