How to Report Section 1202 Exclusion

Section 1202 of the Internal Revenue Code offers a valuable tax benefit for investors in qualified small business stock (QSBS). This provision aims to encourage investment in small businesses by allowing for the exclusion of a significant portion, or even all, of the capital gains realized from the sale of such stock. Understanding the intricacies of this exclusion can lead to substantial tax savings for eligible investors.

Understanding Qualified Small Business Stock

Qualified Small Business Stock (QSBS) refers to shares issued by a “qualified small business” that meet specific criteria under Section 1202. To be considered a qualified small business, the issuing entity must be a domestic C corporation. Its aggregate gross assets must not exceed $50 million at any time from its formation until immediately after the stock issuance. This asset valuation typically considers cash and the adjusted basis of other property, with contributed property valued at fair market value at the time of contribution.

The corporation must also use at least 80% of its assets in the active conduct of a qualified trade or business during substantially all of the taxpayer’s holding period. Qualified businesses generally include technology startups, manufacturing, retail, and wholesale operations. Conversely, businesses providing personal services, such as health, law, accounting, or consulting, alongside banking, finance, real estate, hospitality, farming, and mining, typically do not qualify.

Qualifying for the Section 1202 Exclusion

The Section 1202 exclusion is primarily available to non-corporate taxpayers, including individuals, partnerships, S corporations, and certain trusts. The stock must be held for a minimum of five years from the date of acquisition to qualify for the full exclusion. If the stock is sold before this five-year period, the gain generally does not qualify for the Section 1202 exclusion.

The stock must have been acquired directly from the corporation at its original issuance. This acquisition can be in exchange for money, property (excluding stock), or as compensation for services provided to the corporation. The amount of gain that can be excluded is limited to the greater of $10 million or 10 times the adjusted basis of the QSBS sold by the taxpayer during the taxable year.

While the federal capital gain can be excluded, certain implications for other taxes may arise. For stock acquired before February 18, 2009, a portion of the excluded gain might be treated as a preference item for Alternative Minimum Tax (AMT) purposes. However, for QSBS acquired after September 27, 2010, the exclusion is generally fully exempt from AMT and the 3.8% Net Investment Income Tax (NIIT). State tax treatment of Section 1202 exclusion varies widely, with some states conforming fully, others partially, and some not at all.

Preparing to Report Your QSBS Gain

Before reporting a Section 1202 exclusion, gathering all necessary documentation and confirming eligibility is important. Essential documents include original stock purchase agreements, broker statements (Form 1099-B), and any Schedule K-1s if the stock was acquired through a pass-through entity. Corporate records verifying the company’s QSBS status at issuance and throughout the holding period, such as confirmation of C-corporation status, the $50 million gross asset test, and qualified business activity, are also important.

Key information to confirm includes the exact dates of stock acquisition and sale, the original cost basis of the stock, and the total sale proceeds. It is also important to verify that the issuing corporation met all “qualified small business” criteria at the time of issuance and maintained the active business requirement during the holding period. Taxpayers will need to calculate the total gain, the portion of gain eligible for exclusion, and ensure these amounts adhere to the applicable exclusion limits.

Reporting the Section 1202 Exclusion

Reporting the Section 1202 exclusion on federal tax forms involves specific steps, primarily utilizing Form 8949 and Schedule D. The sale of QSBS is first listed on Form 8949, Sales and Other Dispositions of Capital Assets. This transaction should be reported in Part II of Form 8949, which is designated for long-term gains.

On Form 8949, the sales price is entered in column (d) and the cost basis in column (e). A crucial step involves entering “Q” in column (f) to identify the gain as eligible for the Section 1202 exclusion. The excluded portion of the gain is then entered as a negative adjustment in column (g) of Form 8949. After completing Form 8949, the adjusted figures flow to Schedule D, Capital Gains and Losses, where the excluded gain effectively reduces the total capital gain reported.

Additional Tax Considerations and Record Keeping

For QSBS acquired before February 18, 2009, a portion of the excluded gain was treated as a preference item for Alternative Minimum Tax (AMT) purposes. However, for stock acquired after September 27, 2010, the gain excluded under Section 1202 is generally fully exempt from AMT. Similarly, excluded QSBS gain is typically not subject to the 3.8% Net Investment Income Tax (NIIT).

State tax treatment of the Section 1202 exclusion varies significantly. Some states may conform to the federal exclusion fully, others partially, and some do not conform at all, meaning the excluded gain might still be taxable at the state level. Consulting state tax laws or a tax professional familiar with state-specific rules is advisable. Maintaining comprehensive records is paramount, as the burden of proof for QSBS eligibility rests with the taxpayer. This includes retaining stock certificates, purchase records, corporate documents confirming QSBS status at issuance, and sale confirmations for many years after the sale to substantiate the exclusion claim during a potential audit.