What Is the Section 1202 Capital Gains Exclusion?

Section 1202 of the Internal Revenue Code provides a tax incentive for investors, allowing for the exclusion of capital gains from the sale of Qualified Small Business Stock (QSBS). The goal of this provision is to encourage long-term investment in new ventures and small businesses. By offering a reduction in federal tax liability, the rule aims to stimulate capital flow into these enterprises.

Defining Qualified Small Business Stock

For a stock to qualify as QSBS, the issuing corporation must meet several requirements. The issuer must be a domestic C-corporation, as stock from S-corporations or LLCs does not qualify. If a C-corporation with QSBS elects S-corporation status, the stock loses its QSBS designation. This C-corporation status must be maintained for substantially all of the taxpayer’s holding period.

A taxpayer must have acquired the stock directly from the corporation at its original issuance. This can be in exchange for money, property, or as compensation for services. Purchasing shares from another shareholder on a secondary market disqualifies the stock for that investor.

At the time the stock is issued, the corporation’s gross assets must not have exceeded $50 million. This test is assessed both immediately before and after the stock issuance. For this test, the value of a corporation’s assets is their tax basis, though any property contributed to the corporation is valued at its fair market value when contributed.

The corporation must also satisfy an active business requirement, meaning at least 80% of its assets must be used in a qualified trade or business. Certain fields are excluded from being a “qualified trade or business,” including:

• Services in health, law, engineering, or accounting
• Consulting
• Athletics
• Financial services
• Any business where the principal asset is the reputation or skill of its employees

Taxpayer Eligibility Requirements

The taxpayer seeking the exclusion must also meet specific criteria. The exclusion is reserved for non-corporate taxpayers, which includes individuals, trusts, and estates; it is not available to corporate shareholders.

The primary requirement for the taxpayer is the holding period. To qualify for the capital gains exclusion, the taxpayer must hold the QSBS for more than five years. The five-year clock begins on the date the stock is issued, and selling the stock even one day short of this mark will disqualify the gain from the exclusion.

Calculating the Exclusion Amount

For QSBS acquired after September 27, 2010, the exclusion is 100% of the eligible gain. There is a cap on the amount of gain a taxpayer can exclude per issuer. The excludable gain is limited to the greater of two figures: $10 million or 10 times the taxpayer’s aggregate adjusted basis in the corporation’s stock sold during the tax year. The $10 million cap is a lifetime limit for each issuing corporation, reduced by any exclusion amounts claimed in prior years for that same company.

For example, an investor purchased QSBS for $500,000 and sells it more than five years later for a $12 million gain. The maximum exclusion is the greater of $10 million or 10 times their $500,000 basis ($5 million), which is $10 million. The investor can exclude $10 million of the gain, leaving $2 million to be taxed. If their basis had been $1.5 million, the 10-times-basis calculation would yield $15 million, allowing them to exclude the entire $12 million gain.

State Tax Conformity

While the exclusion provides a federal tax benefit, its application at the state level is not uniform. States have different approaches to how they treat the income excluded under federal law. Some states conform to the federal tax code, allowing for a full or partial exclusion of the QSBS gain on state income tax returns.

Many states, however, do not conform to the federal rules. In these jurisdictions, a taxpayer might owe state income tax on a capital gain that was exempt from federal tax. For example, states like California and Pennsylvania do not follow the federal exclusion. The presence or absence of a state-level exclusion can alter the net financial outcome of a stock sale, so consulting state tax laws is a necessary step.

Section 1045 Rollovers

For investors who sell QSBS before meeting the five-year holding period, Section 1045 of the tax code offers a planning tool. This provision allows a taxpayer to defer capital gains from the sale of QSBS if the stock was held for more than six months. This “rollover” prevents an immediate tax liability and preserves the potential for a future tax-free gain.

To execute a rollover, the taxpayer must reinvest the sale proceeds into new, replacement QSBS within 60 days of the sale. The gain from the original sale is not taxed at that time; instead, it reduces the cost basis of the newly acquired stock.

A benefit of this rollover is that the holding period of the original QSBS is added to the holding period of the new stock. For instance, if an investor held the original QSBS for three years, the replacement QSBS is treated as having already been held for three years, helping the investor reach the five-year requirement.