What is Section 1202?
Section 1202 is a section of the Internal Revenue Code which provides an exclusion (sometimes in whole and sometimes in part) for gain in certain small business stock sales by taxpayers other than corporations.
What is the amount of the exclusion?
For qualified small business stock acquired between September 27, 2010, and until the end of 2013 (thanks to the fiscal cliff bill!), the exclusion is 100%, and that includes an exclusion from the alternative minimum tax. There is an overall cap on this exclusion, but it is significant–in general it is the greater of $10M or 10x the adjusted basis of the taxpayer’s stock.
What is qualified small business stock?
With limited exceptions and subject to compliance with certain reporting requirements imposed by the Internal Revenue Service, QSB stock means any stock acquired on original issuance by the taxpayer from a domestic C corporation after August 10, 1993 that meets the following requirements:
- the aggregate gross assets of the corporation must not have exceeded $50 million at the time of and immediately after the issuance of the stock; and
- at least 80% of the assets, by value, of the corporation must have been used in an active conduct of one or more “qualified trade or businesses.”
Can founders qualify?
Yes, founders’ stock can qualify for the Section 1202 qualified small business stock benefit.
Can you form as an S corporation and still have your founders stock qualify?
No, you have to form as a C corporation in order for the stock to potentially qualify for the 1202 exclusion.
What is a qualified trade or business?
A qualified trade or business generally means any trade or business other than:
- any trade or business involving the performance of a services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees
- any banking, insurance, financing, leasing, investing, or similar business
- any farming business (including the business of raising or harvesting trees),
- any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A
- any business of operating a hotel, motel, restaurant, or similar business
Are there other requirements?
The investment has to be in qualified small business stock, and the stock has to be held for 5 years. There are numerous rules that apply in order to qualify for this benefit. You should consult with a tax advisor to assure that you qualify for the benefit.