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Qualifying as Small Business Stock (Section 1202)
Purpose of Section 1202
The purpose of Section 1202 is to provide non-corporate taxpayers an incentive to invest in small businesses by allowing a capital gains exemption from federal income tax on the sale of small business stock. Small business stock held for at least five years before selling will have a portion or all of its realized gains excluded from federal tax.
The gain exclusion is 100% of any capital gain if the acquisition of the small business stock was after Sept. 27, 2010. Prior to Sept. 27, 2010 the gain exclusion was less than 100% (see background below).
To qualify as QSB stock
- The stock must have been issued by a C corporation, not an S corporation.
- The gross assets of the corporation must have been no more than $50 million at all times after August 9, 1993, and before issuance of the stock, as well as immediately after issuance of the stock.
- The corporation must be an active business, it cannot be a holding company.
Background of Sec. 1202
Before Feb. 18, 2009:
Prior to Feb. 18, 2009, the gain exclusion under Section 1202 is 50% of capital gains from gross income.
Feb. 18, 2009 through Sept. 27, 2010:
The American Recovery and Reinvestment Act increased the gain under Section 1202 from 50% to 75% for stocks purchased between Feb. 18, 2009 and Sept. 27, 2010. This was done to stimulate the small business sector. For small business stocks that are eligible for the 50% or 75% exclusion, a portion of the excluded gain is subject to an additional 7% Alternative Minimum Tax (AMT).
After Sept. 27, 2010
The latest amendment to section 1202 provides for the following:
- 100% exclusion of any capital gains if the acquisition of the small business stock was after Sept. 27, 2010.
- No portion of the excluded gain is a preference item for AMT purposes.
- The capital gains that are exempt from tax under section 1202 are also exempt from the 3.8% net investment income tax applied to most investment income.
- The amount of gain that any investor can exclude under Section 1202 is limited to a maximum of the GREATER OF:
- $10 million or
- 10 times the adjusted basis of the stock.
The taxable portion of a gain from selling a small business stock has an assessment at the maximum tax rate of 28%.
You must hold the stock over five years to qualify for the gain exclusion (the idea is to encourage investment and not speculation).
Reporting the Section 1202 Gain and the Exclusion
- Report the entire gain as a long-term gain on Schedule D.
- Enter the allowable exclusion as a loss below the entry for the gain.
- Label the the entry for the allowable exclusion as follows:
- Section 1202 exclusion
To qualify as qualified small business stock for the purpose of deferring or excluding gain:
- The stock must be stock in a C corporation (not an S corporation)
- The stock was originally issued after August 10, 1993.
- The gross assets of the corporation must have been no more than $50 million at all times after August 9, 1993, and before issuance of the stock, as well as immediately after issuance of the stock.
- The corporation must be an active business, it cannot be a holding company.