Whether you are familiar with or have never heard of Section 1202, this benefit may be of interest to you as an investor. With recent changes by Congress, Section 1202 helps start-ups and other small businesses gain investors, since it essentially creates the ability for investors to make a fully tax-exempt profit. Many investors are interested in both helping small businesses and helping themselves by keeping in mind Section 1202 as they structure their investments. Let’s examine what Section 1202 is, and how it may be of interest to you.
What is a Section 1202 exclusion?
Section 1202, sometimes referred to as the “small business stock gain exclusion,” is a specific section of the IRS tax code. This section allows investors to exclude capital gains from select small business stock from their federal taxes. The purpose of Section 1202 is to incentivize people to invest in small businesses, and in the past few years, Congress has made these incentives more generous.
Section 1202 may be beneficial to investors, but due to the complexity of the requirements, careful planning and analyzing must be done in order to make sure your small business stocks are eligible. You should consult your tax advisor before claiming Section 1202 small business stock gain exclusion benefits.
What are the benefits of a qualified small business stock gain exclusion?
One of the major benefits of Section 1202 is the tax break you will receive for investing your money into small businesses. As long as you hold the stock for at least five years before selling, you will be able to exclude some (or potentially all) of the capital gains from your federal tax.
You may be wondering, what percentage of gain can be excluded from taxes if it qualifies under section 1202? Prior to February of 2009, Section 1202 only excluded 50% of capital gains. However, the American Recovery and Reinvestment Act increased that rate to 75% for any stocks purchased between February 18, 2009 and September 27, 2010. If your stock is eligible for the 50% or 75% exclusion, a portion of the excluded gain may have an additional 7% tax called the Alternative Minimum Tax. A recent amendment to Section 1202 allows for the 100% exclusion of small business stock as long as it was acquired after September 27, 2010.
Although your small business stock may be eligible for exclusion based on the date you acquired it, another thing to keep in mind is that there is a maximum for the exclusion. If the amount of gain is greater than $10 million or 10 times the adjusted basis of the stock, the amount that is outside those limits will be assessed and taxed at a maximum rate of 28%.
Keep in mind that the requirements of Section 1202 are not simple, so it is important to seek advice and make sure that the small business stocks you are looking at investing in are qualified for this tax break.
How do you qualify for Section 1202 exclusion?
What is Section 1202 qualified small business stock? How do you figure out what qualifies as small business stock? These are important questions to ask when trying to understand Section 1202. Small business stocks are only considered qualified if certain conditions apply, which include:
- The stock is issued by a domestic C corporation that is NOT a part of certain industries (like a hotel, restaurant, real estate company, farm, law firm, financial institution, etc).
- The issuing corporation has less than $50 million in assets at the time (and immediately after) the stock is issued
- Originally issued after August 10, 1993 in exchange for money, property (not including stocks), or for a service rendered.
- The corporation uses at least 80% of their assets for the active conduct of one or more of the qualifying businesses
- The stock is held by a non-corporate taxpayer (so corporations aren’t eligible for these benefits if the corporation holds stock)
- Starting two years before the issue date, the issuing corporation cannot purchase any stock from the taxpayer for a four-year period
- Starting one year before the issue date, the issuing corporation cannot significantly redeem its stock for a two-year period.
These criteria may change, depending on what laws are passed. It’s also important to note that state taxes may differ from federal taxes, and so you should seek guidance from your tax advisor on how your state treats profits from the sale of qualified small business stocks.
What is a Section 1202 exclusion example?
Let’s look at the fictional Mary. She is single, and has an ordinary taxable income of $415,000, which puts her in the highest tax bracket. She sold qualified small business stock acquired on November 3rd, 2010, and has a realized profit of $50,000. Mary is able to exclude 100% of her capital gains, so she owes $0 on her federal tax for that $50,000.
However, if Mary acquired those stocks in January of 2009, and then sold it five years later for the same profit, she would owe federal taxes on those gains. Her federal tax would be 28% x (50% x $50,000) = $7,000.
How can I take advantage of Section 1202?
Interested in Section 1202, but worried about the complicated requirements? Here at Delta Wealth Advisors, we’re here to help you make sense of all the jargon and assist you with managing your investments. We offer a comprehensive list of services, from stocks to estates and more. Our goal is to be a trusted and valuable partner who you can rely on for all your investing needs. Schedule a call with one of our expert advisors today to discuss how qualified small business stock could fit into your investment portfolio.