Maximizing Section 1202’s Gain Exclusion

The combination of the 21% corporate federal income tax rate and the possibility of qualifying for Section 1202’s gain exclusion has made operating a business through a C corporation an attractive choice.[1]  This article is one of a series of articles and blogs authored by Scott Dolson addressing planning issues relating to Sections 1202 and 1045.  Additional information regarding qualified small business stock (QSBS) planning and the firm’s tax planning group can be found here and in our QSBS Library and Guidebook.

Section 1202 allows a taxpayer to claim a gain exclusion when QSBS is sold, so long as the taxpayer meets all of Section 1202’s eligibility requirements.  Section 1202 places limits on the amount of gain exclusion that can be claimed by a taxpayer with respect to a corporation’s QSBS.  This article explains how the gain exclusion caps work and provides planning suggestions for increasing the amount of available gain exclusion.

Gain exclusion cap basics (including the standard $10 million per-taxpayer per-issuer cap)

Section 1202(b) provides that, for a specific taxable year, a taxpayer’s aggregate per-issuing corporation gain exclusion is generally limited to the greater of (a) $10 million, minus the aggregate prior Section 1202 gain excluded with respect to such issuer (the “10 Million Cap”), or (b) 10 times the taxpayer’s original adjusted tax basis in the issuer’s QSBS sold during the taxable year (the “10X Basis Cap”).[2]

For purposes of the 10X Basis Cap, a taxpayer’s original adjusted tax basis equals the aggregate cash and fair market value of property exchanged for the shares of QSBS sold during the applicable tax year.  If shares of QSBS sold were originally issued in exchange for services, the original adjusted tax basis would be the value of those shares for Section 83 purposes.[3]  Capital contributions with respect to already issued QSBS are ignored for purposes of calculating the 10X Basis Cap. Therefore, capital contributions without the issuance of additional QSBS should be avoided; instead, additional QSBS should be issued in exchange for each money or property contribution, assuming the issuer is still eligible to issue QSBS.[4]

Several key aspects of Section 1202’s gain exclusion cap are as follows:

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