Section 1202 offers a once little-known exclusion from income for gain on qualified small business stock (“QSB stock”).  The provision has undergone substantial revisions over the years and came back into vogue as a result of the Tax Cuts & Jobs Act.  Where applicable, section 1202’s exclusion offers a substantial and legitimate tax shelter: The exclusion of potentially all of the gain on QSB stock held for more than five years.

Section 1202 of the Internal Revenue Code allows a taxpayer (other than a corporation) to exclude a percentage of gain from the sale or exchange of qualified small business stock held for more than 5 years.  The exclusion is subject to a number of intricate requirements.  But where applicable, the exclusion provides one of the Code’s most significant tax breaks.

Section 1202 

For taxpayers other than corporations, § 1202(a) provides that gross income does not include a percentage of the gain from the sale or exchange of qualified small business stock (QSB stock) that has been held for more than 5 years.  The percentage of the gain that is excludable varies, depending on the date of acquisition of the QSB stock:

• 100% of the gain is excluded for QSB stock acquired after September 27, 2010,[1]
• 75% for QSB stock acquired after February 17, 2009 and before September 28, 2010,[2] and
• 50% for QSB stock acquired on or before February 17, 2009.

Qualified Small Business Stock (“QSB” Stock)

Section 1202(c) provides that, in general, QSB stock includes any stock in a C corporation that was originally issued after the date of enactment of the Revenue Reconciliation Act of 1993 (Omnibus Budget Reconciliation Act of 1993, P.L. 103-66, § 13113(a)) if two conditions are met:

• on the date of the stock’s issuance the corporation is a qualified small business; and
• the stock was acquired by the taxpayer at its original issue in exchange for money or other property or as compensation for services.

Sec. 1202 is generally not available to exclude gain on the sale of S corporation stock or a partnership interest.

Section 1202 provides for a number of tacking rules, which may be applicable in situations where the QSB stock was gifted to a taxpayer or acquired as a result of a conversion of stock, for example.  Taxpayers should seek guidance from a tax attorney with respect to such circumstances, as other complexities may be involved.

What is a Qualified Small Business?

QSB stock is stock originally issued after August 9, 1993 by a domestic C corporation with total gross assets of $50 million or less.  The corporation must satisfy an active business requirement and must have been a C corporation during substantially all of the taxpayer’s holding period of the stock for which the taxpayer is claiming preferential treatment.  As such, the corporation must not be or have been a foreign corporation, DISC, former DISC, regulated investment company, real estate investment trust, REMIC, FASIT, cooperative, or a corporation that has made (or that has a subsidiary that has made) a section 936 election.

For these purposes, gross assets include those of any predecessor of the corporation. And all corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.

The Active-Trade-or-Business Requirement

The code also imposes an active-trade-or-business requirement.  In order to be treated as QSB stock, the corporation issuing the stock must have satisfied the active-trade-or-business requirement during substantially all of the taxpayer’s holding period for the stock. This requires the corporation to use at least 80 percent of its assets (by value) in the active conduct of one or more qualified trades or businesses.

Generally, an active trade or business is defined as any trade or business other than trades or businesses expressly listed in § 1202(e)(3). Section 1202(e)(3) provides that a qualified trade or business means any trade or business other than a trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, athletics, financial services, brokerage services, consulting, or any other trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.

Section 1202(e)(3) further provides that the term qualified trade or business does not include businesses in which the principal activity involves providing services in the fields of finance, insurance, banking, investing, leasing, farming, mining, or running a hotel, motel, restaurant or similar businesses.

Disqualifying Redemptions

The corporation must not have engaged in certain redemptions that would disqualify the stock as QSBS.  For example, stock is not qualified small business stock if it makes significant purchases of its own stock within a 2-year period beginning on the date 1 year before the issuance of the stock.  That is, if the issuing corporation purchases more than a de minimis amount of its stock and the purchased stock has an aggregate value exceeding 5 percent of the aggregate value of all of the issuing corporation’s stock as of the beginning of such 2-year period, the corporation’s stock will lose QSB status.

In addition, Stock acquired by a taxpayer is not qualified small business stock if, in one or more purchases during the 4-year period beginning on the date 2 years before the issuance of the stock, the issuing corporation purchases (directly or indirectly) more than a de minimis amount of its stock from the taxpayer or from a person related (within the meaning of section 267(b) or 707(b)) to the taxpayer.

For these purposes, any purchase of stock that is treated as a redemption distribution under §304 is treated as a purchase by the issuer of an amount of its own stock.

Claiming a Section 1202 Exclusion

Taxpayers seeking to invoke section 1202’s exclusion should generally seek advice from a tax attorney and, in many situations, should obtain a tax opinion regarding qualification under the provision, given the many intricate requirements under the Code, regulations, and case law.  But taxpayers who qualify to take advantage of section 1202’s exclusion for gain on the sale or exchange of qualified small business stock (“QSB stock”) may be entitled to one of the Code’s most significant tax breaks.

[1] Section 1202(a)(4) provides that in the case of qualified small business stock acquired after the date of the enactment of the Creating Small Business Act of 2010, § 1202(a)(1) shall be applied by substituting “100 percent” for “50 percent” and § 1202(a)(2) shall not apply.

[2] Section 1202(a)(3) provides that in the case of qualified small business stock acquired after the date of enactment of § 1202(a)(3) and on or before the date of enactment of the Creating Small Business Jobs Act of 2010, § 1202(a)(1) shall be applied by substituting “75 percent” for “50 percent” and § 1202(a)(2) shall not apply.

Have a question? Contact Jason Freeman, Freeman Law.