What You Need to Know About the 1202 Exclusion
If you’re a business owner who recently sold some or all of your company stock, you may be eligible for an IRS Section 1202 capital gain exclusion. In fact, if you acquired company stock after September 27, 2010, you may be able to permanently exclude from taxes the greater of $10 million or ten times your cost basis if you invested more than $1 million. For example, if you purchased the stock for $3 million, your gain exclusion may be as much as $30 million.
This exclusion is designed to incentivize investment in certain small businesses and startups, which can ultimately result in growth and innovation. Here’s what you need to know about the 1202 capital gain exclusion.
#1 – Qualifying Stock
Only stock considered qualified small business stock (QSBS) is eligible for the exclusion. QSBS refers to originally issued shares of small, domestic companies that meet specific criteria related to their size, nature of business and capital structure, including the following:
- The company must be a C corporation that meets certain active business requirements. S corporations and LLCs don’t qualify.
- The company must be in a qualifying sector, such as technology, retail, wholesale or manufacturing. Companies in the hospitality, personal services, farming, mining and financial services industries aren’t eligible for the exclusion.
- At least 80% of the issuing corporation’s assets must be used to actively operate its qualified business.
- The company must meet an aggregate gross asset limitation. Large companies that own assets over $50 million won’t qualify.
#2 – Holding Period
To qualify for the exclusion, you must have held the QSBS for at least five years from the date you acquired the stock. In addition, you must have acquired the stock at its original issue date. Stock acquired on the secondary market doesn’t qualify.
#3 – Exclusion Percentage
The greatest exclusion applies to QSBS acquired after September 27, 2010; however, stock acquired prior to that date may still qualify for an exclusion, based on the table below.
| Stock Acquisition Date | Percentage Gain That Avoids Taxation |
|---|---|
| Aug 11, 1993 to Feb 17, 2009 | 50% |
| Feb 18, 2009 to Sep 27, 2010 | 75% |
| Sep 28 to Present | 100% |
Some states also allow an exemption for stock meeting the criteria.
#4 – Limitations
As noted above, the total eligible gain that can be excluded under Section 1202 is limited to the greater of $10 million or ten times the taxpayer’s basis in the QSBS.
#5 – Exclusion for Non-Corporate Investors
The 1202 exclusion was originally designed to benefit individual investors.
#6 – Reporting Requirements
To claim the Section 1202 exclusion, taxpayers need to file IRS Form 8949 as well as Schedule D of their federal income tax return. It’s important to also maintain documentation that supports the qualification of the stock as QSBS.
#7 – Maximizing QSBS Exemption
The IRS allows you to gift your stock to an individual or a non-grantor trust prior to disposition, and the recipient of the stock steps into the shoes of the transferor in regard to the stock’s cost basis, holding period and QSBS status. For Section 1202 purposes, the recipient must be a different taxpayer than the transferor, the transfer must be a gift (not a sale or compensation) and it must meet the definition of a gift under Section 1015. If you meet these requirements, the recipient will qualify for their own QSBS exclusion. For example, if a stockholder has $20 million of QSBS stock and is eligible for 100% capital gain exclusion up to $10 million, she can transfer $10 million of her $20 million stock to her son and her son can sell the stock and receive his own $10 million exclusion. Thus each person sells their $10 million and incurs no capital gain. However, gift tax may apply.
1202 Exclusion Example
To illustrate how the 1202 exclusion works, let’s consider Sharon Shareholder. Sharon earns $500,000 per year in taxable income and files as a single individual. Her income places her in the highest capital gains tax bracket, which means her long-term capital gains are subject to a 20% tax rate.
In 2012, Sharon acquired $500,000 in QSBS. After holding it for more than five years, she recently sold the stock for $2 million, realizing a long-term capital gain of $1.5 million.
Because she acquired the stock after September 2010 and held it for more than five years, Sharon is eligible to exclude up to $10 million in capital gains. That means she can exclude her entire gain and would therefore not owe any federal capital gains tax on the sale.
As you can see, taking advantage of the Section 1202 capital gain exclusion can be a great way to save on taxes following the sale of qualifying stock. However, it’s a complex planning strategy that requires careful execution and attention to detail.
Could you use some help navigating the challenges of a 1202 exclusion? Creative Planning is here for you. Our experienced tax advisors work alongside your wealth manager to help ensure your tax planning strategies remain on track. Our teams have experience navigating a wide range of tax and financial challenges, always with a goal of lowering your tax liabilities and helping you achieve your long-term goals.
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