The Small Stock Gains Exclusion, better known as Section 1202, has been around for nearly 30 years. But its tax benefits have largely flown under the radar. Qualifying for the exclusion can be complicated, requiring investors to meet a long list of conditions. 

Additionally, the benefit was underused because the nonexcludable portion of Section 1202 was taxed at a much higher rate than the reduced tax rates for capital gains from the sales of non-qualifying stock. But the Tax Cuts and Jobs Act in 2017 reduced both the corporate tax rate and the individual top tax rate, making Section 1202 more attractive to founders and owners. 

Now, this tax benefit is getting yet another look. The possible passage of the Build Back Better Act could rewrite some income tax and capital gains rules, which could make this tax benefit more valuable for some founders and investors sitting on gains in qualifying small company stock (QSBS). 

To incentivize investment in startups and small businesses, the IRS provides investors in qualified small businesses the opportunity to exclude some or all of the gain they realize from a sale of their QSBS, as long as they meet specific criteria. 

When the law was originally enacted, investors could only exclude 50% of their gains in QSBs. Later, that amount was raised to 75% (for stock acquired between February 17, 2009, and September 28, 2010) and then again to 100% for stock acquired after September 27, 2010. 

If eligible for the Section 1202 exclusion, gains are limited to $10 million or ten times the aggregate adjusted basis of the QSBS sold during the tax year. 

For example, an investor acquired shares in a small business for $1 million and then sold them later for $21 million, with a gain of $20 million. Assuming that he held the stock for more than one year, at a top tax rate of 23.8%, the investor would have a $4.76 million tax liability (plus any state capital gains tax). 

Section 1202 allows this investor to potentially exclude 100% of that gain from federal capital gains tax and possibly from state capital gains tax in states that follow the federal treatment. 

The Section 1202 gain exclusion applies at the ultimate investor level. In other words, non-corporate shareholders such as an individual trust or estate are eligible to receive it, but corporate investors are not. 

However, pass-through entities can make investments in QSBS and receive the gain exclusion even if the total gain is significantly higher than $10 million and ten times the threshold set out by the IRS. For example, a pass-through entity with ten partners, each owning 10% of the qualified small business, can sell their stock for a $100 million gain for the full exclusion since each partner’s gain falls within the $10 million or 10% cap. 

While Section 1202 offers a significant opportunity to exclude capital gains for investing in qualifying small businesses, satisfying all requirements can be complicated. Investors must be mindful not to inadvertently lose QSBS status, thus jeopardizing the benefits of the exclusion. 

These are some of the requirements to get a full gain exclusion. However, it’s essential to consult with a knowledgeable tax advisor to determine if your situation meets the exact criteria. 

• C corporation: The stock must be in a business entity classified as a C corp for federal tax purposes, such as a limited liability company (LLC). LLCs classified as partnerships for tax purposes can change their tax classification to C corporations to take advantage of QSBS planning opportunities. Note that the holding period starts from the date of conversion, not the date of stock issuance in this case.
• Original issuance: The stock must be acquired in exchange for a capital contribution or service at “original issuance.” Therefore, it cannot be purchased from another individual.
• Five-year holding period: A QSBS must be held for five years or more before selling. 
• Qualified small business: The C corp must be a qualified small business during a substantial portion of the taxpayer’s holding period.
• Aggregate gross assets: The aggregate gross assets of the corporation cannot exceed $50 million.
• Active business requirement: At least 80% of the assets are used by the corporating in the active conduct of 1 or more qualified trades or businesses.
• Redemption of stock: Some purchases by a corporation of its own stock can disqualify the corporation if they don’t abide by certain time frames. 

The Build Back Better Act seeks to increase the amount of social spending to pay for these additional social programs such as universal pre-school, expanded Medicare, renewable energy, and eldercare. The latest version of the bill would impose additional surcharges on capital taxes on high-income taxpayers. A higher capital gains rate makes the QSBS exclusion even more valuable and can spur further investment in startups and small businesses. 

However, the bill also proposes eliminating the 100% exclusion for taxpayers with an adjusted gross income of more than $400,000 and entirely for trusts and estates. Instead, those taxpayers would only be eligible for a 50% exclusion. This change would apply to sales on or after September 13, 2021, although agreements entered into before September 13 would be allowed to receive the 100% exclusion. 

Build Back Better is now in the Senate, where it is likely to change further and may not even pass at all. 

The requirements of Section 1202 are complicated and full of potential pitfalls for taxpayers unfamiliar with its complexities. However, working with a knowledgeable tax professional can help small business investors realize valuable tax incentives and bring in additional business investment.