Section 1202 of the Internal Revenue Code allows a non-corporate taxpayer who has held “qualified small business stock” (or “QSBS”) for more than five years to exclude a portion of the gain recognized on a sale of the stock. For stock to be QSBS, it must have been acquired upon original issuance (or by inheritance, gift or, under certain circumstances, distribution from another who acquired the stock upon original issuance) from a C corporation that, among other things, satisfies certain “qualified small business” and “active business” requirements. The “qualified small business” requirement limits the applicability of Section 1202 to stock issued by corporations with aggregate gross assets of $50 million or less. The “active business” requirement limits the applicability of Section 1202 to corporations most of whose assets are used in one or more “qualified trades or businesses” (which exclude, among other things, providing services such as health, law, engineering, accounting and actuarial science). In addition, the corporation may not have redeemed more than de minimis amounts of its outstanding stock within specified periods of time before or after the issuance of the stock in question. “Look-through” rules can allow an S corporation or partnership to pass the benefits of Section 1202 through to its owners.
Since the enactment of Section 1202 in 1993, the maximum excludible portion was 50%. Unfortunately, the non-excluded portion has generally been taxed since 2001 at a 28% rate. In addition, a portion of any excluded gain has generally been a preference item under the alternative minimum tax. Given the rate at which the unexcluded portion was taxed, Section 1202 lost much of its luster in 2003 when the maximum rate generally applicable to long-term capital gains from stock sales was reduced to 15%. The American Recovery and Reinvestment Tax Act of 2009 breathed some new life into Section 1202 by increasing the maximum excludible portion to 75% for QSBS acquired after February 17, 2009 and before January 1, 2011.
Under the Small Business Jobs Act of 2010, the maximum excludible portion of the gain on the sale of QSBS acquired during the period from September 27, 2010 (the date of enactment of the Small Business Jobs Act of 2010) through December 31, 2010 and held for more than five years was increased to 100%. In addition, no portion of the excluded gain was treated a preference item under the alternative minimum tax. Thus, gains of eligible taxpayers on sales of QSBS acquired by December 31, 2010 (and after the date of enactment of the Small Business Jobs Act of 2010) and held for more than five years was not subject to tax under the regular federal income tax or under the federal alternative minimum tax. The 2010 Tax Relief Act extended the 100% exclusion to stock acquired on or before December 31, 2011.
The American Taxpayer Relief Act of 2012, signed by President Obama on January 2, 2013, again extends the 100% exclusion of gains of eligible taxpayers on sales of QSBS and it does so retroactively. Thus, gains on the sale of QSBS acquired by an eligible taxpayer during the period from September 27, 2010 through December 31, 2013 and held for five years may be eligible for 100% exclusion. With respect to QSBS acquired after December 31, 2013, the exclusion will revert back to 50% of eligible gain and a portion of the gain will again be included in income for alternative minimum tax purposes.
Please contact any member of the Tax Law Practice Group with any questions on this topic.