Sec 1202: Small Business Stock Gain Exclusion
To encourage investment in new ventures, small businesses, and specialized small
business investment companies, Section 1202 of The Internal Revenue Code grants
relief to investors who risk their funds in these businesses.
Noncorporate investors may exclude up to 50 percent of gain they realize on the
disposition of qualified small business stock issued after August 10, 1993 and held
more than five years.
As part of recent legislative efforts to stimulate the economy, the Section 1202 exclusion
was raised from 50% to 75% for QSB stock acquired during most of 2009 and 2010. Then in
September, the Small Business Jobs Act of 2010 was enacted, further amending Section 1202
to exclude 100% of qualifying gain from gross income.
For QSB stock purchased between September 27, 2010 and December 31, 2010, a zero percent
effective income tax rate will apply to at least the first $10 million of gain upon its
ultimate sale if applicable requirements are met. Excluded gain from these investments will
not be treated as a preference item for AMT purposes, so the benefits extend equally to AMT
The amount of gain eligible for the exclusion is
subject to per-issuer limits. The exclusion is available to taxpayers who own eligible
stock in a qualified corporation (hold the stock for more than five years), and
the corporation meets requirements that it actively conducts a qualified trade or
business and is under a maximum gross assets test.
The five year holding period requirement can be satisfied no earlier than August
12, 1998, since the exclusion can only apply to stock issued after August 10, 1993.
For gain on its stock to qualify for the exclusion, a corporation must be a C corporation
other than a
- A regulated investment company
- A real estate investment trust;
- A real estate mortgage investment conduit;
- A financial asset securitization investment trust;
- A cooperative; or
- A corporation electing the Puerto Rico and possessions tax credit.
Stock issued to a taxpayer cannot qualify for the exclusion if the issuing corporation
purchases (directly or indirectly) any of its own stock from the taxpayer or persons
related to the taxpayer, with the four-year period beginning two years before the
issue date. A 'safe-harbor' de minimis amount can be redeemed without rendering the
stock ineligible for the exclusion. The aggregate amount paid for the stock by the
issuing corporation in such redemptions cannot exceed $10,000 or more than 2 percent
of the stock held by the taxpayer and all related persons.
Stock will also not qualify for the exclusion if the issuing corporation engages
in a 'significant redemption'. A redemption is significant if the corporation, within
a two year period beginning one year before the issuance of the stock, redeems stock
with an aggregate value exceeding 5 percent of the aggregate value of all the corporation
stock. A de minimis exception applies if either the aggregate amount paid for all
stock redeemed during the two year period does not exceed $10,000 or no more than
2 percent of all outstanding stock.
There is a cumulative limit on the gain from a single issuer that a taxpayer may
exclude. Eligible gain from any one corporate issuer in any given tax year is taken
into account only to the extent that it does not exceed the greater of,
- $10 million reduced by the aggregate amount of eligible gain taken into account
by the taxpayer in prior years from the same issuer, or
- 10 times the adjusted basis of all qualified stock of the issuer that the taxpayer
disposed of during the tax year. Additions to the basis are disregarded. This limitation
can severely restrict the tax benefit of this provision in the event of a truly
The $10 million limitation is applied on a shareholder-by-shareholder basis and
any property contributed to the issuing corporation is its fair market value as
of the contribution date.
Married taxpayers filing separately have $5 million of eligible gain for each spouse.
Original issue requirement (Section 1202(c))
Small business stock must be acquired after August 10, 1993 by a taxpayer other
than a corporation, at its original issue (directly or through an underwriter),
for money, for property other than stock, or as compensation for services other
than underwriting. Please note that the exclusion is not limited to a corporation's
initial stock offering, but also applies to any subsequent issuance of stock.
Gain on qualified stock held by a partnership, S corporation, RIC, or common trust
is excludable if the entity held it for more than five years and the person to whom
the gain passes held an interest in the entity when the entity acquired the stock.
If qualified small business stock is transferred for other stock in a Section 351
incorporation or 368 reorganization transaction, the transferor treats the stock
received as qualified small business stock. The holding period of the exchanged
stock is tacked to that of the stock received.
If qualified small business stock is transferred by gift, at death, or from a partnership
to a partner, the transferee is treated as having acquired the stock in the same
manner as the transferor, and as having held the stock during the continuous period.
Qualified Small Business Requirement (Section 1202(d))
For substantially all of the taxpayer's holding period, the corporation must use
at least 80% by value of its assets in the active conduct of a qualified trade or
business. This includes assets used in furtherance of a prospective active business
(Section 195 and 174 activities). It also includes working capital, investments
expected to finance research, and computer software rights that produce active business
royalties. However, after the corporation has existed two years, no more than 50
% of the assets can be working capital or investments held for future research.
The active business requirement is waived for specialized small business investment companies
(SSBIC). An SSBIC is any corporation licensed by the SBA under Section 301(d) of
the Small Business Investment Act.
A qualified trade or business does not include professional service organizations
(law, accounting architecture, etc), banking, fanning, mining, or hotel and restaurant
management. If an issuing corporation owns more than 50 percent of another corporation,
its pro rata share of assets and activities is attributed to it.
A corporation is not a qualified trade or business for any period during which more
than 10 percent of its assets total value consists of real estate not used in the
active conduct of a qualified trade or business. Owning, dealing in, or renting
real property does not qualify.
Gross Assets Test
Both before and immediately after the issue date, a qualified small business corporation's
aggregate gross assets cannot exceed $50 million. All members of a parent-subsidiary
controlled group are treated as one taxpayer (>50 percent common ownership).
Any contributed property is determined as if the basis were equal to the fair market
value at the contribution.
Subsequently exceeding the $50 million limit does not disqualify otherwise qualifying
stock, but the corporation can never again issue qualified stock.
Recomputation of certain income and deductions based on AGI
In determining whether a net operating loss carryover remains after a net operating
loss is carried to another year, the amount excluded on the sale of qualified small
business stock in the year the loss is carried to must be added back to taxable
The $25,000 exception for passive rental activities phase out with respect to AGI
is determined without regard to the small business stock exclusion.
Gain excludable under this provision is not used in computing the taxpayer's long-term
capital gains or losses, and is not investment income for investment interest limitations.
If a sale of stock qualifies for the exclusion, the remaining gain is not eligible
for the 15 percent long-term capital gain rate. Such gain is treated as "mid-term"'
taxable at 28 percent. If gain does not qualify for the exclusion, the entire gain
may be taxed at 15 percent.
Effective for taxable years ending after May 5, 2003, 7 percent of any gain excluded
under Section 1202 is treated as a preference item for Alternative Minimum Tax.