Section 1202: Unlocking Tax-Free Growth for Small Business Investments

For investors and entrepreneurs, the Qualified Small Business Stock (QSBS) exclusion under Section 1202 of the Internal Revenue Code is one of the most valuable tax benefits available. By allowing eligible shareholders to exclude up to 100% of capital gains from the sale of qualified stock, Section 1202 can significantly enhance after-tax returns. However, leveraging this benefit requires a thorough understanding of the eligibility criteria, strategic planning, and awareness of potential pitfalls.

This article explores the key aspects of Section 1202 and highlights strategies to maximize its advantages, including considerations for companies approaching an exit.

What Is Section 1202?

Section 1202 was enacted to encourage investment in small businesses by offering generous tax incentives to investors. If certain conditions are met, shareholders can exclude a percentage of their capital gains from federal income tax when selling QSBS. Here are the core benefits:

1. Capital Gains Exclusion:

   • Depending on the acquisition date, investors may exclude 50%, 75%, or 100% of the capital gains.

   • For QSBS acquired after September 27, 2010, the exclusion is 100%.

2. High Exclusion Limit:

   • The exclusion applies to the greater of $10 million in gains per issuer or 10 times the investor’s adjusted basis in the stock.

3. No Alternative Minimum Tax (AMT):

   • Gains excluded under Section 1202 are not subject to AMT for stock acquired after September 27, 2010.

Eligibility Criteria for Section 1202

To qualify for the exclusion, both the shareholder and the issuing company must meet specific requirements:

1. Qualified Small Business:

   • The issuing corporation must be a C corporation with gross assets not exceeding $50 million at the time of issuance and immediately thereafter.

   • At least 80% of the company’s assets must be used in an active trade or business.

2. Qualified Trade or Business:

   • Certain industries, such as financial services, real estate, and professional services, are excluded from Section 1202 benefits.

3. Original Issuance:

   • The stock must be acquired directly from the corporation in exchange for money, property, or services.

4. Holding Period:

   • Investors must hold QSBS for more than five years to claim the exclusion.

5. Redemption Restrictions:

   • Significant stock redemptions by the corporation can disqualify the stock from QSBS status. Specifically, redemptions exceeding 5% of the stock’s aggregate value within certain periods are problematic.

Common Pitfalls to Avoid

While Section 1202 provides substantial tax benefits, several missteps can jeopardize eligibility:

1. Failing to Meet the Holding Period:

   • Selling stock before the five-year mark disqualifies the gains from the exclusion.

2. Disqualifying Stock Redemptions:

   • Stock buybacks exceeding allowable limits can strip the stock of its QSBS status.

3. Non-Qualifying Business Activities:

   • If the company pivots into an excluded trade or business, its stock may no longer qualify as QSBS.

4. State-Level Taxation:

   • Some states, such as California, do not recognize Section 1202 exclusions, meaning gains may still be subject to state taxes.

Strategic Planning to Maximize Section 1202 Benefits

Proactive planning is essential to fully leverage Section 1202. Key strategies include:

1. Structuring for Eligibility:

   • Ensure the corporation meets the gross asset test and engages in a qualified trade or business.

   • Avoid stock redemptions that could trigger disqualification.

2. Timing and Issuance:

   • Issue stock when the company’s assets are below $50 million to preserve QSBS eligibility.

3. Exit Planning:

   • For companies nearing an exit, a QSBS analysis is critical. Identifying risks and confirming eligibility can safeguard the exclusion.

   • Lazarus PC can prepare detailed QSBS analyses and draft shareholder-ready documentation ahead of planned exits. This ensures all parties are aligned and able to capitalize on the available benefits.

   For more insights into how to prepare for a tax-efficient exit, read our upcoming article: “Exit Planning with QSBS: A Guide for Shareholders.”

4. Leveraging Section 1045 Rollovers:

   • If selling before the five-year holding period, consider rolling gains into new QSBS under Section 1045 to defer taxes.

5. Combining with Other Tax Strategies:

   • Pair Section 1202 benefits with other tools, such as 83(b) elections or estate planning, to maximize tax efficiency.

Practical Example

Scenario:
A founder acquires QSBS in a biotech startup in 2015. In 2023, after more than five years, the company is acquired, and the founder’s shares are sold for $20 million.

Outcome:
Under Section 1202, the founder can exclude $10 million of gains from federal taxation (per the per-issuer limit). This results in significant tax savings, preserving more of the founder’s wealth for reinvestment or personal use.

Conclusion

Section 1202 is a powerful tax-saving tool for investors and founders, but unlocking its full potential requires careful planning and a thorough understanding of its requirements. From maintaining QSBS eligibility to preparing for exits, proactive strategies can ensure compliance and optimize outcomes.

If you’re considering a transaction involving QSBS or planning an exit, Lazarus offers tailored guidance to navigate the complexities and maximize the benefits of Section 1202. Contact us to discuss your goals and how we can help.

For more on QSBS exit strategies, stay tuned for our companion article on preparing shareholders for success.