Internal Revenue Codes Section (IRC) 1202, also known as the Qualified Small Business Stock (QSBS) provision, is a tax incentive designed to encourage investment in small businesses. It offers significant tax benefits to investors who hold eligible stock in qualified small businesses (QSBS).
The primary benefit of IRC 1202 is a potential exclusion of up to 100% of the capital gains realized upon the sale or exchange of QSBS. Some states also conform to IRC 1202 and provide the same or similar benefits.
Qualifications
To qualify for the exclusion, the stock must be issued by a Qualified Small Business (QSBS) after August 10, 1993, and held for more than five years. A QSBS is generally a domestic C corporation with total gross assets of $50 million or less at all times before and immediately after issuing the stock.
The stock must be newly issued by the QSBS. The stock must be purchased directly from the corporation either in exchange for money, property or compensation. Stock purchased from a previous shareholder or on the secondary market does not meet the original owner requirement.
A qualified shareholder generally must be an individual, trust, partnership (including an LLC taxed as a partnership), single-member LLC, S corporation, RIC or common trust fund can hold QSBS. An entity taxed as a C Corporation will not qualify. For pass-through entities owning QSBS stock, generally all the owners of the pass-through entity must hold the interest in the pass-through entity for the same time period.
Holding Period
The stock must be held for at least five years by the investor to qualify for the exclusion. The amount of gain that can be excluded depends on when the stock was acquired:
- For stock acquired after September 27, 2010, and before February 18, 2009, the exclusion is generally 75%.
- For stock acquired after February 17, 2009, and before September 28, 2010, the exclusion is generally 50%.
- For stock acquired after September 27, 2010, the exclusion is 100%.
There are limitations on the amount of gain that can be excluded under IRC 1202, typically the greater of $10 million or 10 times the taxpayer’s basis in the QSBS.
Additionally, IRC 1202 was intended for more entrepreneurial businesses such that not all types of businesses qualify for these benefits. Generally, businesses that are excluded from IRC 1202 include:
- Service Businesses: Businesses involved in providing services in fields such as health, law, engineering, architecture, accounting, consulting, athletics, financial services, or any other service business where the principal asset is the reputation or skill of one or more employees.
- Financial Businesses: Businesses primarily engaged in banking, insurance, financing, leasing, investing, or similar activities.
- Farming Businesses: Businesses involving farming (including raising or harvesting any agricultural or horticultural commodity).
- Hospitality Businesses: Businesses operating hotels, motels, restaurants, or similar businesses.
- Mining Businesses: Businesses involving the extraction or refining of minerals or any other business involving the exploration or production of oil, gas, or any other mineral resources.
- Real Estate Businesses: Businesses primarily engaged in real estate development, operation, management, or leasing.
- Professional Sports Teams: Businesses that are professional sports teams or that have substantial activities that involve the performance of services as an athlete, manager, coach, trainer, or broadcaster.
IRC 1202 also requires an active trade or business test and an asset use test that the corporation issuing the stock be engaged in an active trade or business during the taxpayer’s holding period. This test ensures that the corporation is not merely holding passive investments but is actively conducting business operations.
At least 80% of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses. The business should be actively operating rather than passively holding investments or assets. The 80% threshold is measured by the corporation’s assets at the end of the year. The corporation must use its assets primarily in the active conduct of its trade or business, not just in occasional or incidental activities.
Deferral Alternative
IRC 1045 provides a way to defer taxes on gains from the sale of QSBS if the proceeds are reinvested in other QSBS. If IRC 1202 stock is sold before the five-year holding period, a QSBS can still receive tax deferral treatment if the proceeds from the sale are reinvested into new QSBS within 60 days of the sale.
The new QSBS can be acquired from one or more QSBS. The newly acquired QSBS must meet the same IRC 1202 requirements as the original stock, including being issued by a QSBS and meeting other eligibility criteria.
The gain from the original QSBS sale is deferred and not immediately recognized. Instead, the new QSBS acquired in the rollover takes on the holding period and basis of the original QSBS. When the new QSBS is eventually sold, the deferred gain from the original QSBS is recognized at that time.
IRC 1202 provides substantial tax benefits to investors who support small businesses through direct investment in QSBS. By incentivizing long-term investment and reducing the tax burden on capital gains, IRC 1202 plays a crucial role in fostering entrepreneurship and innovation in the economy. However, navigating the complexities of IRC 1202 requires careful consideration of eligibility criteria and compliance with IRS regulations to fully realize its benefits. Investors engaged in advanced QSBS tax planning should consider seeking the advice of tax professionals who regularly work with Sections 1202 and 1045.