Section 1202 Stock is a valuable tax provision designed to encourage investment in qualified small businesses by offering significant federal tax exclusions on capital gains. Enacted in 1993, Section 1202 of the Internal Revenue Code incentivizes investors to support emerging companies that drive innovation and job creation in the economy.
How Section 1202 Stock Works
To benefit from Section 1202, an investor must purchase stock from a qualified small business C corporation. The corporation must have gross assets of $50 million or less before and immediately after the stock issuance. Additionally, at least 80% of the corporation’s assets must be actively used in one or more qualified trades or businesses, excluding certain fields such as professional services, finance, and hospitality.
Investors must hold the stock for a minimum of five years to be eligible for the tax exclusion. Upon selling the qualifying stock after this period, the investor may exclude a large portion—or even all—of the capital gains from federal tax, depending on when the stock was acquired.
What Qualifies as a Qualified Small Business?
A qualified small business is generally a domestic C corporation that meets the asset requirement and operates in an allowable trade or business. The IRS provides specific guidance about activities that qualify or disqualify a company, making it crucial for investors to verify the corporation’s status before investing.
Tax Exclusion Limits
The section 1202 gain exclusion is phased based on the acquisition date of the stock:
| Acquisition Date | Maximum Gain Exclusion (%) |
|---|---|
| Before February 18, 2009 | 50% |
| February 18, 2009 to September 27, 2010 | 75% |
| After September 27, 2010 | 100% |
The maximum gain exclusion is subject to a cap of the greater of $10 million or 10 times the taxpayer’s basis in the stock.
Practical Example
Suppose you invest $20,000 in a qualified small business and hold the shares for six years. If the stock appreciates to $120,000, your capital gain of $100,000 could be entirely exempt from federal tax under Section 1202 if it qualifies for the 100% exclusion.
Who Can Benefit?
- Individual investors seeking long-term growth through small business equity.
- Entrepreneurs and startups issuing qualified stock to raise capital.
- Tax professionals guiding clients on maximized tax-efficient investments.
Important Considerations
- Verify the small business qualification prior to investing to ensure eligibility.
- Maintain ownership for the full five-year holding period to receive any gain exclusion.
- Keep thorough documentation of purchase dates and corporate qualifications.
- Consult with a tax advisor because rules about qualified businesses and asset tests can be complex.
Common Misconceptions
- Not all small business stocks qualify; only specific C corporations meeting IRS criteria do.
- Selling before five years forfeits the exclusion.
- State tax laws may not conform to federal exclusions, potentially resulting in state-level tax.
Related Topics
For additional insight, see our Qualified Small Business Stock Credit article that further explains tax credits associated with small business investments.
Frequently Asked Questions
Q: Can I get a partial exclusion if I sell before five years?
No. The stock must be held for five years to qualify for any Section 1202 exclusion.
Q: Does this apply to S corporations or LLC stock?
No. Section 1202 applies only to stock of domestic C corporations.
Q: Is there a cap on how much gain can be excluded?
Yes. The exclusion limit is the greater of $10 million or 10 times your basis in the stock per issuer.
Q: What if the company changes its business type after I purchase the stock?
The corporation must meet the active business requirement for substantially the entire time you hold the stock; changes may disqualify the stock.
Sources and Further Reading
- IRS Topic No. 701, Qualified Small Business Stock (Section 1202)
- Investopedia, Section 1202 Stock Overview
- NerdWallet, What Is Section 1202 Stock?
Understanding Section 1202 Stock can provide substantial federal tax savings while encouraging investment in growing businesses. Careful planning, verification of eligibility, and holding investments for the required duration can make this tax provision a powerful tool for investors supporting the small business economy.