Thinking about investing in a young, promising company? Section 1202 of the tax code offers a significant incentive for individuals to do just that.

What is Section 1202?

Section 1202 is a tax provision enacted in 1993 to encourage long-term investment in smaller startup companies. The aim of Section 1202 is to permit non-corporate shareholders to exclude from gross income 100% of the gain from a sale or exchange of “qualified small business stock” (“QSBS”) acquired after September 27, 2010 and held for more than five years. There is a cap on the exclusion amount available to a shareholder, which is the greater of $10 million of recognized gain, or ten times the adjusted basis of the QSBS per qualifying corporation.

Qualifying for the Exclusion

In order to take advantage of this tax exemption, there are certain conditions that need to be fulfilled:

The issuing corporation:

• Must be a domestic C corporation with gross assets not exceeding $50 million.
• Must use at least 80% of its assets in an active, qualified trade or business. Excluded businesses include finance, law, and certain service-based industries.

The stock:

• Must be acquired by the investor at original issuance in exchange for cash or services.
• Must be held for at least five years before selling.

Qualified Trade or Business

The term “qualified trade or business” excludes the provision of services in certain areas, including health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Certain other business types are also excluded from a “qualified trade or business,” including banking, insurance, investing, farming, extracting minerals, water, oil, or gas, and operating a hotel or restaurant.

Restrictions on Stock

In addition to the requirements imposed on the issuing corporation, several restrictions are imposed on the stock under Section 1202. QSBS includes only stock that the taxpayer acquired at its original issuance in exchange for property (including money but excluding stock) or as compensation for services. The “original issue” requirement means that QSBS generally cannot be sold or exchanged without forfeiting its QSBS status (and favorable tax treatment). However, some types of transfers are exempt from this general rule. Certain types of tax-free transactions impute the transferor’s original issuee status on the transferee.

Transfers of stock to the issuing corporation may also prevent or forfeit QSBS characterization. These restrictions prevent a taxpayer from essentially converting non-QSBS shares into QSBS shares.

Three types of redemption transactions disqualify stock from QSBS status:

• Redemptions from the holder or persons related to the holder within the window of two years on either side of the QSBS issuance.
• “Significant” redemptions from any persons within the window of one year on either side of the QSBS issuance. Whether or not a redemption is “significant” is determined based on the amount paid for the redeemed stock and the redeemed stock’s value in relation to the total value of all the issuer’s stock.
• Certain redemptions of stock through parties related to the issuer.

Three types of transactions are ignored for purposes of determining whether a disqualifying redemption transaction described above has occurred:

• A transfer of QSBS by a shareholder to an employee or independent contractor will not be treated as a purchase by the issuer for purposes of Section 1202.
• If the QSBS was issued to an employee or director in connection with the performance of services, and the corporation subsequently reacquires the QSBS in connection with the termination of such services, the transaction will not be counted as a redemption for purposes of Section 1202.
• If QSBS is converted into other stock of the issuing corporation, the stock received will also be treated as QSBS in the hands of the shareholder.

Holding Period

QSBS must be held for at least five years to qualify for gain exclusion under Section 1202. Generally, the holding period of a transferor will carry over to the transferee in the case of permitted transfer under Section 1202 (i.e., gift, inheritance, partnership distribution). However, in the case of a partnership’s transfer of QSBS to a partner, limitations on the amount of gain that may be excluded may apply. If QSBS is held for more than six months but less than five years when sold, a shareholder can defer capital gains tax by reinvesting the sales proceeds in other QSBS within 60 days of the sale.

Remember, this is a simplified overview of Section 1202. Consulting with a legal or tax advisor is essential for making informed investment decisions and ensuring you understand all the complexities of Section 1202.