Gains on the Sale of Small Business Stock (Section 1202)
In order to stimulate investment in small businesses,
the 1993 tax law introduced code section 1202, which says
that you may exclude from taxable income up to 50 percent
of the gain you realize on the sale of qualified small
business stock.
In order to qualify for the exclusion, you must meet
these criteria:
- You are not a corporation.
- You acquired the stock from a C corporation after
August 10, 1993, in an original issue, in exchange for
money or other property, or issued as compensation for
services that were provided to the corporation.
- On the date the stock is issued, the corporation
was a qualified small business.
- During substantially all the time the stock is held,
the business meets the active business requirements
of section 1202 (c). This requirement will be waived
if the corporation qualifies as a "specialized
small business investment company".
- At all times after August 10, 1993, or after the
inception of the company if later, and immediately after
the issuance, the corporation’s gross assets do
not exceed $50 million.
- At least 80 percent of the assets of the corporation
are used by the corporation in the conduct of one or
more qualified trades or businesses. A qualified business
means any trade or business other than:
any trade or business involving the performance of personal
services in specified fields such as accounting, law,
or medicine;
any business involved in banking, financing, leasing,
insurance, or similar businesses;
any farming business;
any business operating a hotel, motel, restaurant, or
similar business;
any business to which a deduction for depletion is allowed.
- The corporation must be an eligible C corporation,
which precludes a number of specialized corporations
such as REITs, REMICs, DISCs, and cooperatives.
- The corporation must not have purchased stock from
you within two years before or after issuing stock to
you. It cannot have purchased stock of greater than
5 percent of total stock outstanding from anyone within
1 year before or after issuing stock to you.
- If the corporation is an Empowerment Zone Business
the exclusion is increased to 60 percent.
Limits on the Amount of Gain You Can Exclude
For any corporation’s stock, the maximum gain
eligible for exclusion in any one year is $10 million
less any gains excluded in previous years. Therefore,
the maximum lifetime exclusion for any one issuer’s
stock is $5 million, 50% of $10 million ($6 million if
the corporation is an Empowerment Zone Business).
In addition, you are limited to a gain that is not more
than 10 times the adjusted basis of the stock.
The nonexcluded portion of the gain on sale is subject
to tax at 28 percent (resulting in an effective rate of
14 percent (50% x 28%)) on the entire gain.
Also, 7 percent of the excluded gain is a preference
item for purposes of calculating alternative minimum tax
(AMT). A preference item is an item of income that is
added back to your regular income for purposes of computing
the alternative minimum tax, a parallel taxing system
designed to make sure that higher income taxpayers pay
at least a minimum amount of tax.
As you can see, there are a number of hurdles to overcome
in order to exclude the gain. However if you think you
may qualify, or want to structure your investment to make
sure you qualify, you should consult a professional advisor
with expertise in this area.
By Intuit Inc.
