Do Clients Qualify Shareholders for Section 1202?

Section 1202 can exclude long-term capital gain on the sale (or sales) of stock in a C corporation.  It is one of the current incentives for operating as a C corporation.  

There are different rules depending on when the “qualified small business stock” was acquired. The stock needs to be original issue stock, though not necessarily first-issue stock. There is currently a 100-percent exclusion (within limits) as to stock acquired after September 27, 2010. So, the relatively recent investor can disregard the “Partial exclusion” language in the name of the Code provision. 

The stock, despite the “small business” language, can be that of a reasonably large business. One test, which has detailed and at times complex rules, asks if the basis of assets has exceeded $50 million.  

The adjusted tax basis of the assets typically but not always governs this test measurement.  Stock issued when that test is met continues to qualify even if the corporation later exceeds the asset threshold. 

The focus goes back to 1993, so the test for most businesses will look to assets since formation.  Assets increased via debt, for example, can be a problem in passing this test. Most middle-market businesses will readily pass the $50 million test.

The gain exclusion is limited to the greater of $10 million or 10 times the aggregate adjusted basis of the stock when issued (Sec. 1202(b)). So, the measure of the exclusion is also quite generous.

In our current tax environment, the tax rate savings would often be 23.8 percent  – 20 percent capital gain and 3.8 percent net investment income tax. However, one has to do the math of the particular taxpayer; long-term capital gain rates without the 3.8 percent can be zero, 15 percent and/or 20 percent. 

A special 28 percent rate plus the 3.8 percent tax can apply to qualifying stock issued earlier than September 28, 2010, and subject to the 50 percent or 75 percent exclusion rather than the 100 percent exclusion for more recent stock issuances.

Individuals, trusts and estates can qualify for Section 1202 benefit via direct ownership, or subject to certain rules, when qualifying ownership flows through a partnership or S corporation.  Corporate owners of stock don’t qualify.  

Operations can be foreign but the corporation needs to be domestic (Sec. 1202(d)(1)).  Certain types of corporations do not qualify:

• Interest Charge Domestic International Sales Corporation                                                       
• former Domestic International Sales Corporation                                                                
• Registered Investment Company                                                                        
• Real Estate Investment Trust                                                                                                        
• Real Estate Mortgage Investment Conduit
• Cooperative

The exclusion benefit accrues to a “taxpayer other than a corporation…” and requires such stock be held for more than five years (Sec. 1202(a)(1)). So, while the 100 percent exclusion benefit accrues to those acquiring stock after September 27, 2010 (a little over ten years ago as we write), there is also a key holding-the-stock requirement that looks to ownership exceeding five years.   

The five-year holding period requirement looks to the period the stock is held, a rule which isn’t mitigated by looking to the holder period of any property contributed in exchange for the stock. If stock arises under a stock option plan, the option holding period doesn’t count for purposes of the five-year test.

The stock does not meet the key definition of being “qualified small business stock” unless during substantially all of the taxpayer’s holding period, the C corporation meets the active business requirements of Section 1202(e) which asks if at least 80 percent (by value) of assets are used in one or more active and qualified trades or businesses. Multiple tiers of entities bring into play special tax rules in applying the active business test.

The qualifying taxpayer needs to have acquired the stock after August 10, 1993, from the company although stock received in exchange for other stock may qualify. The stock does not have to be issued in connection with the initial incorporation.   

As noted, for 100 percent exclusion, the stock issuance date must begin after September 27, 2010. The exclusion can not only apply to stock sales but also stock redemptions and corporate liquidations. Stock redemptions require precautionary planning and bring into play special rules.

There is a lengthy list of nonqualifiers, which asks if the trade or business involves performing services in these fields: health, law, engineering, architecture, accounting, actuarial science, performing arts; consulting, athletics, financial services, brokerage services, any trade or business if the principal asset is the reputation or skill of 1 or more of its employees; any banking, insurance, financing, leasing, investing, or similar business; any farming business (including the business of raising or harvesting trees); any business involving the production or extraction of products of a character that yields a depletion deduction under section 613 or 613A; and running a hotel, motel, restaurant, or similar business.

A recent private letter ruling summarizes the list as involving “specified services” or “individual expertise.”  It concluded a software company qualified because it was not providing health services but rather was creating an asset to be used by customers in healthcare.  Nor did it provide value in the form of individual expertise (PLR 202144026, 11/15/21; see also PLR 201717010, 4/28/17, and PLR 201436001, 9/25/14).

The Section 1202 provision is one that often requires advance planning and foresight. The decision to hold stock for more than five years prior to disposition can involve economic downturn risks from the economy or the particular business that have to be balanced against the potential tax savings. 

There may also be state tax savings which would need to be researched. Many states follow the federal treatment. The measure of gain that can be excluded under this provision can result in major tax savings for the client. Transfer tax and family tax planning may also be an important consideration (See Sec. 1202(h)(2)).

Barring legislative limitations to Section 1202 under the Biden administration, it is possible the long-term capital gain exclusion could be even more valuable if we see higher long-term capital gains tax rates in the future.  This could also occur if/when there are limitations on the rule that says death of the taxpayer results in step-up in tax basis to the heir receiving appreciated property.  

As of late 2021, there are provisions in the House version of the Build Back Better bill that would limit the benefits of Section 1202 for certain sales or exchanges on or after September 13, 2021, barring a binding and unmodified transaction in effect on September 12, 2021.  The rule limits the 100 percent and 75 percent exclusions for taxpayers with adjusted gross income of $400,000 and more, and trusts and estates. 

The $400,000 threshold apparently is without regard to the section 1202 exclusion.  It is also without regard to sections 911, 931 and 933. As such, the provision, if enacted in the proposed House form, would introduce severe limitations on the current benefit of section 1202.  

It is hoped that the benefits of this important business incentive will not be severely limited by new legislation.