Section 1202 of the Internal Revenue Code was enacted to provide an incentive for investment in start-up corporations. In its current form, § 1202 allows the exclusion of 100 percent of the gain realized on a sale of qualifying small business stock (QSBS).
In its original form, § 1202 did not provide much benefit to taxpayers. Perhaps for this reason, Treasury has not promulgated many regulations to aid in interpreting § 1202 and its practical implications, leaving many unanswered questions. There is also very little in the way of case law around § 1202. After the percentage of exclusion was increased to 100 percent in 2010, § 1202 became much more interesting to investors.
To qualify for the exclusion, the QSBS must be held for at least five years. The stock must be acquired through an original issuance in exchange for money or property (other than stock), or in exchange for services. Only C corporations can issue QSBS, and shareholders that are C corporations cannot benefit from the exclusion. The deemed issuance of C corporation stock as part of a check-the-box election is treated as an original issuance.
In addition to the five-year holding period and original issuance requirements, there are several other requirements for achieving excludability under § 1202. These include:
Active Business Requirement: At least 80 percent of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses. There is a look-through rule that treats the assets of subsidiaries as assets of the parent.
Gross Assets Limit: Once a corporation has gross assets that exceed $50 million in value, it can no longer issue QSBS. This limitation does not impact QSBS that was issued before the corporation hits this limit. There are aggregation rules that can come into play, so the ownership structure should be analyzed to make sure no large corporations have over 50 percent of the ownership, directly or indirectly.
Qualified Trade or Business Requirement: Certain types of businesses are not eligible for § 1202 exclusion even if all the other requirements are met. Many professional services businesses are on this list, including in the areas of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage. Farming and mining businesses are also not eligible, as are banking, insurance, financing, leasing, investing, or similar businesses. Hotel, motel, restaurant, and similar businesses are ineligible as well.
Restrictions on Significant Redemptions: A corporation must not redeem more than 5 percent of the aggregate value of its stock within one year before or after an issuance that is intended to be QSBS.
Also, stock is not considered QSBS in the hands of a shareholder if the corporation redeemed more than a de minimis amount of stock from that shareholder or a related person with two years before or after the issuance date of that stock.
Per-issuer Limitation on Excludable Gain: There is an overall limit on the amount of gain that can be excluded under § 1202. This limit is the greater of $10 million or 10 times the basis of the QSBS at the time it is acquired. This limit applies to each shareholder, though married filers are treated as one shareholder. The limit is also applied per issuer; excluding QSBS gain on one corporation’s stock does not impact the investor’s ability to exclude QSBS gain on another corporation’s stock.
QSBS can be owned by a pass-through entity, such as an S corporation or a partnership. To be able to exclude gain under § 1202, a partner or shareholder must have been an owner of the pass-through entity at the time the entity acquired the QSBS, and the owner’s percentage of the § 1202 excludable gain can never increase beyond that partner/shareholder’s percentage ownership in the entity at the time the QSBS is acquired. For example, if a partnership with five equal partners (20 percent each) acquires QSBS and later one of the partners buys out 3 of the other partners (so that partner owns 80 percent and the other remaining partner owns 20 percent) only one fourth of the 80 percent partner’s gain (20 percent of the total) on an eventual qualifying sale of the QSBS will be excludable under § 1202. Because profits interests by definition do not represent any ownership of partnership capital, most experts agree that gain allocated to profits interests cannot be excluded under § 1202.
One question that has not been clearly answered is whether partners in an upper-tier partnership can benefit from the 1202 exclusion on gains realized by the lower-tier partnership on sales of QSBS owned by that lower-tier partnership. There is nothing in the Code or regulations that expressly denies this. Regulations under § 1045 – another QSBS-related Code section, regarding the tax-free rollover of QSBS gains – clearly allow for the benefits of that section to flow to upper-tier partners. But the language of § 1202 could be read to require direct ownership in the entity that holds the QSBS:
[Amounts must be] attributable to gain on the sale or exchange by the pass-thru entity of stock which is qualified small business stock in the hands of such entity (determined by treating such entity as an individual) and which was held by such entity for more than 5 years, and such amount is includible in the gross income of the taxpayer by reason of the holding of an interest in such entity which was held by the taxpayer on the date on which such pass-thru entity acquired such stock and at all times thereafter before the disposition of such stock by such pass-thru entity. I.R.C. § 1202(g)(2) (emphasis added).
Such a reading may be overly literal, but in the absence of IRS guidance, we cannot be sure of the position the IRS may take. Due to the similarities between § 1045 and § 1202, it makes sense to look at § 1045 regulations for guidance on § 1202, and it would be reasonable for the IRS to do so.
If partners in an upper-tier partnership are eligible for exclusion on § 1202 gains, they would of course be subject to the rules described above, limiting their share of the § 1202 benefit to their share of the upper-tier partnership at the time the lower-tier partnership acquired the QSBS, taking into account the upper-tier partnership’s percentage ownership in the lower-tier partnership.
Most states follow the federal treatment of § 1202, but not all of them. Notably, California does not conform, so residents of California will have to pay California income tax on gains that are excludable on the federal return.
CAVEAT: As of the date of this writing (September 17, 2021) there is legislation pending in Congress that would significantly reduce the benefit of § 1202 for many investors. If the current language is enacted, investors with adjusted gross incomes (AGI) exceeding $400,000 and trusts and estates will essentially go back to the pre-2009 version of § 1202, where only 50 percent of the gain is excludable, the gain that is recognized is taxed at a 28 percent rate, and there is an Alternative Minimum Tax (AMT) adjustment of 7 percent of the exclusion amount.