Which Stock Qualifies for Section 1202 Tax Benefits?

IRC Section 1202, known as the Small Business Stock Gains Exclusion, allows taxpayers to exclude from federal income tax capital gains from the sale or exchange of Qualified Small Business Stock (QSBS). The exclusion applies to certain small business stock held for more than five years with an exclusion limited to the greater of $10 million or 10 times the aggregate adjusted basis of the stock.

Small business stock may qualify for QSBS treatment if it meets certain requirements related to eligibility, gross assets, maintaining an “active business,” and avoiding “significant redemptions.” Answering the following questions can help taxpayers determine whether their capital gain qualifies for QSBS treatment and the amount of the gain that can be excluded.

Eligibility Requirements

Was the stock issued by a domestic C corporation after August 10, 1993? This eligibility requirement excludes domestic international sales corporations (DISCs) or former DISCs, regulated investment companies (RICs), real estate investment trusts (REITs), real estate mortgage investment conduits (REMICs), and cooperatives.

Was the stock an original issue stock issued to a non-corporate taxpayer? The stock can be acquired directly or through an underwriter either (1) in exchange for money or other property (not including stock), or (2) as compensation for services provided to such corporation (other than services performed as an underwriter of the stock).

Gross Asset Test

Do the corporation’s assets exceed $50 million? The corporation’s “aggregate gross assets” cannot exceed $50 million before and immediately after the issuance of the stock. A corporation’s aggregate gross assets are the amount of cash and the aggregate adjusted bases of contributed property held by the corporation; the adjusted basis of contributed property is its fair market value at the time of contribution. The test takes into account amounts received in the issuance of the stock to determine gross assets “immediately after” the issuance of the stock.

Were subsidiaries included in the gross asset test? All corporations that are members of the same parent-subsidiary controlled group are treated as one corporation for purposes of determining the total gross assets. A “parent-subsidiary controlled group” is any controlled group of corporations in which the parent has more than 50 percent ownership.

Active Business Test

Does the corporation use at least 80 percent of its assets in an “active business?” The issuing corporation must have used at least 80 percent of its assets in one or more “qualified active trade or business” during substantially all of the time the stockholder held the stock. Businesses that are not qualified include professional services; banking, insurance, and similar businesses; farming; lodging and restaurants.

Were subsidiaries included in the “active business” test? If a corporation owns more than 50 percent of subsidiary, measured through either voting power or value, then it must include its ratable share of the subsidiary’s assets in determining the active business requirement.

Do the corporation’s portfolio investments exceed 10 percent of its assets? As part of the “active business” test, the corporation’s “portfolio stock or securities” cannot exceed 10 percent of the value of its net assets since the issuance of the stock.

Do the corporation’s real estate holdings exceed 10 percent of its assets? A corporation’s holdings of real property that is not used in an active business cannot be more than 10 percent of the total value of its assets. The ownership of, dealing in, or renting of real property is not the active conduct of a qualified trade or business under this rule.

Holding Period

Is the stock subject to any restrictions such as vesting requirements or risk of forfeiture? In general, the holding period for stock options will not begin until the options are exercised. Even after the options are exercised, certain vesting requirements could delay the start of the holding period. Making, and timely filing, a valid IRC Section 83(b) election, however, will usually allow the stock to be considered issued upon the initial date.

Significant Redemptions

Has the corporation had any “significant redemptions?” The corporation cannot make any repurchases of stock from any of its stockholders of more than 5 percent of the aggregate value of all of its stock one year before or one year after the issuance of the stock.

Has the corporation purchased stock from the taxpayer or a related person? The issuing corporation cannot purchase, directly or indirectly, any of its stock from the taxpayer or from a person related to the taxpayer two years before or two years after the issuance of the stock.

Amount of Exclusion

If the requirements are met, the taxpayer can then exclude a share of its capital gain from federal income tax along the following schedule:

• 50 percent exclusion for stock issued between August 11, 1993-February 17, 2009;
• 75 percent exclusion for stock issued between February 18, 2009-September 27, 2010;
• 100 percent exclusion for stock issued after September 28, 2010.

If you have any questions about determining whether your small business stock qualifies for QSBS treatment, please contact us.

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