Sec. 1202: small business stock capital gains exclusion.

• Author: DeSanty, Tina M.

Congress has provided a variety of incentives to encourage taxpayers to invest in small businesses. In the past several years, Congress has made these incentives more generous, to the point where a complete exemption from federal income tax on gains from the sale of certain stock is possible. Although the more generous of these incentives have been enacted on a temporary basis, there is still an opportunity for investors to make investments that could qualify for a full federal income tax exemption on a subsequent sale. This item explores the nature of the Sec. 1202 exclusion and identifies some recent changes to the exclusion.

Qualified Small Business Stock

For taxpayers other than corporations, Sec. 1202 excludes from gross income at least 50% of the gain recognized on the sale or exchange of qualified small business stock (QSBS) that is held more than five years. As described more fully below, for qualifying stock acquired after Feb. 17, 2009, and on or before Sept. 27, 2010, the exclusion percentage is 75%, and for qualifying stock acquired after Sept. 27, 2010, and before Jan. 1, 2014, the exclusion percentage is 100%. The amount of the exclusion is 60% in the case of the sale or exchange of certain empowerment zone stock that is acquired after Dec. 21, 2000, and sold before 2015.

Sec. 1202 was enacted in 1993, before the maximum capital gain rate for noncorporate taxpayers was reduced in 1997 to 20% and then in 2003 to 15% (for 2013, iris back up to 20%, but only for taxpayers in the 39.6% income tax bracket). The Jobs and Growth Tax Relief Reconciliation Act of 200.3 (JGTRRA), P.L. 108-27, eliminated virtually all of the tax rate benefit related to the Sec. 1202 gain exclusion. However, the ability to roll over gains on Sec. 1202 stock remains an advantage.

For most taxpayers, QSBS is a capital asset subject to capital gain tax rates. Most taxpayers to whom Sec. 1202 applies are subject to a lower effective tax rate than would have been the case had Congress not provided for partial gain exclusion for QSBS. However, a tax-payer is not entitled both to partial gain exclusion under Sec. 1202 and to the reduced capital gain rates that otherwise would be available. The taxable portion of the gain is taxed under the normal rules and subject to a maximum rate of 28% on capital gains. This makes the maximum effective rate on the gain from the sale of QSBS 14%. The potential application of the alternative minimum tax (AMT) further erodes the benefits of investing in QSBS.

The gain eligible to be taken into account for purposes of this exclusion is limited to the greater of $10 million or 10 times the taxpayer's basis in the stock (Sec. 1202(b)(1)). The limitation is computed on a per-issuer basis, with lower limits applying to married individuals filing separately. In the case of married individuals filing joint returns, gain excluded under this provision is allocated equally between the spouses in applying the exclusion in later years. Gain excluded under this provision is not used in computing the taxpayer's long-term capital gain or loss, and it is not investment income for purposes of the investment interest limitation. For purposes of the modifications to income for computing a noncorporate taxpayer's net operating loss deduction...