Walking the Sec. 1202 minefield.

• Author: Bongorno, Richard P.
• Position: Illustration

Sec. 1202, enacted as part of the Revenue Reconciliation Act of 1993, was touted as a bona fide incentive for long-term investors in small businesses to reduce their capital gains tax if the investment should prove to be successful. It does so in the form of a 50% capital gain exclusion (on the first $10 million of gain or 10 times the stock's adjusted basis, whichever is less), reducing the maximum tax on the gain on sale of Sec. 1202 stock to 14%; half of the exclusion is an alternative minimum tax preference that could raise the rate to 21%. (Pending tax legislation would not change this result.) This incentive should attract more money from nonactive investors to small business start-ups. While the basic structure of Sec. 1202 does serve to provide an incentive, actually realizing this benefit will require careful navigation of the many and complex rules from acquisition to the ultimate sale. While most practitioners will never be involved in structuring such actions, many will have clients who are investors and will need to know how to achieve and maintain Sec. 1202's benefits.

Tax prepares have yet to encounter Sec. 1202, since die benefit of this provision cannot yet be obtained. For this provision to apply, an investor (other than a C corporation) must have purchased qualified small business stock (QSBS) after Aug. 10, 1993 and have held that stock continuously for a five-year period. The basic rules here seem quite dear and, obviously, quite beneficial to taxpayer/investors. However, the intricacies of Sec. 1202 have many pitfalls that will trigger loss of it's benefits; this can sometimes be done by an act of the company and sometimes by the shareholder.

The first completely appears in the definition of QSBS. The basic definition in Sec. 1202(c)(1) is straightforward, providing for QSBS to be issued after Aug. 10, 1993 by a C corporation that is a qualified small business (QSB) and the stock acquired as an original issue. Generally, a QSB is defined as a C corporation with aggregate gross assets of not more than $50 million at all times from Aug. 10, 1993 through (and including) the issuance of the QSBS (Sec. 1202(d)(1)). But Sec. 1202(c)(2) adds a significant restraint by requiring that "... [s]tock in a corporation shall not be treated as qualified small business stock unless, during substantially all of the taxpayer's holding period for such stock, such corporation meets the active business requirements of subsection (e) ...."...