Michael Hampleman Section 1202 Stock: How most taxpayers can exclude up to $10 Million on the Sale of their Business!
The title of this article is NOT a typo, that’s right…up to $10 Million United States Dollars can be excluded from the sale of a business if certain parameters are met. Business owners should take note of the very important requirements that allow the exclusion of up to $10 million in federal tax. Section 1202 is an EXTREMELY beneficial portion of the Internal Revenue Code and so long as the correct rules are followed, the exclusion is easy to apply.
Section 1202 is also referred to as the Small Business Stock Gains Exclusion. The Section only applies to qualified small business stock acquired after Sept. 27, 2010, that is held for more than five years. The Protecting Americans from Tax Hikes (PATH) Act of 2015 was passed by Congress and signed into law by President Obama. One tax benefit, made permanent by the Obama presidency, is the Small Business Stock Capital Gains Exclusion found in Section 1202 of the Internal Revenue Code. The intent behind Section 1202 is to provide an incentive for non-corporate taxpayers to invest in small businesses in the United States.
Before 2009, this provision of Section 1202 excluded 50% of capital gains from gross income. To stimulate American small businesses, the American Recovery and Reinvestment Act increased the exclusion rate from 50% to 75% for stocks purchased between February 18, 2009, and September 27, 2010. The latest revision to Section 1202 provides for 100% exclusion of any capital gains if the acquisition of the small business stock was after September 27, 2010. Also, the treatment of no portion of the excluded gain is a preferential element for alternative minimum tax (AMT) purposes. The capital gains that are exempt from tax under this section are also exempt from the 3.8% net investment income (NII) tax applied to other investment income. The amount of gain that any shareholder can exclude under Section 1202 is limited to either $10 million or 10 times the adjusted basis of the stock. The taxable portion of a gain from selling a small business stock has an assessment at the maximum tax rate of 28%.
As previously discussed, not all small business stocks are lucky enough to qualify for the tax breaks under Section 1202. There are very stringent requirements that must be followed with regard to qualified small business stock. Those requirements are as follows.
- It was issued by a domestic c-corporation other than a hotel, restaurant, financial institution, real estate company, farm, a mining company, or business-related to law, engineering, or architecture.
- Note: while Section 1202 does not speak to an LLC taxed as a c-corporation, a Private Letter ruling by the IRS allowed Section 1202 treatment for an LLC that chose to be taxed as a c-corporation.
- It was initially issued after August 10, 1993, in exchange for money, property, or as compensation for a service that was rendered.
- On the date of the stock issue and immediately thereafter, the issuing corporation had $50 million or less in assets.
- The use of at least 80% of the corporation’s assets is for the active conduct of one or more qualified businesses.
- The issuing corporation does not purchase any of the stock from the taxpayer during a four-year period beginning two years before the issue date.
- The issuing corporation does not significantly redeem its stock within a two-year period beginning one year before the issue date. A significant stock redemption is redeeming an aggregate value of stocks that exceed 5% of the total value of the company’s stock.
If your business satisfies these requirements, then congratulations! When you sell your company, you should be able to exclude (almost all) of your federal capital gains tax. State taxes that conform to federal tax will also exclude capital gains of small business stock. Since not all states correlate with federal tax directives, taxpayers should seek guidance on how their states treat realized profits from the sale of qualified small business stocks.
Let’s walk through an example whereby a business owner decides to close up shop and sell their business. The business owner is single and has $410,000 in ordinary taxable income, therefore placing them in the highest tax bracket. They sell qualified small business stock acquired on September 30, 2010, and have a realized profit of $50,000. The taxpayer may exclude 100% of their capital gains, meaning the federal tax due on the gains is $0. The exclusion could possibly be even greater if the applicable state laws recognize Section 1202! Now, let’s change the facts a little bit. Suppose the taxpayer purchased the stock on February 10, 2009, and after five years sells it for a $50,000 profit. The Federal tax due on capital gains would be 28% x (50% x 50,000) = $7,000. This example really illustrates the importance of timing with regards to when the stock was acquired. Only stock acquired on or after September 27, 2010, is eligible for exclusion of up to $10 million.
Business owners should immediately check with their legal counsel, accountant, or business broker regarding the structure of their business, ESPECIALLY if they plan on selling their business within the next few years. Failure to do so could potentially leave millions on the table!
About the Authors:
ROMAN A. BASI
Michael S. Hampleman focuses his practice on small business taxation and corporate structuring. He is an associate attorney at the Center for Financial, Legal, & Tax Planning, Inc. Roman A. Basi is an expert on closely held enterprises. He is an Attorney/CPA and the President of the Center for Financial, Legal & Tax Planning, Inc. If you have any questions, please contact us at (618) 997-3436.
