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. 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, it is back up to 20%, but only for taxpayers in the 39.6% income tax bracket). The Jobs and Growth Tax Relief Reconciliation Act of 2003 (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 taxpayer 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, the partial exclusion is not allowed (Sec. 172(d)(2)(B)).
For a detailed discussion of the issues in this area, see “Sec. 1202: Small Business Stock Capital Gains Exclusion,” by Tina M. DeSanty, CPA, in the May 2013 issue of The Tax Adviser.
—Alistair M. Nevius, editor-in-chief
The Tax Adviser
Also look for articles on the following topics in the May 2013 issue of The Tax Adviser:
- An analysis of the tax considerations in Chapter 13 bankruptcies.
- A discussion of modifying or terminating nonqualified deferred
- A look at taxation of trusts and estates under the new net
investment income tax.
The Tax Adviser is the AICPA’s monthly journal of tax planning, trends, and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price of $85 per year. Tax Section members can subscribe for a discounted price of $30 per year. Call 800-513-3037 or email firstname.lastname@example.org for a subscription to the magazine or to become a member of the Tax Section.