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Section 1202

Section 1202
InvestingLaws and RegulationsSECSec and Regulatory Bodies

What Is Section 1202?

Section 1202, likewise called the Small Business Stock Gains Exclusion, is a portion of the Internal Revenue Code (IRC) that permits capital gains from select small business stock to be excluded from federal tax. Section 1202 of the IRS Code just applies to qualified small business stock acquired after Sept. 27, 2010, that is held for over five years.

Understanding Section 1202

The Protecting Americans from Tax Hikes (PATH) Act of 2015 was passed by Congress and endorsed into law by President Barack Obama. The PATH Act recharges some expired tax provisions for two or three years and permanently expands some tax benefits. One tax break, made permanent by the Obama administration, is the Small Business Stock Capital Gains Exclusion found in Section 1202 of the Internal Revenue Code.

Section 1202 gives an incentive to non-corporate taxpayers to invest in small businesses. The capital gains exemption from federal income tax on the sale of small business stock is the underlying purpose of this IRC section. All a small business stock held for something like five years before selling will have a portion or its realized gains excluded from federal tax.

Special Considerations

Before Feb. 18, 2009, this provision of Section 1202 excluded half of capital gains from gross income. To invigorate the small business sector, the American Recovery and Reinvestment Act increased the exclusion rate from half to 75% for stocks purchased between Feb. 18, 2009, and Sept. 27, 2010. For small business stocks that are eligible for the half or 75% exclusion, a portion of the excluded gain is taxed as a preference thing that causes an extra 7% tax called Alternative Minimum Tax (AMT). AMT is generally forced on people or investors who have tax exemptions that permit them to diminish the income tax paid.

The furthest down the line amendment to Section 1202 accommodates 100% exclusion of any capital gains assuming the acquisition of the small business stock was after Sept. 27, 2010. Likewise, the treatment of no portion of the excluded gain is a preference thing for AMT purposes. The capital gains that are exempt from tax under this section are likewise exempt from the 3.8% net investment income (NII) tax applied to most investment income.

The amount of gain that any investor can bar under Section 1202 is limited to a maximum of the greater of $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 evaluation at the maximum tax rate of 28%.

Requirements of Section 1202

Not all small business stocks are qualified for tax breaks under the IRC. The Code characterizes a small business stock as qualified if:

  • It was issued by a domestic C-corporation other than a lodging, restaurant, financial institution, real estate company, farm, a mining company, or business connecting with law, engineering, or design
  • It was initially issued after Aug. 10, 1993, in exchange for money, property excluding stocks, or as compensation for a service delivered
  • On the date of stock issue and following, the responsible corporation had $50 million or less in assets
  • The utilization of somewhere around 80% of the corporation's assets is for the active conduct of at least one qualified businesses
  • The responsible corporation doesn't purchase any of the stock from the taxpayer during a four-year period beginning two years before the issue date
  • The responsible corporation doesn't fundamentally recover its stock inside a two-year period beginning one year before the issue date. A huge stock redemption is recovering an aggregate value of stocks that surpass 5% of the total value of the company's stock

State taxes that adjust to federal tax will likewise prohibit capital gains of small business stock. Since not all states relate with federal tax orders, taxpayers ought to look for guidance from their accountants on how their states treat realized profits from the sale of qualified small business stocks.

Illustration of Section 1202

Consider a taxpayer who is single and has $410,000 in ordinary taxable income. This income places them in the highest tax bracket. They sell qualified small business stock acquired on Sept. 30, 2010, and have a realized profit of $50,000. The taxpayer might prohibit 100% of their capital gains, meaning the federal tax due on the gains is $0.

Expect the taxpayer purchased the stock on February 10, 2009, and following five years sells it for a $50,000 profit. Federal tax due on capital gains would be 28% x (half x 50,000) = $7,000.

Features

  • The amount of gain excluded under Section 1202 is limited to a maximum of $10 million or 10 times the adjusted basis of the stock.
  • Under Section 1202, capital gains from select small business stocks are excluded from federal tax.
  • It gives an incentive to non-corporate taxpayers to invest in small businesses.
  • Not all small business stocks qualify, be that as it may.