December 2015: Critical Change in Section 1202 of the Tax Law

Joseph W. Bartlett

The attractions of Section 1202 of the Internal Revenue Code for investors in small to medium sized private companies (under $50 million in “aggregate gross assets”) have been around for a long while … exclusion of the federal tax on capital gains on the sale of stock held for at least five years. The benefits started out as an exclusion of 50% of the gain from tax but that morphed into 100%; that said, the benefit was subject to periodic renewal and disappearance in the absence of Congressional action … dampening tax planning opportunities, for example. One holds the shares for four years and then finds the benefit has expired.

The good news, quoting from a recent Wilson Sonsini alert:

“Legislation signed by President Obama on December 18, 2015, makes permanent a U.S. federal income tax exclusion from gross income of 100 percent of the gain recognized by non-corporate taxpayers on the sale or exchange of certain “qualified small business stock” (QSBS). The 100 percent gain exclusion applies to QSBS acquired after September 27, 2010, and held for more than five years. Entrepreneurs and investors who have formed or made investments in corporations that are qualified small businesses, or those who are considering doing so, should be aware of the potential advantageous tax treatment of investing in QSBS and of potentially delaying a taxable sale or exchange of QSBS until the five-year holding period has been satisfied.”[1]

There are, of course, certain limitations on the amount of gain one can exclude ($10 million or, if greater, 10 x the taxpayer’s basis) and other restrictions which are set out in the appended article (Appendix A) on Section 1202, published well prior to the current version, including stock in a corporation not an LLC; as indicated above, acquisition post September 27, 2010; various issuers are ineligible … hospitality; financial (banks, brokers);consultants; engineering, etc., are not deemed “”active” businesses. See the laundry list in the Appendix.

That said, this is a Big Tax Break in my opinion. Trade groups like the Angel Capital Association (disclosure: I am chair emeritus of the ACA’s Advisory Council) have looked long and hard for 1202’s permanent status and , as of December 18, 2015, have succeeded.

Why, a reader may ask, should a lawyer be like yours truly be making such a big deal about yet another tax break at this juncture? What does this mean to financial and legal advisers and their clients?

Response: Assume your client, Newco was organized just under five years ago, issued shares in the friends and family round for small money and now has a cash bid on the table for the shares, which you then held close without mentioning 1202. Not good for one’s reputation in this business, if the Newco shareholders discover that, had they wanted another month to close, zero U.S. capital gains tax.

P.S. When Newco is out raising early cash, one of the arguments in the pitch deck is typically: “Invest now! Don’t wait for the C round. You will pay a higher price.” If the investor is still nervous and wobbles: ”No exit for five years, you forecast? My IRR is driven by the time value of money,” the response is: “Invest now and three years later you could save $2 million (+/-) which otherwise goes to Uncle Sam.”

The moral of the story: “Circulate the information to colleagues and clients … before it’s too late.

[1] WSGR Alert, “Recent Legislation Permanently Extends Important Tax Planning Opportunity for Investors in Small Businesses,” Jan. 6, 2016.


Sections 1202 and 1045
Joseph W. Bartlett

Zero Capital Gains

A provision of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, which was signed into law on December 17th, 2010, provides a 100% exemption for gains made in Qualified Small Business Stock. This benefit relates to investments made between September 27, 2010 and December 31, 2011.

“This creates an immediate opportunity to lock in a zero percent capital gains rate on long-term investments in small business stock.” says Payson R. Peabody, Of Counsel at Dykema Gossett PLLC, Washington, DC. “Taxpayers have from September 27th until the end of 2011 to take advantage of the new provision by acquiring stock. Those who can take advantage of it could profit handsomely.” Peabody says.

The new provision modifies the existing law tax break for small business stock purchases in two ways:

  • It provides for a zero percent rate on 100 percent of the gain instead of just the first 50 or 75 percent on sales of qualifying small business stock.
  • It removes the gain from the Alternative Minimum Tax (AMT) calculation for the first time.

Under prior law, even though 50 percent of small business stock gain could be excluded, part of the gain was added back into the calculation of AMT.


Investments of individuals or partnerships in the stock of a regular C corporation (not a corporation) with less than $50 million in assets ordinarily will qualify. The stock must be purchased directly from the corporation and held for at least five years. The amount of gain that can be excluded is limited to the greater of ten times the investment or $10 million.

At least 80 percent of the corporation’s assets must be used to carry on a business or to conduct research or startup activities. Most businesses are eligible, except for businesses in the service, finance, mining, extraction, restaurant, and hospitality industries and certain types of real estate businesses.

If qualifying companies are acquired in a tax-free reorganization by a publicly traded company during the five year holding period, the tax rules in some cases allow investors to hold the stock of the acquiring company to satisfy the five-year holding requirement.

Small business stocks are sometimes eligible for special tax treatment under Section 1202 of the IRS code. In some cases, you can defer your capital gains indefinitely. In others, you can exclude up to 50% of your profits from the tax calculation.

Individual investors may qualify for a special tax treatment on capital gains earned from small business stocks under section 1202 of the IRS code. Normally, small business stocks are taxed at 28% rates. There are actually several capital gains tax savings provisions that you can take advantage of to help you build wealth.

Here’s how it works:

Exclusion of 50% of Capital Gains from the Capital Gains Tax Calculation

  • Shares of regular C Corporations that qualify under Section 1202, bought by investors that are not themselves corporations, that have a holding period of five (5) years or longer, can exclude 50% of the capital gain from the calculation of capital gains tax. In other words, if you made a $100,000 profit, you would only pay capital gains taxes on 50%, or $50,000.
  • This exclusion on the small business capital gains tax is limited to $10 million or 10 times the cost basis of your shares. If you bought your stock for $100,000 and it went to $2,000,000, for instance, you would have a gain of 20x your investment, exceeding the 10x limit.
  • From 2003 through 2011, this benefit is of limited value because the maximum capital gains tax on long-term capital gains profits is 15%.

Deferred Capital Gains Taxes on Section 1202 Small Business Stocks

You can also defer the gains you earn from small business stocks under a provision in IRC Section 1045. If you have held your shares for at least six (6) months, and you sell them, you won’t have to pay the capital gains tax as long as you use the money to buy shares of another qualifying small business.

What Counts as a Qualified Small Business Stock Gain Section 1202 Profit?

According to Startup Company Lawyer, “Qualified small business stock is defined in Section 1202 as any stock in a qualified small business issued to the taxpayer after August 10, 1993 in exchange for money or other property (not including stock), or as compensation for services. A qualified small business is a domestic C Corporation in which the aggregate gross assets of the corporation at all times since August 10, 1993 up to the time of issuance do not exceed $50,000,000. However, stock will not be considered to be qualified small business stock unless during substantially all of the taxpayer’s holding period the corporation meets certain “active business” requirements. Stock issued by an S corporation does not qualify as qualified small business stock (even if the S election is later revoked), although subsequently acquired stock may qualify. In general, gain from stock issued to “flow-through entities” such as partnerships and S corporations should qualify under Section 1202. However, the amount of the qualifying gain is limited to the interest held by the partner or S corporation shareholder on the date the stock is acquired. This limitation may be significant in certain venture fund settings when the general partners’ interests fluctuate over time.”

Below are links to several articles that pertain to “QSBS” or Qualified Small Business Stock Capital Gain Tax Exclusion Expanded. These articles help to explain the history and purpose of 1202; the fine print in understanding qualified small businesses and stock, the impact on AMT, and tax implications.


Investing in qualified small businesses can be beneficial to both the individual investors and to the economy as a whole. Especially with the increased 100 percent exclusion of eligible gain, taxpayers may take advantage of these potentially significant tax savings and qualified small businesses may receive the support they need as they struggle to recover from the economic downturn.

Because of these benefits, Taxpayers planning to incorporate their business in 2011 should consider pushing to file necessary documents and issuing stock before the end of 2010.

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