Strategies to Maximize Section 1202 Gain Exclusion Amount
We have seen more understanding among company founders and investors about Section 1202. Investors in QSBS are entitled to an exclusion from taxable profits of up to $10 million under Internal Revenue Code Section 1202. The standard $10 million gain exclusion ceiling under Section 1202 will be more than enough for many taxpayers. However, some taxpayers’ QSBS gains will be far more than $10 million. When QSBS is sold, these proficient taxpayers can benefit from proactive planning to raise the maximum prospective gain exclusion.
This article will discuss how to maximize Section 1202 Gain Exclusion. Additionally, we will extend an understanding to the reader about Section 1202 Gain Exclusion requirements and how to report Section 1202 Gain Exclusion on your taxes.
Section 1202 Gain Exclusion
Since Congress recently increased the scope of Section 1202 of the Internal Revenue Code, angel investors and company owners now enjoy significant tax benefits. 100% of startup investment earnings up to $10 million per investment are tax-free thanks to the Section 1202 tax exemption. Due to this law, business owners may deduct earnings up to $10 million. Let’s see how investors can maximize the Section 1202 Gain Exclusion Amount.
What is section 1202?
Certain small business stock capital gains are exempt from federal taxes under Internal Revenue Code (IRC) Section 1202, often called Small Business Stock Gains Exclusion. Only shares of qualifying small businesses purchased after September 27, 2010, and held for over five years, are covered under Internal Revenue Code Section 1202.
Section 1202 is an initiative to encourage taxpayers who are not corporations to invest in startups and small businesses. However, the small business distributing the shares must qualify as a QSB and a QSBS. Section 1202 limits an investor’s ability to deduct capital gains to a maximum of $10,000,000, or 10 times the stock’s acquisition price (whichever is higher).
How do Section 1202 Gain Exclusion work for partnerships and S corporations holding QSBS?
Holding QSBS via a fund treated as a limited liability company (“LLC”) can significantly enhance the total amount of Section 1202 gain exclusion, which is essential for planning purposes. Each partner or investor is recognized as a distinct taxable entity with an individual regular $10 Million Cap and a particular 10X Basis Cap in the case of a partnership or S corporation owning an issuer’s QSBS. The distribution of Section 1202 gains passing via the pass-through firms among partners and S corporation shareholders are governed by specific procedures. The amount of Section 1202 gain and accompanying sale profits that may be awarded to partners holding carried interests may be subject to restrictions.
How does Section 1202 Gain Exclusion apply to QSBS?
Qualified small business stock, or QSBS, is the stock of a corporation that meets the requirements for a “qualified small business” (QSB) under Internal Revenue Code Section 1202. The common name for QSBS is Section 1202 stock. The stock should fully satisfy the requirements of IRC Section 1202 for shares of qualified small business stock. Let’s examine the criteria:
- The company issuing the stock must be an active, domestic C-corporation.
- The company’s assets immediately before and after issuance may be $50 million.
- The company’s primary objective must be a qualified business or trade. The retail, manufacturing, wholesale, and technology industries are just a few examples of the numerous qualifying businesses. Particularly unacceptable are the industries and professions of hospitality, finance, agriculture, mining, and personal care services.
- 80% or more of the corporate assets must come from one of the listed eligible trades or businesses.
Strategies to maximize Section 1202 Gain Exclusion
The following planning strategies will help QSBS investors to maximize the Section 1202 gain exclusion:
- Take advantage of the 10X Basis Cap – Using the 10X Basis Cap, a taxpayer who owns shares of QSBS with Section 1202 tax basis may be able to exclude a cumulative gain of over $10 million. For instance, if a taxpayer owns both shares of QSBS with Section 1202 tax basis and shares of QSBS with no tax basis, the taxpayer can sell the shares without any tax basis or with a low tax basis in the first year, and the shares with a more significant tax basis in the following years. If the calculations pan out, this strategy might lead to a cumulative gain exclusion of over $10 million.
- Dividing an issuer’s QSBS among multiple “taxpayers” – If an issuer’s QSBS is divided among more than one taxable individual, each gets a $10 Million Cap or $10X Basis Cap. The prospective total Section 1202 gain exclusion might be significantly raised by taking advantage of it. The fact that any individual liable to any internal revenue tax is included in the Internal Revenue Code’s definition of “taxpayer” allows for many planning strategies to raise the cumulative Section 1202 gain exclusion ceiling. The founders may set up the ownership of QSBS to include a partner, adult offspring, and other relatives. Similarly, individuals, entities like spouses, grown offspring, non-grantor trusts, limited partnerships, LLCs, and S companies may invest in preferred stock together.
- Use multiple corporations for Section 1202 planning – Each QSBS issuer’s gain exclusion ceiling is established independently. The QSBS of brother-sister companies is not combined for gain exclusion purposes under Section 1202 in any way. These facts imply that there may be a chance to run enterprises via several C corporations, which should be possible, provided each organization is involved in a stand-alone qualifying small business. Since no company acting alone will be a stand-alone qualifying small business, operating a unified firm across many companies is unlikely to enhance the gain exclusion.
- Reinvest Section 1202 gain in multiple issuers – QSBS holders who have not accrued the requisite five-year holding term may trade their QSBS and deposit the profits in more QSBS following Section 1045. One question that doesn’t seem to have an obvious solution is if the profits from the sale of a QSBS that are reinvested into other QSBS investment opportunities under Section 1045 maintain their original identification for the Section 1202 gain exclusion cap’s purposes or whether doing so allows one to increase the gain exclusion cap by spreading the money raised of one issuer’s QSBS into several QSBS investments.
Report Section 1202 Gain Exclusion
It’s crucial for holders of qualified small business stock (QSBS) to understand what to do both when you report the Section 1202 exclusion on your taxes.
Requirements for Section 1202 Gain Exclusion
Investors should be aware that Section 1202’s exclusion of profits from the sale of shares is subject to four conditions. Each of these prerequisites is covered in further depth below. The company shares will not be eligible for Section 1202 processing if the four conditions below are unmet.
- Qualified small business requirements – According to Sections 1202(c)(1) and 1202(c)(2)(A), the issuing company must be a “qualified small business” as of the date of issue. A domestic company is referred to as a “qualified small business” under IRC Section 1202(d)(1) if:
- This corporation’s total gross assets must not have exceeded $50 million at any time before the issue of the stock being scrutinized for prospective QSB stock qualification on or after the date of adoption of the Revenue Act of 1993.
- Such a corporation’s total gross assets do not exceed $50 million immediately after the issue of the stock being scrutinized for prospective QSB stock qualification.
- Such a company undertakes to provide any “reports” that the IRS requires to carry out for Section 1202 to the IRS and its shareholders.
- The stock of a Subchapter C Corporation should be Acquired at an “Original Issuance” – According to IRC sections 1202(c)(1) and 1202(c)(1)(B), QSBS is stock in a C corporation that was initially issued after the 1993 act of Revenue Reconciliation if such shares are obtained in return for cash, other property, or as payment for services rendered for a corporation. QSBS must be purchased at the “original issue” accordingly. This means the seller seeking the Section 1202 tax advantage must be the seller who originally purchased the QSB shares. According to this criterion, shares of QSBS must be bought straight from the issuer in return for money, other assets, or as payment for services rendered to the issuing company.
- Five-Year Holding Period – To exclude profits, QSBS must be kept for a minimum of five years. This is because regardless of whether the QSBS was acquired via a taxable or non-taxable transaction, the holding period generally starts on the day of the issue. However, if the QSBS is changed into another stock of the same company, or if the stock is obtained as a gift, via inheriting, or as a move from a partnership, special law applies to the calculation of the holding period.
- Active business requirements – As per Internal Revenue Code Section 1202(c)(2), a company’s stock cannot be regarded as QSB stock unless it is a subchapter C corporation and fulfills the “active business criteria” of Internal Revenue Code Section 1202(e) during virtually the whole of the taxpayer’s holding period. For any time, a company is deemed to have satisfied the “active business requirement” of section 1202(e) if:
- The company actively engages in one or more qualified trades or businesses, with at least 80% of its assets employed for such purposes.
- This business qualifies as an eligible corporation
How to report Section 1202 Gain Exclusion
Filing the following forms is a requirement in reporting Section 1202 gain exclusions:
- Form 1099-DIV – On Schedule D, line 13 of your individual tax return, the gain from Section 1202 will be recorded. It will show in box 2(c) of the form. Enter as a positive integer the amount of your exclusion permissible 2nd line of the 28% Rate Gain Worksheet on lines 18 and 19 of Schedule D. Enter the name of the company sold in column (a) of Form 8949, Part II. On Form 8949, you must also put “Q” in column (f) and a negative figure for the excluded gain’s amount in column (g). Enter the amount that your Section 1202 exclusion does not cover 2nd line of the 28% Rate Gain Worksheet as a positive figure on lines 18 and 19 of Schedule D.
- Form 1099 – Whether box two on the 1099-B is selected for short- or long-term gain and whether it was or was not reported to the IRS, one may check one of four boxes on Form 8949. Your broker cannot determine whether your gain or loss is short-term or long-term if box 2 is unfilled and code X is in the box that reads “Applicable checkbox on Form 8949” towards the top of Form 1099-B. To assess if your gain or loss is short-term or long-term, consult your own records. Enter the company’s name sold in column (a) of Form 8949, Part II. On Form 8949, you must also put “Q” in column (f) and a negative figure for the excluded gain’s amount in column (g). Enter the amount your Section 1202 exclusion does not cover on line 2 of the 28% Rate Gain Worksheet as a positive figure on lines 18 and 19 of Schedule D.
- Form 1099-CAP – The profits from the sale or exchange of shares will be reported on Form 8949 and Schedule D in box 2 of the form, per the instructions above.
- Form 1099-MISC – In the form’s box 3, labeled “other income” the QSBS will be shown. Enter the company’s name sold in column (a) of Form 8949, Part II. On Form 8949, you must also put “Q” in column (f) and a negative figure for the excluded gain’s amount in column (g). Enter the amount your Section 1202 exclusion does not cover on line 2 of the 28% Rate Gain Worksheet as a positive figure on lines 18 and 19 of Schedule D.
- Schedule K-1 – On line 10 of the k-1 obtained via the 1120S (S Corporation) tax return or line 11 of the k-1 obtained through a 1065 (Partnership) tax return, QSBS profits obtained through a pass-through business must be recorded. A statement detailing each sale or exchange will be attached to the K-1 and include the following information: (a) the name of the company that issued the QSB stock; (b) the partner’s portion of the partnership’s adjusted basis and sales price; and (c) the dates the QSB stock was purchased and sold.
- Form 2439 – The Section 1202 gain will be recorded in box 1(c) of the form, and box 1(a) will contain the whole gain. Fill out Schedule D, line 11, and include the whole gain from box 1(a). Enter the company’s name sold in column (a) of Form 8949, Part II. On Form 8949, you must also put “Q” in column (f) and a negative figure for the excluded gain’s amount in column (g). Enter the amount your Section 1202 exclusion does not cover on line 2 of the 28% Rate Gain Worksheet as a positive figure on lines 18 and 19 of Schedule D.
- Form 6252 – When a QSBS gain is acquired via an installment sale, Form 6252 is used to document the transaction. On line 11 of Schedule D, the long-term gain declared on Form 6252 shall also be declared. By increasing the exclusion by a percentage of the profits received each year of the installment schedule, you must figure out the eligible gain for each installment’s reporting year. Enter the company’s name sold in column (a) of Form 8949, Part II. On Form 8949, you must also put “Q” in column (f) and a negative figure for the excluded gain’s amount in column (g). Enter the amount that your Section 1202 exclusion does not cover on 28% Rate Gain Worksheet, line 2, as a positive figure on lines 18 and 19 of Schedule D.
Why choose Eqvista to manage and track your QSBS?
Utilizing QSBS effectively may lower investor tax obligations and increase a company’s ability to raise capital. To get and maintain QSBS certification, however, certain rules must be adhered to. Therefore, it is essential that everyone understands and abides by the standards. A highly sophisticated cap table tool called Eqvista was created with entrepreneurs like you in mind. Because of its user-friendly interface and advanced programming, Eqvista makes it simple to track and manage the shares of your company. You just need to create your company profile and utilize the app to issue shares electronically.