Industry Insights

Internal Revenue Code (IRC) Section 1202 provides an increasingly rare type of benefit:  a permanent tax benefit. While Sec. 1202 is not new—it was first introduced in August 1993—Congress’ most recent modifications are extremely favorable to taxpayers, causing practitioners and taxpayers to revisit the benefits available by qualifying stock as Sec. 1202 stock. 

Congress intended to encourage new entrepreneurial capital investment through Sec. 1202, specifically in the form of C corporations. Sec. 1202 originally provided a permanent 50 percent exclusion from qualifying gains income. While this sounds good on the surface, the 1993 law included some alternative minimum tax (AMT) preference strings. These strings, as well as a lack of taxpayer and tax practitioner knowledge, caused many taxpayers to ignore or not be aware of Sec. 1202. In 2009, Congress modified Sec. 1202 to provide a 75 percent exclusion, but the AMT preference strings remained.

In contrast, the current provisions of Sec. 1202, introduced in late 2010, provide for a permanent exclusion from income of 100 percent of qualifying gains, and the AMT strings have been severed. The exclusion from income is limited to the greater of 10 times the taxpayer’s adjusted basis in the stock or $10 million; these limitations apply to a taxpayer’s cumulative investment in the stock of the qualifying corporation.

To qualify for the 100 percent exclusion, the stock must be acquired after September 27, 2010, and before January 1, 2012. To qualify for the 50 percent exclusion, the stock must be acquired after August 10, 1993, and before February 18, 2009, while stock acquired after February 17, 2009, and before September 28, 2010, qualifies for the 75 percent exclusion from income.

To benefit from Sec. 1202 treatment, the taxpayer must clear a number of hurdles. Here are some of the requirements that must be satisfied for stock to qualify under Sec. 1202:

• C corp requirements
• Sec. 1202 applies exclusively to the stock of domestic C corps. 
• The stock must be acquired from a C corp by a noncorporate entity, and the issuing corporation must be a C corp at the time the taxpayer sells the shares. The issuing corporation also must have remained a C corp during substantially all of the taxpayer’s holding period for such stock.
• Original issue requirement
• The stock must be acquired as “original issue stock” from the corporation (or through an underwriter) for money, property or services provided to the issuing corporation.
• Holding period requirement
• The taxpayer must hold the stock for more than five years. Note:  IRC Sec. 1045 provides for a rollover election whereby qualified Sec. 1202 stock could be replaced with other qualifying Sec. 1202 stock.
• Qualified small business stock requirement
• The domestic C corp must be a qualified small business. This generally means the corporation must not have had aggregate gross assets exceeding $50 million at any time after August 10, 1993, or immediately after the issuance of the qualifying stock, including the assets contributed to the corporation related to the issuance of the stock.
• Active trade or business requirement
• The corporation must be engaged in a qualified trade or business activity. Under Sec. 1202, a qualified trade or business activity is any trade or business other than those involving services in the fields of health, law, engineering, architecture, accounting, actuarial services or brokerage services or any trade or business where the principal asset is the reputation or skill of one or more of its employees; any banking, insurance, financing, leasing, investing or similar business; any farming business, including the business of raising or harvesting trees; any business involving the production or extraction of products for which a depletion deduction is allowed; or any business of operating a hotel, motel, restaurant or similar business.

These do not fully represent all of the issues and difficulties that could arise in trying to determine whether stock qualifies under Sec. 1202. There are a number of areas for potential difficulty in determining whether acquired stock meets all the required tests. In particular, certain redemption transactions that may occur shortly before or after the issuance of stock will deny Sec. 1202 treatment to newly issued stock. These stipulations were intended to reward entrepreneurial effort, while denying these rewards to taxpayers who merely substitute one investment for another, even if the original investment was not their own. 

Also note Sec. 1202 is not elective. However, to take advantage of the benefits, the status needs to be recognized by both the taxpayer and tax practitioner so it can be properly documented upon acquisition and claimed upon sale.

For more information about IRC Sec. 1202, contact your BKD advisor.