Do you qualify for a Section 1202 Election?
What is a section 1202 election? This election allows stockholders in a C Corporation to claim a federal income tax gain exclusion on the sale of their Qualified Small Business Stock (QSBS) held for a minimum of 5 years. In simpler terms, if you own stock in a small business C Corporation you could be eligible for an exclusion on the gain from the sale of the stock when you sell it. For example, if you are selling $10 million worth of QSBS, you could be eligible for $2.38 million tax free gain assuming the max capital gain rate of 20% plus the net investment income tax of 2.38%. The amount of gain that would potentially be excluded under Section 1202 would be limited to a maximum of $10 million or 10 times the adjusted stock basis.
What are the criteria to qualify? There is certain criteria that must be met before and during the election and holding periods. The criteria needed to initially qualify is below:
- The Qualified Small Business Stock (QSBS) must be acquired from a United States C Corporation
- QSBS cannot be claimed by a corporate stockholder. Stockholders can be individuals, trusts, S corporations and pass-through entities
- QSBS must be acquired directly from the issuing corporation for cash, property or services
- QSBS must be reported as stock for federal income tax purposes
- Meaning it has to be one of the following; voting, nonvoting, common or preferred stock
- The corporation issuing the QSBS must not have had aggregate gross assets in excess of $50 million at any time prior to or immediately after the issuance of stock
- Aggregate gross assets generally means the amount of cash plus the tax basis of other assets on the issuing corporation’s balance sheet
- Once the initial $50 million test is passed, subsequent failure of the $50 million test will not affect the corporation’s outstanding QSBS
There are other qualifying criteria that needs to be met during the holding period of QSBS. The following criteria includes things that need to be maintained throughout the life of the outstanding QSBS in order for the stockholders to qualify for the Section 1202 exclusion.
- QSBS must be held for at least 5 years
- Stockholder of originally issued QSBS must also be the seller of the QSBS
- QSBS must be sold to take advantage of the gain exclusion
- Be cautious of entering into a stock sale vs asset sale
- During the first 5 years of ownership, stockholders must not have any offsetting short positions in respect to their QSBS
- If an offsetting short position is taken in respect to QSBS before the 5 year holding period, the stock forfeits its QSBS status
- If the offsetting short position is taken after the 5 year holding period, the stock forfeits its QSBS status unless the stockholder makes an election to recognize gain as if the QSBS was sold for fair market value on the date the short position was established
- The issuing corporation must use at least 80% of corporate assets by value in the operation of a qualified trade or business during each stockholders entire QSBS holding period
- The issuing corporation must not have held stock or securities of another corporation with a value more than 10% of the value of the issuing corporations assets
- For example, if the issuing corporation has $10 million in assets they cannot hold stock or securities worth more than $1 million
- The issuing corporation cannot have more than 10% of their total assets value consist of real property which is not used in active trade or business
- The issuing corporation can own real property if they are actively using the property for their trade of business. Rental of real property is not considered an active business activity. For example, a manufacturer can own a warehouse that they actively use for production.
- Applicable facts must not bring the stockholder or the issuing corporation within the scope of “anti-churning” redemption
- A stockholders QSBS can forfeit its status if there are redemptions of the corporation’s stock during the four year period beginning two years prior to the original issuance of QSBS. The status of all QSBS can forfeit their status if there have been redemptions of the corporation’s stock during the two year period beginning one year prior to the original issuance of QSBS
- Recapitalizations and restructuring involving the issuing corporation or the QSBS itself can forfeit the favorable status
- Any activity should be vetted to ensure it will not affect the favorable QSBS status
There are a lot of moving parts involved with ensuring that the stockholders qualify and stay qualified for the QSBS gain exclusion. Both the issuing corporation and stockholders need to be careful with the business activities and operations so they don’t forfeit their favorable tax status. If there are any specific instances where there might be a forfeiture and/or exclusion, refer to the IRS code for more guidance.