Section 1202 of the Internal Revenue Code provides a substantial tax benefit to startup employees, founders, and investors. It allows startup shareholders to take advantage of exclusion from tax on the sale or exchange of Qualified Small Business Stock (QSBS). Qualifying for Section 1202 can have big benefits for people investing in Qualified Small Businesses (QSB). This article discusses Section 1202 requirements in more detail so you can understand if you are eligible to receive its benefits.

What is Section 1202?

Section 1202 provides a federal tax exclusion on capital gains from the sale or exchange of QSBS. QSBS is stock issued by a QSB, or a C corporation with gross assets of less than $50 million at the time of issuance.

QSBS issued after September 27, 2010 are eligible for 100% exclusion, while QSBS issued after August 10, 1993 and before September 27, 2010 are eligible for a 50% or 75% exclusion. The maximum amount of gain excluded under Section 1202 is the greater of $10 million or ten times the aggregate adjusted basis of the stock.

What are the requirements to qualify for Section 1202 gain exclusion?

To qualify for Section 1202 gain exclusion, you must meet all of the following requirements:

1. You have held QSBS for more than five years.
2. The issuing company must be a C corporation engaged in a qualified business. This includes any business other than a hotel, restaurant, financial institution, real estate company, farm, mining company, or business relating to law, engineering, or architecture.
3. The stock was issued by a domestic corporation with no more than $50 million in gross assets at the time of issuance.
4. At least 80 percent of the corporation’s assets must be used in the active conduct of business.
5. You did not purchase your stock from an affiliate or a person related to you.
6. You have held more than five percent of the total issued company stock for any period during which it was a C corporation.
7. The stock must have been issued after August 10, 1993.

What are the benefits of Section 1202?

Section 1202 benefits startup founders, employees, and investors because it reduces the compensation subject to income tax. In particular, startup shareholders can avoid paying taxes on up to 100% of their gains from QSBS if they meet all requirements.

Example of Gain Exclusion Under Section 1202

Lily purchased QSBS from her company ABC Inc. in November 2010 after it became a C corporation. Lily then held her stock through 2018 before selling it with a gain of $12,000.

Lily’s stock qualifies for Section 1202 gain exclusion because she held the QSBS for more than five years. Moreover, because ABC Inc. is a C corporation, its stock is considered QSBS. Provided that she meets all other requirements, Lily can exclude up to 100% of her gain from taxation under Section 1202. Hence, she does not have to pay federal income tax on capital gains.

In sum, Section 1202 benefits startup founders, employees, and investors by allowing them to avoid paying taxes on up to 100% of their gains from QSBS so long as they meet specific requirements imposed by law.