Most entrepreneurs don’t know of a simple way to avoid millions of dollars in capital gains tax. Section 1202 of the Internal Revenue Code grants non-corporate taxpayers a tax break of up to $10,000,000 in capital gains on “qualified small business stock” that the taxpayer holds for more than five years. This is a huge exclusion. I believe all entrepreneurs should have a basic grasp on Section 1202’s high-level requirements so that they can take full advantage of its tax breaks. So, here they are.
What Are The Requirements for Capital Gains Tax deductions?
C-Corporation for Capital Gains Tax Deductions
In order to qualify for, capital gains tax deductions, the issuer of the stock must be a C-corporation. S-Corporations or LLCs taxed as partnerships do not qualify. Founders should consider this in particular when choosing an entity.
Less Than $50,000,000 in assets
The issuer must have less than $50,000,000 in aggregate gross assets before and immediately after you receive your shares.
80% of Assets Used
The issuer must use at least 80% of its assets in the active conduct of its Qualified Trade or Business (more on that below).
Issued After August 10, 1993
The company must have issued the stock after August 10, 1993.
Generally for, capital gains tax deductions, you must acquire the stock directly from the company. This becomes more complicated if you receive equity compensation, like options or restricted stock, or if you hold convertible debt or a warrant.
The company must be organized in the United States.
Qualified Trade or Business
The issuer’s business not be any of the following. I generalized the descriptions below for simplicity’s sake. For details, see the statute.
- Professional services
- Financial services
Five Year Holding Period
You must hold the stock for more than five years before you sell it for capital gains tax deductions. This also begins becomes more complicated if you receive equity compensation, like options or restricted stock, or if you hold convertible debt or a warrant. This will also become more complicated if a company began as an LLC, and converted into a C-corporation.
In Exchange for Money or Other Services
The company must issue the stock in exchange for money or other services. If the company issues the stock in exchange for other stock, it won’t count.
We have written about Section 1202 before here, here, and here. This post is just a summary, and Section 1202 can get complex quickly depending on the situation. If you have any questions about 1202 or any of its complexities, feel free to contact me.