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The Ultimate Preparation Step for a M&A Sale


Section 1202 was enacted in 1993 and was meant to help encourage investment in small businesses. Put simply, Section 1202 allows individuals to avoid 100% of the federal capital gains tax incurred upon the sale of qualified small business stock (also known as QSBS), given the shareholder and business have met the (many) requirements that will be discussed in this article. This exclusion is available for certain stock issued after August 10th, 1993. Some states follow federal tax treatment as well.

The amount of capital gain eligible for tax exclusion is limited to the greater of $10 million or 10 times the average cost basis of the eligible shareholder’s investment. For example, let’s say an investor owns stock that at issuance was valued at $2 million and later grows to a value of $15 million. The amount eligible for tax exclusion under Section 1202 is equal to $20 million (10 times the cost basis of $2 million). The 100% tax exclusion under Section 1202 is obviously an attractive tool when it comes to dealing with capital gains, but very specific requirements must be fulfilled in order to obtain this exclusion.

First, the amount of the gain excluded depends on the stock issuance date. The table below summarizes the percent of federal gain exclusions possible:

Stock Issuance Date FromStock Issuance Date To1202 Exclusion %1202 Effective Tax Rate – FederalFederal Tax Rate w/o 12021202 Fed Savings

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

      1. Eligible Shareholder – In order to qualify for the tax exclusion, the shareholder must be deemed an “eligible shareholder,” which includes all non-corporate shareholders, such as individuals, trusts, and estates. Partnerships and S Corp shareholders may still qualify, but additional requirements must be met in order for the non-corporate owners of the pass-through entity to claim the benefits of Section 1202.
      2. Holding Period – The small business stock must be held for more than five years before it is eligible for exclusion. The holding period of the stock begins on the date the stock was issued. Therefore, a shareholder can include previous holding periods if the stock was received as a result of an inheritance, as a gift, or in a distribution from a partnership.
      3. Original Issuance of Stock – The eligible shareholder must have purchased the small business stock upon original issuance from a company after 8/10/1993. The stock must be purchased from a company, rather than a shareholder.  However, stock received as a gift or in an inheritance, from an individual that acquired the stock at original issuance from a company, would be allowable.
      4. Eligible Corporation – The business issuing stock must be a domestic C corporation, excluding the following: domestic international sales corporations (DISC) or former DISCs, regulated investment companies (RIC), real estate investment trusts, real estate mortgage investment conduits, or cooperatives. It is important to note that LLCs are not eligible for Section 1202 unless the LLC has elected to be taxed as a C corporation.
      5. $50 million Gross Assets Limitation – The corporation must not have had more than $50MM of tax basis in its assets at any time from 8/11/93 until the moment immediately after the issuance of the stock. This test is evaluated at the time of each stock issuance. Once the asset test is met, this test is not reevaluated at a later date for that stock. Therefore stock issued when the corporation had less than $50MM in tax basis in its assets continues to qualify, even if the corporation’s assets later exceed $50MM.
      6. Qualified Trade or Business – There are strict rules concerning the industry/trade of the corporation when examining Section 1202 eligibility. A qualified trade or business excludes the following industries:
        Personal ServicesFinancialFarmingOil, Gas, & MiningHospitalityReal Estate
        Health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the trade or business is the reputation or skill of one or more of its employees.Banking, insurance, financing, leasing, investing, or similar business.Farming, gardening, growing, or similar business.Mining, drilling, or other extraction-type business.Hotel, motel, restaurant, or similar business.Ownership of, dealing in, or renting of real property.
      7. Active Business Requirement – The corporation must use at least 80% of the fair market value of its assets in a qualified trade or business. This requirement must be satisfied during substantially all of the taxpayer’s holding period in order to qualify for the Section 1202 exclusion.
      8. Redemptions – Any significant redemptions in the year preceding or following a stock issuance can disqualify the stock from Section 1202.

The following example illustrates the tax benefits of the Section 1202 exclusion: Let’s say an entrepreneur named John founded XYZ company in 2012 as an LLC that is taxed as a C Corp.  In 2022, John closed on the sale of the business at a purchase price of $35 million.

Under typical circumstances, John would have to pay the Federal government capital gains tax rate of 20% plus an additional 3.8% for the Net Investment Income (NII) tax. Assuming his cost basis upon founding the business in 2012 was $1MM, he would owe $8,092,000 in capital gains taxes.

  • Since the stock sold meets all of the requirements for the Section 1202 exclusion, John is able to dodge over $2MM of the $8.1 million owed in capital gains taxes. As stated earlier, the amount eligible for exclusion under Section 1202 is equal to the greater of $10 million or 10 times the investor’s cost basis. The table below summarizes the tax savings for John.
    Typical Tax Treatment1202 Tax Treatment
    Sale Price$35,000,000 $35,000,000
    Less Cost Basis
    Realized Capital Gain

    $34,000,000 $34,000,000
    Taxable Gain$34,000,000$24,000,000
    $8,092,000 (23.8% of gain)$5,712,000 (23.8% of gain)
    Net Proceeds$26,908,000$29,288,000

    • The Tax Advisor – Practical considerations of Sec. 1202 in M&A transactions, June 1, 2021
    • The Tax Advisor – Qualified small business stock gets more attractive, Nov 1, 2018
    • Plante Moran – Almost too good to be true: The Section 1202 qualified small business stock gain exclusion, Aug 3, 2021
    • Smith Anderson – Qualified Small Business Stock and Section 1202 of the Internal Revenue Code, July 8, 2021
    • Investopedia – Section 1202, Dec 9, 2021