IRS Tax Section 1202: Excluding Your Gains on Small Business Investments

By Daniel DeWolf and Rachel Gholston

2016 promises to be another very good year to invest in start-ups because of the extension of significant tax breaks for investors who invest in early stage companies. Investors who invest in small businesses can realize exclusions on capital gains if they choose the right type of company. The Section 1202 exclusion of 100% of gains on qualified small business stock has recently been extended, but this time there is no end is in sight for this extension. When enacted, Section 1202 of the Internal Revenue Code provided a 50% exclusion from income of gains on stock of a qualifying small business held by an investor for more than 5 years. In recent years, this exclusion amount has been increased to 75% then to 100% and then returned to 50%; but these higher exclusion rates have only been extended in short intervals. Now, thanks to the Protecting Americans from Tax Hikes Act, the “PATH Act”, signed into law in December of 2015, gains on qualifying small business stock obtained any time after December 31, 2014 and onward are eligible for the 100% exclusion.

To take advantage of this exclusion investors have to invest in the right type of company. Investors should look for C-corporations with assets under $50 million to be eligible for this exclusion. Companies in certain sectors, however, such as finance, law, health and hospitality, are not eligible for this exclusion. Asking the right questions and doing your due diligence is crucial to determining whether an investment will allow you to take advantage of the 100% gains exclusion.

Under the rules as recently modified, if an investor invests in eligible qualified small business stock, and holds that investment for five years, then 100% of his or her gain is excluded from income up to the greater of ten times the basis and $10 million. Consulting with your legal and accounting advisors is recommended to see if you are eligible to take advantage of this major tax break.

While the exclusion extension is a step in the right direction for encouraging small business investment, we note that the incentive for investing in start-ups would be greatly increased if Congress chose to shorten the five-year holding period to a more reasonable duration such as a two-year holding period. But we leave that proposal for the next legislative session.