As small business owners begin preparing their tax documents for the 2022 filing period, it’s important to understand the tax implications of events that could determine one’s tax obligations—especially if you are selling the business.
Case in point is the small business stock capital gains exclusion—Section 1202 of the Internal Revenue Code. Within the Protecting Americans from Tax Hikes (PATH) Act in 2015, one tax benefit, made permanent by the Obama administration, was the Small Business Stock Capital Gains Exclusion found in Section 1202. The intention of this section in the Internal Revenue Code was to provide an incentive for non-corporate taxpayers to invest in small businesses in the United States. Before Feb. 18, 2009, Section 1202 allowed up to 50% of capital gains to be excluded from gross income.
It is important that business owners take note of the requirements as they are very important to qualify for the exclusion. Section 1202 can only be applied to qualified small business stock acquired after Sept. 27, 2010, that is held for more than five years.
The American Recovery and Reinvestment Act increased the exclusion rate from 50% to 75% for stock purchased between Feb. 18, 2009, and Sept. 27, 2010. This was done to stimulate the small business sector. The latest revision to Section 1202 provides for 100% exclusion of any capital gain if the small business stock was acquired after Sept. 27, 2010.
The capital gains exempt from tax are also exempt from the net investment income tax applied to most investment income at a rate of 3.8%. The limit upon amount of gain a shareholder can exclude is limited to either $10 million or 10x the adjusted basis of the stock. Any taxable portion of the gain from selling small business stock has an assessment at the maximum tax rate of 28%. Keep in mind that not all small business stocks qualify for this tax break. Some stringent requirements must be followed regarding small business stock.
These are as follows:
- It was issued by a domestic C-corporation other than a hotel, restaurant, financial institution, real estate company, farm, a mining company, or business relating to law, engineering or architecture.
- It was originally issued after Aug. 10, 1993, in exchange for money, property (not including stocks) or as compensation for a service rendered.
- On the date of the stock issue and immediately after, the issuing corporation had $50 million or less in assets.
- The use of at least 80% of the corporation’s assets is for the active conduct of one or more qualified businesses.
- The issuing corporation does not purchase any of the stock from the taxpayer for four years beginning two years before the issue date.
- The issuing corporation does not significantly redeem its stock within two years beginning one year before the issue date.
If you own a business that satisfies these requirements, you can start celebrating. Whenever you decide sell your business, you should be able to exclude all or almost all your federal capital gains tax. Keep in mind, though, that state taxes differ from federal taxes. If your state taxes conform to federal taxes, you could also exclude capital gains from your state taxes.
Roman Basi is an attorney and CPA with the firm Basi, Basi & Associates at the Center for Financial, Legal & Tax Planning. Bart Basi, senior advisor with the firm, co-authored the article.