Individual investors may qualify for a special tax treatment on capital gains
earned from small business
stocks under section 1202 of the IRS code. Normally, small business stocks are taxed at 28% rates.
There are actually several capital gains tax savings provisions that you can take advantage of to help you build wealth
Here's how it works:
Exclusion of 50% of Capital Gains from the Capital Gains Tax Calculation
- Shares of regular C Corporations that qualify under Section 1202, bought by investors that are not themselves corporations, that have a holding period of five (5) years or longer, can exclude 50% of the capital gain from the calculation of capital gains tax. In other words, if you made a $100,000 profit, you would only pay capital gains taxes on 50%, or $50,000.
- This exclusion on the small business capital gains tax is limited to $10 million or 10 times the cost basis of your shares. If you bought your stock for $100,000 and it went to $2,000,000, for instance, you would have a gain of 20x your investment, exceeding the 10x limit.
- From 2003 through 2011, this benefit is of limited value because the maximum capital gains tax on long-term capital gains profits is 15%.
Deferred Capital Gains Taxes on Section 1202 Small Business Stocks
You can also defer the gains you earn from small business stocks under a provision in IRC Section 1045. If you have held your shares for at least six (6) months, and you sell them, you won't have to pay the capital gains tax as long as you use the money to buy shares of another
qualifying small business.
What Counts as a Qualified Small Business Stock Gain Section 1202 Profit?
According to Startup Company Lawyer
, "Qualified small business stock is defined in Section 1202 as any stock in a qualified small business issued to the taxpayer after August 10, 1993 in exchange for money or other property (not including stock), or as compensation for services. A qualified small business is a domestic C Corporation in which the aggregate gross assets of the corporation at all times since August 10, 1993 up to the time of issuance do not exceed $50,000,000. However, stock will not be considered to be qualified small business stock unless during substantially all of the taxpayer’s holding period the corporation meets certain “active business” requirements. Stock issued by an S corporation does not qualify as qualified small business stock (even if the S election is later revoked), although subsequently acquired stock may qualify. In general, gain from stock issued to “flow-through entities” such as partnerships and S corporations should qualify under Section 1202. However, the amount of the qualifying gain is limited to the interest held by the partner or S corporation shareholder on the date the stock is acquired. This limitation may be significant in certain venture fund settings when the general partners’ interests fluctuate over time."