Section 1202 of the Internal Revenue Code has long allowed taxpayers to exclude the sale of certain qualified small-business stock from federal capital gains taxes, creating a tremendous lure for investing in small businesses.

“If certain requirements are met at the time of the investments, investors can exclude up to $10 million of capital gains (per stockholder per issuing corporation) on their federal returns, and in some circumstances, much more,” said John Pantekidis, managing partner and general counsel at wealth advisory firm TwinFocus in Boston. “Additionally, the 3.8% surtax on the federal side does not apply to the gain, and many states also follow this federal tax treatment.”  
But this break, which is not widely known in the investment industry, comes with conditions, advisors note.

Section 1202 generally only applies to C corps, which are “typically not the way most small businesses are established,” said Bill Smith, national director of tax technical services at CBIZ MHM’s National Tax Office in Washington, D.C.

“The investor must ... acquire the stock at its original issue, and needs to hold the stock for at least five years,” said Collin Gutman, co-founder and managing partner of SaaS Ventures. Yet “there are not only incredible financial benefits but subjective and social benefits to supporting American small business,” he said, who added that this was the original intention when it was signed into law by President Bill Clinton in 1993 and was further incentivized in 2017 under President Donald Trump.

The corporation must be in a qualified trade or business, Smith said, which cannot be in several fields, including health; law; engineering; architecture; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; banking; insurance; financing; leasing; investing; farming; extracting or producing natural resources; operating a hotel, motel, restaurant, or similar business; or any trade or business where the principal asset is the reputation or skill of one or more of its employees. The company’s aggregate gross assets must be $50 million or less from August 1993.

Pantekidis said many investors, business owners, execs and even fund managers don’t know about this tax planning tool. “We’ve seen many business owners, as well as private equity and venture capital managers, structure their investments as C corporations to take advantage of 1202 once they realize the benefits,” he added.

“Another pitfall is quite often associated with determining whether the stock qualified from the time of acquisition,” Pantekidis said. “Where clients hold stock in small businesses and don’t know whether they qualify, we reach out to the company personnel who would be best suited to know the facts necessary to determine status. Because they rarely know what Section 1202 is, not to mention their requirements, we often have trouble tracking down the necessary information.”

Despite the break’s allure, taxes should remain a secondary factor for clients who discover 1202. “Excluding capital gains is not relevant if the company fails, so it’s a business decision first,” Smith said. “Also, in many cases the company has to convert from one type of business entity to a C corp, which poses its own unique challenges.”

“Business people focus on operating their businesses and not optimizing on taxes, at least not initially,” Pantekidis said. “Moreover, we’ve found that even tax professionals don’t understand all the nuances of all the requirements.”

One example, he added, is that a close reading of the 1202 statute reveals that exclusions exist beyond the first-year $10 million.

“It isn’t easy to have access to investing in startups that have a bright future, so it isn’t on the radar of many investors,” Smith said, adding that legislation has been introduced to apply Section 1202 to S corporations and to allow smaller gain exclusions for shorter holding periods, “but it will be tough to pass.”