Potential Changes on the Horizon for Qualified Small Business Stock – IRC Sec. 1202
December 01, 2021
By Benjamin Aspir, CPA, MST
On November 19, the House of Representatives (“House”) passed H.R. 5376, the Build Back Better Act (“BBBA”). The 2,000 plus pages of the BBBA contain many tax incentives and revenue raisers. The BBBA’s Section 138150 Limitation On Certain Special Rules For Section 1202 Gains would potentially reduce the tax benefits of IRC Sec. 1202.
IRC Sec. 1202 was enacted with the goal of encouraging long-term investments in startup companies and other small businesses by exempting capital gain taxes upon the sale of stock in these entities. Accordingly, IRC Sec. 1202 allows holders of qualified small business stock (“QSBS”) to exclude up to the greater of $10 million or ten times the taxpayer’s basis in the QSBS sold.
Under current law, the percentage of gain on the sale of QSBS excluded from federal income tax is determined based on the date the QSBS was issued, as follows:
- QSBS issued from August 11, 1993 - February 17, 2009 = 50% gain exclusion;
- QSBS issued from February 18, 2009 - September 27, 2010 = 75% gain exclusion;
- QSBS issued from September 28, 2010 - Present = 100% gain exclusion.
Under the proposed BBBA, effective for stock sales after September 13, 2021, taxpayers with adjusted gross income of $400,000 or more would only be eligible for the 50% gain exclusion rate. Trusts and estates would also be ineligible for the 75% and 100% exclusion rates, regardless of income level. To the extent that an IRC Sec. 1202 gain is subject to tax, the gain would be taxed at 28% plus the 3.8% net investment income tax, instead of regular capital gain rates. Additionally, the amount excluded under IRC Sec. 1202 would be subject to an alternative minimum tax adjustment equal to 7% of the amount excluded. If the BBBA were passed into law, the effective tax rate on eligible QSBS gains (for stock purchased after September 27, 2010) would increase from 0% to approximately 15.9%.
There are still several hurdles to clear before the BBBA would become law.
The final BBBA bill ultimately presented to the Senate and then to the President may be materially different from its current version. The Senate must first approve the bill. If there are any changes from the House version, the House would need to vote on the BBBA again. If the House and Senate agree upon a final version, the BBBA would then be sent to President Biden for signature and subsequent enactment.
Even after factoring in the reduction of the exclusion amount, IRC Sec. 1202 is still a relevant tax planning vehicle. IRC Sec. 1202 provides investors and founders an opportunity to potentially shield future capital gains from federal taxation. There are many traps for the unwary throughout the investment and sale process in which an investor can mistakenly lose QSBS status. Therefore, proper tax planning and execution of QSBS is essential. A tax professional should be consulted in order to determine potential eligibility.