Many early stage investors are vaguely aware of IRS code Section 1202, but there are some lesser known facts that can save you a lot of money in the long run if you take the time to master them.
Section 1202 of the Internal Revenue Code deals with a gain on a stock sale. If your investment qualifies for 1202 treatment, up to 100% of the gain could be excluded up to the greater of $10,000,000 or 10 times your investment. To quality, this stock must 1) Be a domestic C Corporation from inception; 2) The gross assets of the Company must be under $50 million at the time the investment is made; and 3) The stock can be issued for cash, property, or services. The Corporation must again be an active business versus an investment business or one similar to a service business such as a law firm. You must hold the stock for at least five years.
The percentage of your gain excluded depends on when you acquired the qualifying stock. If you became an investor between February 17, 2009 and September 27, 2010, your exclusion percentage is 75% of the gain. If you became an investor after September 27, 2010, the exclusion is 100%.
But 1202 does have a few gotchas. Here are few things to know about 1202 stock that many people are not aware of. If you held convertible debt early on in a company and then it converted into stock later on, the holding period from the time you got your note qualifies for long term cap gain determination. Even if you did not hold the shares long enough for long term treatment, the stock may still qualify for holding period testing because you can tack your note-holding period on. For calculations under 1202 (5 year holding period), however, the clock starts when the note converts to equity. And you need to keep in mind that other measures don’t tack back, such as the $50 million in assets test, which is tested at the date of conversion of the debt to stock.
Another thing to note is that if you own 1202 stock, and then decide to gift it to another individual later, the stock will retain its character of 1202 stock to the donee. Thus a parent that owns 1202 stock can gift it to his kids, and they can benefit from the same reduced capital gains exclusions that the parent would have. This is a great estate planning technique and one that should not be overlooked.
These rules are quite complicated and their application to your situation may or may not work depending on your particular investment and when you acquired and sold your shares. You should contact your tax advisor for further discussions if you believe you could potentially qualify.
This article was updated March 14, 2017.
Jeffrey D. Solomon is the Managing Partner of Katz, Nannis + Solomon, PC. The firm is now ranked one of the Top 25 CPA firms in Massachusetts and its emerging business group has grown to be a true leader in Massachusetts. Jeff can be reached at email@example.com.