Tax-Free Stock Option | IRC Section 1202 | Ohio CPA Firm | Rea CPA

Tax-Free Stock Option Exists For Some Small Businesses

Back in the early 90s, Congress passed a tax provision designed to increase investment in America’s small businesses. And while the provision’s name, IRC Sec. 1202, may not roll off your tongue very easily, it’s one that some small business owners need to know.

Since its introduction, several small businesses have enjoyed significant exclusion of the gains generated by qualified small business stock. As you prepare to file your 2014 tax return, remember to ask your tax preparer about this provision. The result could equal big tax savings for you and your business.

What’s So Important About IRC Sec. 1202?

IRC Sec. 1202 was passed by Congress as a way to help reinvigorate the importance of continued investment into our country’s small business infrastructure. This allows those who are willing, and able, to reap the rewards of starting a business, creating jobs and contributing to the local and national economy.

Here’s how it works: Imagine that you recently sold or exchanged qualified small business stock (QSBS) that you had previously owned for more than five years. Under IRC Sec. 1202, at least 50 percent of any gain that resulted from this transaction is excluded from your gross income, allowing you to realize a significant tax savings.

Now, some people believe that timing is everything; and when it comes to getting the most out of IRC Sec. 1202, I would agree. Since originally enacted in 1993, Congress temporarily altered the provision in an effort to help stabilize the U.S. economy. The American Recovery and Reinvestment Act of 2009 ushered in significant changes to the rule. Take a look:

  • Those who acquired QSBS between Feb. 17, 2009, and Sept. 27, 2010, before selling it off and exchanging it would see an exclusion of 75 percent of any gain received.
  • And the exclusion percentage for QSBS acquired between Sept. 27, 2010, and Jan. 1, 2014, is 100 percent.

Does Your Small Business Stock Qualify?

As you can see, as long as the stock you sold was qualified small business stock, your tax savings could be pretty significant. But what if you’re not sure if your stock actually qualifies. The best advice I can give you is to consult with your tax advisor every step of the way. However, in the meantime, you can take a look at a few basic characteristics of QSBS to get an idea of what the IRS will be looking for.

Primary characteristics of QSBS:

  • Only stock issued after Aug. 10, 1993, qualifies for this provision.
  • Qualified stock must have been issued by a domestic C-corporation that had no more than $50 million worth of gross assets at the time the stock was issued.
  • The corporation that issued the qualifying stock must be one that uses at least 80 percent of its assets (by value) in active trade or business activities. Certain types of personal services and business types are excluded.
  • The qualified stock must be held by a non-corporate taxpayer.
  • Acquisition of the stock must have been made when it was originally issued or in a tax-free transaction (i.e. gift, inheritance or partnership distribution).
  • To be eligible for the gain exclusion, you must have held the stock for more than five years.

There are several nuances to complying with IRC Sec. 1202.  This is why consulting with your tax advisor is so important.  For example, gain exclusions are also possible for QSBS stock owned in partnerships and S-corporations if certain requirements are met. But there are some calculations that have to be made with regard to the ownership of the pass-through entity. Alternative minimum tax implications also exist, as a portion of the excluded gain becomes a preference item. There is also a provision for a rollover under IRC Sec. 1045.  But the only way to find out what QSBS and IRC Sec. 1202 means to you and your business is to speak with a tax advisor who can guide you through your options.

Not sure if you qualify? Email Rea & Associates to learn more.