Selling stock in a business? The QSBS Section 1202 capital gains exclusion could minimize your taxes

If you’re considering selling your business, it’s likely that one of your main goals is to keep as much money from the transaction as possible. But taxes can take a big chunk out of the sale proceeds — up to almost a quarter of the taxable gain recognized on the sale.

Fortunately, there’s a provision in the tax code that can eliminate federal capital gains taxes on the sale of qualified small business stock (QSBS). Section 1202 of the Internal Revenue Code allows business sellers to avoid paying federal taxes on up to 100% of the capital gains recognized on the sale of QSBS.

What is Section 1202?

Though Section 1202 is referred to as a qualified small business stock exclusion, it applies to up to $10 million in capital gains, or 10 times the aggregate adjusted basis of the stock when it was issued.

“The savings for a business owner who is preparing to sell can be substantial,” says Jenna Guenther, senior vice president and managing director of client advisory with Ascent Private Capital Management of U.S. Bank. “It includes the capital gains tax rate of up to 20% plus the 3.8% Net Investment Income Tax (NIIT) for federal tax purposes alone, possibly more depending on the state of residence.”

Who qualifies for the QSBS Section 1202 exclusion?

Any shareholder who owns qualified small business stock may benefit from the Section 1202 exclusion, including investors, employees (as long as they’re U.S. residents), and trusts and estates. In closely held businesses, owners are often family members or family trusts.

Several requirements must be met for a business sale to qualify for the QSBS Section 1202 exclusion, including:

• Only domestic C corporations qualify for the exclusion. S corporations don’t qualify, although LLCs that have elected to be taxed as S corps may qualify. According to Guenther, if your company stock was issued as S corp stock initially, you can switch the corporate structure to a C corporation to meet the qualifications. “The exclusion will primarily apply to manufacturing, retail, wholesale, technology, equipment sales firms and auto dealerships,” she says.
• The original issue of stock must have occurred after Aug. 10, 1993. Also, the issuing corporation must have had assets (on the date of issue and immediately after) valued at $50 million or less.
• The corporation must be engaged in a qualified trade or business. More specifically, it must use at least 80% of the fair market value of its assets on the active conduct of a qualified trade or business.
• Significant redemptions of stock cannot be made in the year proceeding or following a stock issuance.
• Shareholders must be non-corporate, including individuals, trusts and estates.
• The stock must have been held for more than five years before it is sold, starting on the date it was issued.
• The stock must have been purchased from the corporation, not from another shareholder. However, it can be obtained through an inheritance or as a gift from someone who acquired the stock when it was originally issued.

How much QSBS Section 1202 capital gain can be excluded?

The amount of capital gain that may be excluded from taxes depends on when the QSBS was originally issued:

• Qualifying stock issued between Aug. 11, 1993, and Feb. 18, 2009, is eligible for a 50% exclusion from capital gains taxes and NIIT. Note that if this provision is used, the applicable capital gains tax rate would be 28%, not 20%. Therefore, the effective tax rate would be 15.9%. The Alternative Minimum Tax (AMT) may also apply to the excluded gain.
• Qualifying stock issued between Feb. 19, 2009, and Sep. 27, 2010, is eligible for a 75% exclusion, again using 28% as the base capital gains tax rate plus NIIT. This would result in an effective tax rate of 7.95%. AMT may also apply to the excluded gain.
• Qualifying stock issued from Sep. 28, 2010, to present is eligible for a 100% exclusion from capital gains and NIIT. In this case, AMT does not apply.

How much could be saved in capital gains taxes using the QSBS Section 1202 exclusion?

“If you qualify for this provision of the law when you sell company stock, it’s a real opportunity for notable tax savings,” says Guenther. Consider the following example:

Chris received qualifying small business stock in ABC Corporation on Jan. 1, 2015, in exchange for $3 million in cash. On Jan. 1, 2023, Chris sold the stock for $25 million, realizing a capital gain of $22 million. Since the stock meets the Section 1202 qualification criteria, the entire $22 million gain will be free from capital gains tax and the NIIT. Chris will pocket the entire $25 million in proceeds from the sale and save $5,236,000 in federal taxes.

Is the QSBS Section 1202 exclusion appropriate when selling a business?

Guenther encourages anyone who is completing the sale of a business under Section 1202 to work closely with their tax and financial professionals to do a projection on what the ultimate result would be. “Look at the sale price and what the gain would be versus a standard stock sale or asset sale, or other form of business transition such as gifting stock,” she says.

For some business owners, she adds, completing a corporate reorganization and a stock-for-stock exchange would be a consideration.

Learn how U.S. Bank wealth advisors and teams can help you balance the needs of your business while working toward your personal wealth goals.