In my last article, titled Why You Should Consider Private Equity in Your Investment Portfolio, I explored reasons why incorporating private equity into your investment portfolio could be a smart, strategic move to build wealth.
Private equity’s potential benefits in terms of true diversification in a concentrated market, alignment of interests for long-term success and strong performance make it an investment category worth considering. Unique and substantial tax benefits can be obtained by investing in private equity.
One such potential tax benefit is Internal Revenue Code (IRC) Section 1202; this provision allows individuals to exclude up to 100% of the capital gains realized from the sale of qualified small business stock (QSBS). Certain criteria must be met to qualify as a Section 1202 stock. This article will explore the eligibility criteria for QSBS, gain exclusion percentage, limitations and strategic implications.
Subscribe to Kiplinger’s Personal Finance
Be a smarter, better informed investor.
Save up to 74%
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more – straight to your e-mail.
Profit and prosper with the best of expert advice – straight to your e-mail.
Eligibility criteria for qualified small business stock
The aforementioned capital gain tax exclusion not only encourages investment in small businesses but also presents significant tax-saving opportunities for investors and entrepreneurs alike. To leverage the benefits of IRC Section 1202, it’s essential to understand the stringent requirements that define QSBS.
C corporation status
The issuing entity must be a domestic C corporation at the time of stock issuance. S corporations and partnerships do not qualify under this provision; however, LLCs that have elected to be taxed as a C corporation are eligible.
Gross assets limitation
At the time of issuance and immediately thereafter, the corporation’s aggregate gross assets must not exceed $50 million.
Original issuance
Investors must acquire the stock directly from the company, not through secondary market transactions.
Active business requirement
During substantially all of the investor’s holding period, at least 80% of the corporation’s assets must be utilized in the active conduct of a qualified trade or business. Certain service-based businesses, such as those in health, law or consulting, are excluded from this definition.
Holding period
The investor must hold the QSBS for more than five years to be eligible for the capital gains exclusion.
These requirements are designed to foster, encourage and incentivize long-term investment into small growth-oriented businesses.
Kiplinger Advisor Collective is the premier criteria-based professional organization for personal finance advisors, managers, and executives. Learn more >
Gain exclusion percentage
IRC Section 1202 was enacted in 1993 and has undergone several amendments affecting the percentage of gain exclusion. An investor’s capital gain exclusion is dependent on the timing of such investment:
- 50% exclusion: For stock acquired between August 10, 1993, and February 17, 2009, 50% of the gain could be excluded.
- 75% exclusion: This increased to 75% for stock acquired from February 18, 2009, to September 27, 2010.
- 100% exclusion: For stock acquired on or after September 28, 2010, the exclusion rose to 100%, significantly enhancing the appeal of QSBS investments.
Limitations
Section 1202 was enacted to encourage investment in small businesses. While the tax benefits are substantial, knowing the provision’s limitations is important:
Exclusion cap
The maximum gain eligible for exclusion is the greater of $10 million or 10 times the investor’s basis in the QSBS. This cap applies on a per-issuer basis, allowing investors to potentially multiply exclusions by investing in multiple qualified small businesses.
Alternative minimum tax
For stock acquired before September 28, 2010, the excluded gain is treated as a preference item for alternative minimum tax (AMT) purposes, potentially affecting the investor’s tax liability. However, for stock acquired on or after this date, the gain exclusion is not considered a preference item, thereby not impacting AMT calculations.
Strategic implications
Entrepreneurs should consider structuring their startups as C corporations to attract investors adept at investing in private equity seeking QSBS benefits. For investors and entrepreneurs alike, IRC Section 1202 presents a strategic avenue for tax-efficient investment:
Investment incentive
The potential to exclude up to $10 million in capital gains per issuer is a powerful incentive for investors to invest in small, growth-oriented businesses. The potential tax benefits are substantial.
Estate planning
Gifting QSBS to family members or trusts can be a powerful tool in estate planning. This strategy can multiply the available gain exclusion, as each recipient is entitled to their own $10 million exclusion limit, thus magnifying the transfer of wealth in a tax-efficient manner.
Private equity investment does not come without risks, which I’ve outlined in a prior article. But reasons to consider private equity in your investment portfolio include diversification and alignment of investor interests. In addition, the substantial tax benefits IRC Section 1202 offers investors willing to commit to long-term investments in small businesses is just another reason to consider the appropriateness of investment in private equity.
By understanding and navigating the specific requirements and limitations of this provision, both investors and entrepreneurs can strategically position themselves to maximize benefits, potentially helping one find the right balance between risk and reward in their investment strategy.
Related Content
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.