Potential Benefits of Section 1202 Continue to Grow

July 2021

Section 1202 of the Internal Revenue Code is growing in popularity among investors and may become even more valuable in 2022.

Section 1202 allows founders and investors of corporations to exclude up to 100% of their capital gains derived from the sale of qualified small business stock (QSBS) held for more than five years (subject to limitations). Because the gain exclusion percentage for a shareholder depends on the QSBS issuance date, as time goes on more investors are becoming eligible for the full, 100% exclusion—and thus its rise in popularity.

Further, the 2021 Green Book proposes far-reaching changes to the taxation of long-term capital gains, which are taxed at graduated rates under the individual income tax. Today, the highest rate is generally 20% (23.8% including the net investment income tax, if applicable, based on the taxpayer's modified adjusted gross income (AGI)).

Under the Green Book proposal, long-term capital gains of taxpayers with AGI of more than $1 million would be taxed at ordinary income tax rates to the extent that the taxpayer's income exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2022. Currently, the highest rate for individuals is 37% (40.8% including the net investment income tax), though the Green Book also includes a proposal to raise the individual rate to up to 39.6% (43.4% including the net investment income tax).

While reinvestments into Qualified Opportunity Zones, like-kind exchanges for real property (possibly limited going forward), and reinvestment of proceeds into qualified replacement property from sales of corporate stock to an Employee Stock Ownership Plan of 30% or more of the corporation’s outstanding stock provide some deferral opportunities, Section 1202 is the only provision that provides an exclusion opportunity for QSBS. The higher that the capital gains tax rate goes up, the greater the potential tax benefit of utilizing an available Section 1202 exclusion.

Want to learn more about Section 1202 considerations? BDO’s Heath Wang wrote an article for The Tax Adviser, Practical considerations of Sec. 1202 in M&A transactions, discussing the potential tax benefits of the QSBS gain exclusion under Section 1202.