As part of a sweeping, 887-page tax bill passed by Congress on December 18, risk-taking entrepreneurs and investors who create jobs through building businesses will now be rewarded for their efforts with lessened tax burdens. The PATH Act (Protecting Americans from Tax Hikes), as it’s called, made a number of significant taxpayer-friendly changes to the tax law, including a new code (Section 1202) which will enable company’s founders and employees holding stock, including that obtained upon exercise of options, to save up to millions of dollars in taxes upon a company achieving a successful liquidation event. Although Section 1202 has actually been around since 1993 (with modifications over the years), Congress’ recent vote makes it significantly more powerful because it (i) makes the tax benefit permanent, (ii) increases the exemption from 50 percent to 100 percent and (iii) eliminates all ambiguity around ancillary tax codes.
Here’s how it works (via TechCrunch):
In essence, Sec. 1202 allows individual investors or entrepreneurs and their employees who put money into a qualifying corporation with aggregate gross assets not exceeding $50 million before and immediately after the stock issuance, and which does not engage in repurchasing any of their outstanding stock, to now enjoy a 100 percent tax break on the specific investment gain with no offset to the benefit from the Alternative Minimum Tax (AMT). The investment must be held for a minimum of five years.
Sec. 1202 provides that the amount of the gain that can be excluded from taxation for an individual is the greater of either 10 times the investment or $10 million for each specific qualifying investment made by the fund. Spread over multiple investments, the tax-free gain could be dramatic.
A brief history of Section 1202 (via Pillsbury Law):
- Section 1202 of the Internal Revenue Code was enacted in 1993 to encourage investment in small businesses. Subject to certain dollar limitations, it originally provided that 50 percent of the gain from the sale of QSBS (Qualified Small Business Stock) held for more than five years was excluded from a taxpayer’s gross income. The reduction in capital gains rates following enactment of section 1202, a rate of 28 percent on the non-excluded gain, and inclusion of a portion of the excluded gain as an item of tax preference under the alternative minimum tax (AMT) eroded the benefits of the exclusion.
- In 2010, and subject to the same dollar limitations, section 1202 was amended to increase to 100 percent the amount of gain from the sale of QSBS held for more than five years eligible for the exclusion, and also eliminated treatment of any portion of the excluded gain as an item of tax preference under the AMT. This change was originally applicable to QSBS acquired after September 27, 2010 and before January 1, 2012, but was later extended to apply to QSBS acquired in 2012, 2013 and 2014.
- Prior to the PATH Act, the section 1202 exclusion percentage for QSBS acquired after December 31, 2014 had reverted to 50 percent and the AMT tax preference item had been reinstated. However, the PATH Act makes permanent the 100 percent exclusion and AMT preference elimination, retroactive to QSBS acquired after December 31, 2014.
- The amount of the exclusion continues to be limited to the greater of (i) $10 million per taxpayer per issuer (reduced by any gain excluded in prior taxable years on the sale of QSBS of the same corporation) or (ii) 10 times the basis of any QSBS of the same corporation sold during the taxable year (determined without regard to any basis additions occurring after the date on which the QSBS was originally issued).
- All other provisions of section 1202 remain unchanged, including the definitions of QSBS and “qualified small business” and the limitations on excludable amounts. For more information regarding the definitions, eligibility requirements and limitations of section 1202, please see our September 1998 Tax Bulletin, Qualified Small Business Stock Update, and our February 2013 Tax Bulletin, Qualified Small Business Stock Developments.