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Sec. 1202 Qualifications

Sec. 1202 Qualifications

The Revenue Reconciliation Act of 1993 created Sec. 1202, which allows noncorporate investors in certain C corporation stock a 50% capital gains exclusion on sale or exchange. The investor must hold the stock for more than five years to qualify for Sec. 1202 treatment; the stock must have been acquired on or after Aug. 12, 1993. Therefore, the earliest point in time at which this tax benefit would be available to taxpayers is on or after Aug. 12, 1998. Practitioners now need to consider if Sec. 1202 applies to their clients' transactions.

Sec. 1202 contains many obstacles in qualifying for the exclusion; more importantly, because it is not an elective exclusion, practitioners need to help clients understand when this provision applies. Much has been written over the last five years on the tax benefits derived from the ownership of Sec. 1202 stock. However, practitioners have begun to see how complicated it is to qualify for Sec. 1202 treatment. Additionally, the alternative minimum tax (AMT) has significantly affected the benefits that taxpayers derive from the Sec.1202 stock gain exclusion.

Sec. 1202 was enacted to encourage investment in small businesses and small-cap companies, and to increase the after-tax returns for investors. However, it appears the benefits of Sec. 1202 are diminishing, as capital gains rates have been reduced and more taxpayers are subject to the AMT. The following table illustrates the effect of the AMT on the gain on the disposition of Sec. 1202 stock:

 

More and more taxpayers are creeping into the AMT regime, for a number of reasons. For example, increasing state and local income tax deductions and the reduced benefit of the AMT exemption as a result of nonindexing of the phaseout are common reasons why a middle-income taxpayer may now be AMT-sensitive. Instead of the 14% rate on qualified capital gains from Sec. 1202 stock, the investor faces an effective tax rate of 19.9%. In addition, this AMT preference is permanent and, therefore, does not qualify for the AMT credit.

The recent reduction in long-term capital gains rates has also eroded the tax benefits under Sec. 1202. When Sec. 1202 was enacted in 1993, the maximum long-term capital gains rate was 28%. When originally enacted, the AMT preference related to Sec. 1202 stock was 50% of the excluded gain. The Taxpayer Relief Act of 1997 (TRA '97) reduced the long-term capital gains rate to 20%, while Sec. 1202 stock continues to be subject to a 28% rate. Effective for tax years beginning after 2000, the capital gains rate is further reduced to 18% for certain transactions. The TRA '97 reduced the AMT preference related to the gain exclusion, from 50% to 42%.

Because investors can now avail themselves of the favorable results of Sec. 1202, they must very carefully monitor the requirements to prevent disqualification. Some of the criteria to qualify as Sec. 1202 stock include:

• Gross assets of the C corporation must not exceed $50 million before and immediately after the stock issuance (Sec. 1202(d)(1)(A) and (B)).
• Personal service corporations, financial organizations, farms, restaurants and hotels or similar businesses do not qualify (Sec. 1202(e)(3)).
• At least 80% by value of the corporation's assets must be used in the active conduct of one or more "qualified trades or businesses" (Sec. 1202(e)(1)).
• No more than 10% of the corporation's assets can be invested in stock of other corporations that are not controlled subsidiaries (Sec. 1202(e)(5)(B)).
• Stock redemptions are limited, in that stock will not be qualified small business stock (QSBS) if the issuing corporation repurchases it (Sec. 1202(c)(3)).

The TRA '97 also created Sec. 1045, which provided a deferral from recognizing gain on the disposition of Sec. 1202 stock. Sec. 1045 is available when an investor realizes a gain on the sale of QSBS. To qualify for a Sec. 1045 deferral, the original small business stock must have been held for at least six months and within 60 days of the sale, replacement small business stock is purchased. The deferred gain reduces the basis of the newly acquired small business stock. The holding period of the stock purchased will include the holding period of the stock sold. Sec. 1045 is important, because an investor is no longer required to hold the new QSBS for the 60-month period (if it was acquired through a qualified rollover transaction) to be eligible for Sec. 1202 treatment.

There are many requirements that must be fulfilled for investors to avail themselves of Sec. 1202 treatment. Practitioners need to be aware that Sec. 1202 or 1045 or both may apply to their clients' transactions. Proper planning for the capital gain exclusion and AMT effects will maximize the benefits to investors. In addition, with the tacking of holding periods to qualified rollover stock, new opportunities for planning through timing of gain recognition are now available.

From Maura P. Flynn, CPA, MT, Cohen & Company, CPAs, Mentor, OH

©1999 AICPA