On November 3, 2010 and January 18, 2011, we issued client alerts discussing the opportunities provided by the Section 1202 exclusion from tax on gain realized on the sale of certain stock issued by a “qualified small business corporation” (a “QSBC”). These alerts discussed Congress’ increase of the exclusion percentage to 100% with respect to stock issued by a QSBC between September 27, 2010 and December 31, 2011. On January 2, 2013, the president signed the American Taxpayer Relief Act (“ATRA”), which again extended the increase in the 1202 exclusion to 100%; this time for stock issued by QSBCs during calendar years 2012 and 2013. ATRA also includes other important provisions impacting taxes, including changes in the income tax and capital gains tax rates for taxpayers with incomes above certain thresholds.

Benefits of the Exclusion

The 100% exclusion shields up to $10 million (or, if greater, 10 times the amount of the taxpayer’s investment in the stock) of gain recognized on the sale of stock issued by a QSBC after September 27, 2010 and no later than December 31, 2013, so long as the taxpayer holds the stock for more than five years prior to sale. This exclusion of gain applies not only to the computation and payment of federal income taxes (including the new 3.8% “Medicare” tax on net investment income and the alternative minimum tax), but may also shield the gain from state income taxes (unless the state, like California, includes an “add back” when calculating state income taxes).

The 100% exclusion is primarily an incentive for QSBCs to raise new equity capital before the end of 2013. As such, it is an incentive for individuals, estates, and trusts seeking investment opportunities in start-up and other early stage corporate ventures as well as existing small and middle-market corporations.