According to the Small Business Administration Office of Advocacy, there were 33.2 million small businesses in the United States as of 2022. These businesses employ 61.7 million people and represent a significant piece of the U.S. economy. Many small businesses desire outside investment to aid in their growth and expansion, but the higher potential risk involved makes them less attractive to investors. Fortunately, the Internal Revenue Code contains several provisions that encourage and reward investment in small businesses.
The provisions contained in Sections 1244 and 1202 of the Tax Code allow an investor to purchase “small business stock” and receive favorable tax treatment upon sale. These provisions have powerful potential for tax savings, however, certain rules must be followed to obtain this favorable treatment.
First, a quick refresher of the basics: a capital gain or loss may occur when stock is sold or exchanged. If the selling price is greater than the purchase price, the transaction results in a gain. If the selling price is lower than the purchase price, a loss occurs. The sale of stock at a loss usually generates a capital loss, which can only be deducted in any particular year to the extent of capital gains, plus $3,000 ($1,500 for married taxpayers who file separate returns).
Losses on Certain Small Business Stock (Section 1244)
Fortunately, Congress recognizes that investors in small corporations often run more of a risk of loss. As a result, the Internal Revenue Code permits an individual to deduct, as an ordinary loss, a loss from sale or exchange, or from worthlessness, of “small business stock” (more commonly called “Section 1244 stock”) issued by a qualifying small business corporation. Unlike a capital loss, an ordinary loss may fully offset wage income, dividends, or similar “ordinary” income.
To qualify as Section 1244 stock and be entitled to an ordinary loss deduction, the stock must be issued by a domestic corporation that is considered a “small business corporation” at the beginning of the tax year in which the stock is issued. A corporation is considered to be a small business corporation if the total amount of cash and other property received for stock does not exceed $1 million. If this $1 million threshold is exceeded only a portion of the corporation’s stock can qualify as Section 1244 stock.
Additionally, the corporation must meet a test to prove that it derives more than 50% of its aggregate receipts from noninvestment income. Investment income includes gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities.
Unfortunately, there are limits to the tax advantages of using Section 1244 stock. The maximum amount deductible as an ordinary loss in any one year is $50,000 ($100,000 on a joint return). Losses that exceed this limit are capital losses.
Gains on Qualified Business Stock (Section 1202)
The Tax Code provisions not only protect investors from the downside with Section 1244 stock, but also provide favorable treatment on the upside for gains from investing in small business stock under Section 1202.To qualify for a Section 1202 gain exclusion, the stock must be acquired at its original issue or in a tax-free transaction, such as by inheritance, gift, or partnership distribution. The stock must then be held for more than five years to qualify for gain exclusion.
For stock acquired after September 27, 2010, individual investors may exclude 100% of the gain they realize on the disposition of qualified small business stock if it is held for more than five years. (For stock acquired after February 17, 2009, and on or before September 27, 2010, the exclusion from gain is 75%, and for stock acquired after August 10, 1993, and on or before February 17, 2009, the exclusion from gain is 50%. For certain empowerment zone stock acquired after December 21, 2000, and on or before September 27, 2010, the exclusion is 60%).
Unlike losses under Section 1244, a “small business” for purposes of Sec. 1202’s gain exclusion is defined more broadly to include a corporation with gross assets of less than $50 million at issuance. The exclusion allowed is limited to the greater of $10 million or 10 times the taxpayer’s basis in the stock. The amount of gain eligible for the partial exclusion is subject to limits computed on a per-issuer basis.
Any capital gains excluded from regular federal income tax under Section 1202 are also exempt from the 3.8% net investment income tax. Additionally, any investor (other than a C corporation) that has held small business stock for more than six months may elect to sell it and defer any gain that is used within 60 days to buy stock that also qualifies as small business stock. The holding period of the stock purchased under this swap provision generally includes the holding period of the stock sold.
Final Thoughts
If you have any questions regarding the above information, or how other provisions related to Section 1244 stock or Section 1202 stock might benefit your particular tax situation, please reach out to the GYF tax professionals at 412-338-9300 for additional guidance and assistance.
