Included in the American Taxpayer Relief Act of 2012 (ATRA) are provisions that extended some of the more significant benefits of Internal Revenue Code Section 1202, the Code provision that permits eligible noncorporate taxpayers to exclude from taxable income (within limits) a specified percentage of any gain from the sale or exchange of “qualified small business stock” (QSBS) held for more than five years.  That percentage, which, when Section 1202 was first enacted in 1993, was 50 percent of the recognized gain from the sale of the QSBS, was increased to 100 percent of such gain for QSBS acquired after September 27, 2010, and before December 31, 2010.  The 100 percent exclusion was extended through December 31, 2011, pursuant to the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010.  ATRA retroactively extended the 100 percent exclusion for QSBS acquired in 2012 and 2013.  More importantly (to some), ATRA also extended the rule that excluded that gain not only for regular income tax purposes but for alternative minimum tax (AMT) purposes as well.

Historically, trying to qualify for the benefits of Section 1202 was of little interest to private equity investors.  This was the case for a number of reasons, including the following:

  • Section 1202 is, by its terms, limited to newly issued stock of a C corporation.  Section 1202 has a number of requirements that must be satisfied in order for stock to qualify as QSBS relating to the method by which the noncorporate taxpayer acquires the stock, the type of business in which the corporation can be engaged and, as discussed below, the size of the corporation (measured by gross assets).  Indeed, with regard to the first requirement, it is arguably the case that the benefits of Section 1202, which were aimed at encouraging investments in new enterprises, were not intended to apply to a typical private equity investment (which often results in no new capital being invested in the business but rather a cashing out of the current owners’ invested capital).  That said, where, as in the situation with many private equity investments, the structure of the transaction calls for a new corporation to be created, it may be that this particular requirement can be satisfied.
  • The corporation issuing the QSBS could not, at the time the QSBS was issued (and at all times since August 10, 1993, through that date), have more than $50 million of gross assets.  Many corporations in which private equity is invested have gross assets that exceed this threshold.
  • The five-year holding period for the stock was not realistic.  Many private equity firms plan to, or in fact do, exit their investment in less than five years.  Whatever tax benefits might be derived from Section 1202 are frequently (and appropriately) trumped by business and investment considerations.
  • The treatment of a portion of the excluded gain as a “tax preference” item for AMT purposes would often negate the regular income tax benefit from Section 1202.  The allocation of gain on a disposition of a private equity investment and the eligibility of such gain for exclusion under Section 1202 is all determined at the investor level.  For an investor who is otherwise an AMT taxpayer or whose allocable share of Section 1202 gain made the investor an AMT taxpayer, the treatment of a portion of that excluded gain as a tax preference would often make the effective federal income tax rate on the gain only two to 12 basis points below what was the effective rate had the gain not been eligible for Section 1202.  Indeed, in this situation, an investor probably would only claim the benefits of Section 1202 if, as was sometimes the case, it resulted in an effective reduction in the state income tax rate payable with respect to the gain.

So why should private equity investors now take another look at Section 1202? 

First, while the requirements for what constitutes QSBS remain unchanged, the character of certain private equity investments has changed—in particular, it may no longer be considered unrealistic for holding periods to be longer than five years or for investments to be in companies with gross assets of less than $50 million. 

Second, federal long-term capital gains tax rates have gone up, from 15 percent to what is, for most individual private equity investors, 23.8 percent.  In the meantime, the tax rate applied to the non-excluded Section 1202 gain has not changed.  As such, a 2013 sale at a gain of otherwise eligible QSBS stock (i.e., stock that, among other things, has been held since 2008) would be subject to an effective federal income tax rate of 15.9 percent or, to the extent the investor is an AMT taxpayer, an effective federal income tax rate of 16.88 percent—in either case, a savings over the regular capital gains tax rate of almost nine percentage points.  (These effective rates assume that the investor’s income will be at a level at which the new 3.8 percent “net investment income tax,” enacted as part of the Obama health care legislation, will be applicable and that the 50 percent of the gain not excluded under Section 1202 will be subject to this tax.)  This savings, of course, is on top of any effective reduction in the investor’s state income tax rate on the gain.

Third, depending on when the QSBS was acquired, the reduction in the effective federal income tax rate on the gain from a sale in future years could be even more significant.  For QSBS acquired between February 18, 2009, and September 27, 2010—not eligible for the benefits of Section 1202 until February 19, 2014, at the earliest—the portion of the gain eligible for the exclusion under Section 1202 is 75 percent, making the effective federal income tax rate on the gain 7.95 percent (for investors who are not subject to AMT) and 13.83 percent (for investors who are).  For QSBS acquired between September 28, 2010, and December 31, 2013, the effective federal income tax on such gains is zeropercent for both regular income tax and AMT purposes.  Of course, the first sales of QSBS eligible for the zero percent rate cannot occur until September 29, 2015, and, for any QSBS investments made in 2013, not until sometime in 2018 (by which time the federal capital gains tax rates generally may have changed one or more times).

Although the recent changes in capital gains tax rates have made the benefits of Section 1202 more compelling, these benefits are still speculative for many reasons.  Therefore, an otherwise unsuitable investment should not be made, nor fundamental business terms compromised, solely to fit within the parameters of Section 1202.  That said, if the size of the investment, the structure of the transaction and the anticipated holding period for the stock all indicate that private equity investors could take advantage of reduced federal (and state) capital gains tax rates, making sure that the investment otherwise constitutes valid QSBS should not be overlooked.