Section 1202 Exclusion Overview
Section 1202 Exclusion is a federal income tax provision that permits investors to exclude a substantial portion of capital gains when selling qualified small business stock (QSBS). For stock purchased after September 27, 2010, investors can exclude up to 100% of their gains, provided certain holding period and business requirements are met.
Why It Matters for Angel Investors
This tax benefit is particularly valuable for angel investors who fund early-stage companies. Rather than paying capital gains tax on successful exits, investors can retain more of their profits. This effectively increases the after-tax return on investment, making angel investing more attractive and improving portfolio performance.
Key Requirements
- Stock must be issued directly by the company (not purchased on secondary markets)
- The company must be a C corporation with assets under $50 million
- At least 80% of company assets must be actively used in business operations
- Investor must hold the stock for at least five years
- The company cannot operate in certain excluded industries like hospitality or finance
Practical Example
An angel investor purchases $100,000 in QSBS from a startup. After seven years, the company is acquired for $1 million, generating a $900,000 gain. Under Section 1202, the investor can exclude $900,000 from federal taxation, owing no federal capital gains tax on that profit. State taxes may still apply depending on jurisdiction.
Important Limitations
The exclusion is capped at the greater of $10 million in gains or ten times the investor's basis in the stock. Additionally, the 100% exclusion only applies to stock purchased after 2010. Stock purchased between 2009-2010 qualifies for a 75% exclusion, while stock purchased before 2009 qualifies for a 50% exclusion.
Related Terms
Learn more about Qualified Small Business Stock (QSBS), Capital Gains Tax, and Holding Period to better understand this important tax benefit.