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• Qualified small business stock;

• Startup News 🚀;

• Venture Capital News 💰;

• Other Tech News 💻.

Reflection No. 3: Qualified Small Business Stock and Section 1202

Benjamin Franklin once said, “In this world, nothing can be said to be certain, except death and taxes.” But did you know that Section 1202 of the U.S. tax code actually provides a unique opportunity to reduce the impact of taxes on certain capital gains? This section of the Internal Revenue Code—the 'Qualified Small Business Stock' provision—offers significant tax exclusions on gains from selling eligible small business stock. This provision of the Tax Code benefits founders, investors, and early employees by allowing them to save millions of dollars on taxes! Let’s dig in. 

I - Issue: What’s qualified small business stock (QSBS)?

R - Rule: Section 1202 of the U.S. Tax Code allows non-corporate taxpayers to exclude up to 100% of the gains from the sale of qualified small business stock.

A - Analysis: Typically, gains from the sale of capital assets are taxed at favorable rates if you hold an investment for more than one year. These rates can range from 0% to 20%, depending on the taxpayer’s income level.

However, Section 1202 provides an exception, allowing for a 100% capital gain exclusion on up to $10 million per taxpayer or ten times the taxpayer’s basis in the QSBS. 

First, to qualify for the gain exclusion under Section 1202, certain conditions must be met, including:

• Five-Year Holding Period: Section 1202 requires the taxpayer to hold the QSBS for at least five years.

• Company Size: The corporation must have gross assets of $50 million or less when issuing QSBS.

• Original Issuance: The taxpayer must acquire the QSBS directly from the corporation.

• Active Business Requirement: The corporation must use at least 80% of its assets to conduct a qualified trade or business.

• Qualified Trade or Business: Only certain types of businesses can qualify for the Section 1202 exclusion. Generally, health, law, finance, farming, hospitality, and businesses that rely on the reputation or skill of employees would not qualify for Section 1202 gain exclusion.

Second, Section 1202 can benefit many stakeholders, including the founders, early investors (like angel investors), and early employees.

• Founders can benefit from Section 1202 during an exit, such as a merger or acquisition, where significant capital gains are realized and serve as an incentive to start a high-growth company. 

• Early investors in startups often face high risk but are rewarded if the company succeeds—section 1202 incentivizes this risk-taking by eliminating taxes on some of the gains.

• Employees who receive restricted stock or stock options as part of their compensation package can also benefit from Section 1202. The holding period for the employees with restricted stock begins on the grant date. Whereas, the holding period for the employees with an ISO stock option starts once the employee exercises the vested options. The gain exclusion under Section 1202 can really increase the financial rewards for early employees who take on the risk of joining a startup.

Lastly, the taxpayer's gain exclusion under Section 1202 is calculated separately for each issuing corporation the taxpayer invests in. For example, if a taxpayer holds QSBS in five different corporations, the gain exclusion is calculated independently for each corporation, allowing the taxpayer to take advantage of Section 1202 each time it invests in an early-stage startup.

C - Conclusion: Section 1202 of the U.S. tax code provides substantial tax benefits by allowing the exclusion of gains from the sale of qualified small business stock. It is arguably the most attractive tax provision for founders, early startup employees, venture capitalists, and angel investors.

Startup  🚀, Venture Capital 💰, and Other Tech News 💻

• Starbucks has hired its new CEO

• Peloton is finally pedaling in the right direction

• First ever Fall batch at YC … applications are open now!

• An acqui-hire might not be so bad after all

• Mark Bezos—Jeff’s brother—launches a new $100 million fund

Quote of the Reflection

As with any early-stage venture, pivots are quite common. I'm excited to share that I've decided to change Reasoned Reflections from a startup, venture capital, and technology newsletter to a newsletter focused on basic income, investing, and personal finance. 

Although I do enjoy talking about venture capital, startups, and technology, the topics relate too closely to my area of work. The new topics—essentially everything related to one’s personal finance journey—are also topics I could talk endlessly about and might resonate with a broader audience. 

Thanks for sticking with me during this change, and I look forward to sharing insights into the world of personal finance. We’ll see you in two weeks!

If you want to see a topic featured on Reasoned Reflections, please email [email protected].