Qualified Small Business Stock Options

Now that the qualified small business stock 100% tax exclusion is going to be permanent, one question that will come up more often is:

Qualified Small Business Stock Options

Do optionees qualify? Meaning, do holders of compensatory stock options, who exercise those options and acquire stock–can they qualify for the Section 1202 qualified small business stock benefit?

The answer is yes. Stock acquired upon the exercise of compensatory stock options can qualify as qualified small business stock.

Specifically, Internal Revenue Code Section 1202 Says:

(c) Qualified small business stock. For purposes of this section—

(1)In general. Except as otherwise provided in this section, the term “qualified small business stock” means any stock in a C corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993, if—

(A) as of the date of issuance, such corporation is a qualified small business, and

(B)except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its original issue (directly or through an underwriter)—

(i) in exchange for money or other property (not including stock), or

(ii) as compensation for services provided to such corporation (other than services performed as an underwriter of such stock).

Of course, the biggest trouble optionees might have is not meeting the holding period requirement. But Section 1045 will be available for optionees to roll over Section 1202 gain even if they haven’t held the stock for more than five years.

Congress did a lot for encouraging a certain type of activity when it made the 100% tax benefit of Section 1202 permanent.
[This blog post does not constitute legal or tax advice. Always consult with your tax or legal advisor with respect to the particulars of your situation.]
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  • Does 1202 pass through an LLC, or must the investment be made by a natural person to qualify? How about a C corp investing in another C corp? This change makes me think a holding company model might have better tax treatment than a traditional investment fund, as a C-corp holding company shares become a tax-free asset after 5 years.

    • joe.wallin@gmail.com

      Luni, if an LLC makes the investment in the C corp, the benefits of 1202 can pass through the LLC to the members of the LLC (assuming the LLC is taxed as a partnership).

      But a C corp cannot qualify for the 1202 benefit–only individuals can benefit.

      A holding structure would not work–because the company you invest in–for it to qualify–it has to be an operating company.