Qualified Small Business Stock Can Provide A Strategic Advantage To Private Equity Groups And Venture Capitalists

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Internal Revenue Code Section 1202 may offer a generous tax benefit for private equity groups and venture capitalists. Section 1202 permits a taxpayer, other than a corporation, to exclude up to 100% of the gain from the sale or exchange of qualified small business stock (QSBS) held for more than five years. Originally enacted in 1993 to encourage investment in small companies, Section 1202 initially granted a 50% exclusion of gain, which was later increased to 75% for QSBS stock acquired after February 17, 2009 and then to 100% for QSBS stock acquired after September 27, 2010.

The investment in QSBS can be made either directly by an individual or by an eligible pass-through entity, which can be defined for these purposes as an S corporation, partnership, regulated investment company or common trust fund. Private equity (PE) groups and venture capital (VC) firms will be eligible to invest in QSBS in most cases, as they are typically taxed as partnerships, and should consider the potential tax benefits offered by such an opportunity.

The percentage of excludable gain under Section 1202 depends on the year in which the stock was acquired, and the holding period of QSBS begins on the day after the date the stock was issued, regardless of whether the QSBS is received in a taxable or non-taxable transaction.
 
The exclusion of the gain can provide PE funds and VC a valuable tax savings opportunity upon their exit from an investment in a qualifying small business.