The section 1202 tax exclusion provides a 100% tax exclusion on the long-term capital gains from the sale of QSB stock if all of the requirements on a company and investor level are met. The tax exclusion is limited to $10 million or 10x the investment; therefore, in theory the capital gains exclusion can exceed $10 million. The current long-term capital gains tax rate for assets held over 12 months is 0%, 15%, or 20%. In addition to capital gains taxes, if an individuals income exceeds a certain threshold they will also be subject to a Net Investment Income (NIT) tax of 3.8% on the long-term capital gains. In short, an investor could save $2.38 million in taxes if their capital gains were $10 million ($10,000,000 x (20% + 3.8%)). If the investment was $10 million and the invest sold his/her shares for $110 million, which is 10x the initial investment, they would save $23.8 million in taxes (($110,000,000 – $10,000,000) x (20% + 3.8%)). The 10x gain is calculated as a multiple of the initial investment not including the initial investment in the capital gains. Below is the capital gains tax bracket and a real world example of calculating the capital gains tax exclusion and savings.
Capital Gains Tax Bracket
- 0%: Income between $0 – $39,375
- 15% : Income between $39,376 – $434,550
- 20%: Income over $434,550
Net Investment Income Thresholds for Modified Adjusted Gross Income
- Married filing jointly $250,000
- Married filing separately $125,000
- Single $200,000
- Head of household (with qualifying person) $200,000
- Qualifying widow(er) with dependent child $250,000
Real World Example
Andrew Craig, an accredited investor, was approached by a legal tech startup, ABC, Inc., to invest in its Pre-Seed Round of financing at a $1.5 million pre-money valuation that included friends, family, and angel investors. Mr. Craig who had successfully exited legal tech startup was ready to sit back and let other founders do the dirty work. Mr. Craig decided to invest $250,000, which was half of the target raise by ABC. Due to his experience, he was aware of section 1202 and decided to file for QSBS qualification. Five years later, ABC was raising its Series B round at a $25 million pre-money valuation and had strategic incumbents like Thomson Reuters interested in getting on the cap table. Mr. Craig saw an opportunity to sell his shares with 20x return after dilution. Therefore, Mr. Craig’s shares were worth $5.25 million (($250,000 x 20) + 250,000). After the sale he pocketed the $5.25 million and did not have to pay any capital gains tax because his gain was under $10 million and qualified for section 1202. Even though he returned 20x his initial investment, which is more than the 10x cap the tax code reads the greater of $10 million or 10x. Mr. Craig, who is in the highest tax bracket, saved $1.19 million in taxes ($5,000,000 x (20% + 3.8%)).
What is a cap table?
What are financing rounds for startups?
What is a pre-money valuation?
What are incumbents?
How do I calculate Modified Adjusted Gross Income?
What is Net Investment Income (NIT)?