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Back to basics: Section 1202 capital gain exclusion

Paul Clark
Paul Clark
Last updated: June 4, 2024
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Why do we claim that angel investing can create especially attractive types of capital gains? The answer is Section 1202 of the tax code. (Primary source here for those that like to read the tax code.)

Section 1202 basically says that capital gains from angel investments are exempt from capital gains taxes.

On our basic scenario from the last post, delete the words “you pay capital gains taxes on your gain.”

(And change the post-tax proceeds from $7.20 back to $9. Enjoy that extra (extra) $1.80.)

Obviously not everyone is a fan of other people paying fewer taxes, but assuming you’re the one facing the tax bill you probably consider this a good thing.

There are, of course, limitations on Section 1202.

  • The gain has to come from a C-Corp’s “originally issued stock” (that means that the company must be selling shares, not you buying them from an existing owner).
  • The stock must be a “qualified small business stock” (which is shortened to “QSBS” a lot), which means the company must use at least 80% of its assets in the active conduct of a business, cannot have more than $50M in assets when you invest, and must be in an eligible industry (so not, generally, service businesses or similar things).

If you’ve read anything about angel investing, you’ll see that these limitations very rarely apply: early-stage companies do not have $50 million of assets!

So to recap: an investor could make $9 of interest income and end up with $5.67; or angel investor could make $9 of capital gain and end up with the full $9 after the Section 1202 exclusion. Win for angels.

But there are two real limitations on Section 1202. First, it only applies to the first 10x return or $10M (whatever is greater). So if you have a >20x winner, only your first 10x of gain is exempt and you pay (capital gains) on the gains above that. A nice but rare problem to have.

A more frequent problem, though, is that Section 1202 only applies if you held the stock for five years or more. What if you learned the lessons of “early exits” in angel investing and your gain was faster than five years? Come back next year to find out…