For years (since 1993), section 1202 of the U.S. tax code has provided a partial exclusion of gain realized on the sale of "qualified small business stock" (QSB stock) that is held for more than 5 years.
The big glitches under the law as it has heretofore existed: (a) the exclusion was only partial (for many years, only 50% but higher for qualifying stock acquired in 2009 and in 2010 prior to September 27); and (b) a portion of any gain that was so excluded had to be added back as a preference for AMT purposes. Thus, this exclusion had more limited value over the years that it has now, during this current window.
The benefit of a "section 1202 exclusion" today is that 100% of the gain realized is excluded (subject to a cap as discussed below) and the exclusion applies for purposes of both the regular federal income tax and the alternative minimum tax.
Thus, if a taxpayer today acquires qualifying QSB stock, holds it for more than 5 years, and then sells it at a gain, the gain on that sale will be completely free of federal income tax.
Who is a qualified buyer of such stock? The exclusion may be claimed by any "taxpayer" who meets the statutory requirements. It is not limited to "investors" but includes anyone who buys stock in a qualifying corporation and otherwise meets the section-1202 tests. This would include founders.
The exclusion may not be claimed if the taxpayer is a corporation. However, and this is important for VCs, angel groups and others who might be organized as some form of partnership, the gain from the disposition of qualified small business stock by a partnership, an S corporation, or certain trusts that is taken into account by a partner, shareholder or participant in such entity is eligible for section-1202 exclusion if (a) all requirements of section 1202 are otherwise met, and (b) the partner, shareholder or other participant held his interest in the entity on the date the QSB stock was acquired and at all times thereafter until the stock's disposition. Bottom line on this piece: corporations can't benefit from a 1202 exclusion but some entities can - check with a competent tax adviser on this - as can individual investors and founders.
A "qualified small business" under section 1202 is a domestic C corporation. An S corporation will not qualify; nor will an LLC.
In addition, to be a "qualified small business," the gross assets of the entity through the date of the issuance of the stock in question cannot have exceeded $50 million without regard to liabilities.
The business must also be an "active business" - that is, it cannot be an investment company (entities will fail this test if more than 10% of the value of their net assets consists of stock or securities, other than those of a subsidiary, and will similarly fail if more than 10% of their assets consist of real property that is not used in the active conduct of a qualified trade or business).
Concerning such "qualified small businesses," then, what is "qualified small business stock"?
This can be any stock in a domestic C corporation. Not preferred stock only, as might be purchased by outside investors. It is any stock, including common stock that is purchased by founders and others in a typical startup.
It must be stock that is "originally issued" to the taxpayer during the applicable time period (in this case, on or after September 27, 2010 through the date of expiration of the window for 100% exclusion). This means newly issued from the corporation. It can't be bought in a resale deal. Nor can the corporation and the taxpayer play games by trading equivalents (e.g., by redeeming x amount of stock from the taxpayer and then issuing it again to him); thus, it is not QSB stock if the corporation purchases any such stock from the shareholder/taxpayer within two years before or after the issuance of the shares for which the exclusion is sought. Section 1202 treatment will also be denied if, within one year before or after the issuance, the corporation redeems more than 5% of the aggregate value of all its stock as measured at the beginning of such period (certain redemptions, such as on death, are disregarded for this purpose).
Finally, to qualify as QSB stock, the stock must be acquired by the taxpayer in exchange for money or other property (not including stock) or as compensation for services provided to the corporation (this was the rule historically under section 1202 but please confirm with a good CPA or tax lawyer to make sure this carries forward during the 100% exclusion window - I think it does but am not 100% sure - to be safe, pay cash). Nothing in the rules specifies that the amount paid has to exceed any particular sum and so the amounts typically contributed by founders should generally qualify.
The 1202 exclusion is capped. Specifically, a taxpayer can exclude qualifying gain up to the limit of the greater of $10 million or 10 times the taxpayer's basis in the stock. Even more, this is measured "per issuer," meaning that someone who holds QSB stock in multiple, unrelated entities and otherwise meets the rules in each case would be able to exclude a potentially very large amount of gain if multiple entities proved to be success cases.
To sum up: if you as a non-corporate taxpayer acquire QSB stock during this window and hold it for more than 5 years, you will be able to realize substantial gains on the eventual sale of any such stock free of federal income tax.
Now, this is a very complex tax area and so you should definitely check with a competent tax professional before making important decisions here. That said, from the narrow view of startup founders and investors (and setting aside public policy concerns about the wisdom of this sort of legislation), this is a pretty amazing opportunity for those who have plan to invest or build out their ventures for the long term. With a whole year to plan for it (assuming this is finalized as anticipated), many interesting possibilities exist. Think of the above as suggestive, of things to consider in weighing options for such planning.