ARTICLE
4 March 2025

IRC Section 1202: Tax-Free Gains On Qualified Small Business Stock

Someone recently asked me to share some of my favorite provisions in the tax code. Of course, that's not true, what kind of people do you think I hang out with?
United States Tax

Someone recently asked me to share some of my favorite provisions in the tax code. Of course, that's not true, what kind of people do you think I hang out with? Nonetheless, it does serve as a seamless (and impressive) segue into an often-overlooked section of the "Code" (or as we cool kids refer to the Internal Revenue Code of 1986, as amended). As such, I direct you to Code Section 1202.

Qualified Small Business Stock

The allure of IRC Section 1202 is that, when all of the requirements are met, 100% of the gain recognized on the sale or exchange of Qualified Small Business Stock (QSBS) is excluded from income. I know what you're thinking, no tax on the sale of stock, sign me up!

As federal income tax isn't always that straightforward (which ensures I remain employed), the requirements for the exclusion from income are somewhat stringent.

Let's start with the basic idea that the sale of stock is generally the sale of a capital asset subject to capital gain tax rates. With regular talks on capital gains tax rates increasing, avoiding any tax is always a plus.

In this analysis, we only care about the sale of QSBS. Therefore, it's important to distinguish QSBS from all those other kinds of stock.

Three Key Qualified Small Business Stock Requirements

QSBS is stock that meets three (3) requirements:

  1. Small Business;
  2. Original Issuance;
  3. And Active Trade or Business.

The C Corporation Factor

The "small business" requirement is where I'll lose a good chunk of you. The reason is that QSBS stock must be issued by a C Corporation, a legal entity that is separate from its owners, with cash and other assets totaling $50,000,000 or less immediately after the stock is issued.

It's not often the dollar amount that gets people; it's the fact that people do not like to hold an interest in a C Corporation. You may have heard of the dreaded "double tax" in a C Corporation and that a "pass-through" entity is often more appealing to business owners. However, for the right investor (one likely targeting a realization event as opposed to a stream of income) the C Corporation has a unique appeal. Further, with the 2017 reduction in the corporate income tax rate from 35% to 21%, there has been some resurgence in the elusive C Corporation.

Original Issuance Requirement

The "original issuance" requirement is another hurdle. The owner of the QSBS must acquire the stock as an original issue in exchange for money/property or as compensation. Therefore, the purchase of an existing shareholder's shares will not satisfy the original issuance requirement. The key here is planning at the outset of a new venture. There are limited exceptions to the original issuance requirement, however, a transferee can preserve QSBS status if the transferee acquired the stock by gift, at death, or in a qualifying partnership distribution.

Active Trade or Business Requirement

If you've made it this far, the "active trade or business" requirement is, arguably, less stringent. Under the active business requirement, at least 80% of the corporation's assets must be used in a "qualified" trade or business during the shareholder's holding period.

A qualified trade or business has certain exclusions, namely:

  • Services in the fields of health, law, engineering, architecture, accounting, etc.;
  • Banking, insurance, finance, leasing, investing, or similar;
  • Farming;
  • The production/extraction of certain products subject to depletion;
  • Hotel, motel, restaurant, or similar.

The exclusions from a qualified trade or business often become a fact analysis on a case-by-case basis.

Five-Year Holding Period: Patience Pays Off

Assuming the above requirements are met, congratulations – you have QSBS. To reap the benefits of income exclusion under Section 1202, you must hold that QSBS for at least five (5) years before it is sold. The five-year holding period starts from the date the stock is issued to the shareholder. If the QSBS is sold before the five-year holding period, only a portion, if any, of the gain will be excluded.

Now that you've got QSBS after holding it for five years, what happens now? The benefits from Section 1202 are only realized when the shareholder eventually sells the QSBS (i.e., sorry, not asset sales!). This matters because, typically, buyers prefer to purchase assets.

Understanding the Section 1202 Exclusion Limits

Too good to be true? The IRS thought so, too. The Section 1202 exclusion is limited to the greater of: (i) $10,000,000 and (ii) ten times the aggregate basis of stock sold. While basis can be a confusing concept for some, the following example should shed some light on this limitation.

Assume that in 2015 you purchased QSBS for $3,000,000. In 2020, you sell the stock for $15,000,000, realizing a gain of $12,000,000 (i.e., $15M – $3M). The maximum excluded gain is $30,000,000 (the greater of $10M and ten times a basis of $3M). As a result, the entire $12,000,000 gain would be excluded (not a bad day!).

Is Qualified Small Business Stock Right for You? Key Takeaways

As in all good tax planning, if the narrative fits, the opportunities can be worthwhile. The key is to know what you're looking for. So, if you find yourself considering investing in a particular C Corporation, at original issuance, that's engaged in an active trade or business for five years, don't forget about good ol' Section 1202.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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