Key Takeaways:
- Section 1202 offers capital gains exclusion for QSBS but requires detailed qualification and documentation.
- Eligibility depends on both objective facts and nuanced interpretation of business activity.
- Companies — not shareholders — should lead the Section 1202 qualification process and share results with investors.
—
If your company has issued or plans to issue stock, Section 1202 of the Internal Revenue Code could provide your shareholders with one of the most powerful tax planning opportunities available. Known as the Qualified Small Business Stock (QSBS) exclusion, Section 1202 allows eligible shareholders to exclude up to 100% of capital gains from federal income tax on the sale of their stock — if specific criteria are met.
Though Section 1202 has existed since 1993, it gained traction after the 2017 Tax Cuts and Jobs Act lowered corporate tax rates, making QSBS one of the few remaining high-impact planning tools for growth-stage companies — along with the research and development (R&D) tax credit and bonus depreciation.
But this isn't something that happens automatically. The rules are layered, the guidance is limited, and a casual approach can result in missed opportunities or unintended exposure. Section 1202 deserves focused attention and deliberate planning.
The Value Behind Section 1202
Section 1202 provides a unique tax benefit: qualifying shareholders may exclude from income greater than $10 million or ten times their investment basis in stock. That makes it a strategic asset for early investors, founders, and employees with equity — particularly in industries where growth and exit events are part of the long-term plan.
Despite the high value, Section 1202 remains underutilized. Many companies assume they qualify but never take steps to confirm the details. At the same time, investors often expect — or even require — 1202 status in contracts signed by issuers. When companies fail to verify and document their status, it creates uncertainty that can complicate capital raises, shareholder communications, or M&A negotiations or investments.
Understanding What Makes a Company Qualify
Qualifying for Section 1202 is part science, part strategy. Several conditions can be verified through documentation. These include whether the shareholder bought the stock at original issuance, the date the stock was issued, and whether the company's gross assets were under $50 million at the time of issuance. These are foundational tests and can typically be confirmed with cap table records and financial statements.
However, other elements are less straightforward. The most critical part of the 1202 analysis is deciding whether your company is a "qualified trade or business." Unlike asset thresholds or holding periods, this isn't a checkbox — it requires legal interpretation, familiarity with evolving IRS thinking, and a clear narrative about how your business operates. If you're in a gray area, this is where the real analysis begins.
Section 1202 categorically excludes broad types of businesses — such as those engaged in health, law, consulting, brokerage, and finance — but it offers little clarity on how those terms are defined or where those boundaries lie. This ambiguity means that even businesses working in related or emerging industries may not know where they stand.
Don't Put the Burden on Your Shareholders
Section 1202 status is not something individual shareholders can — or should — figure out on their own. They don't have access to your financials, legal history, stock issuance records, or the operational detail needed to determine eligibility. If your company issued shares in exchange for cash, property, or services, it is your responsibility as management — not theirs — to evaluate and document whether that stock qualifies for the QSBS exclusion.
This isn't just good tax planning; it's a matter of fulfilling the expectations you've set with investors — especially if you've raised capital under the assumption or implication that your stock qualifies. In that sense, Section 1202 eligibility functions as a corporate tax asset. Like any high-value benefit, it needs to be understood, tracked, and preserved — particularly when planning for new investment rounds, reorganizations, or exit transactions.
Leaving this analysis to shareholders — or suggesting they should determine it independently — is not realistic and not defensible. If your investor base includes individuals, family offices, funds, or even crowdfunding participants, it's management's duty to confirm and communicate 1202 status clearly. Without that, shareholders may hesitate to claim the benefit, or worse, face scrutiny if challenged during an audit or liquidity event.
How to Move Forward with Confidence
The good news is that most Section 1202 eligibility criteria can be evaluated and documented with the right support. If you're unsure where you stand, now is the time to assess. Focus on reviewing your entity structure, stock issuance records, and the nature of your business operations.
Where interpretation is needed — especially around excluded industries — consider how your business delivers value. Are you acting as a passive intermediary, or do you provide infrastructure, administrative support, or proprietary systems? These distinctions matter and could influence how the IRS or buyers assess your eligibility under Section 1202.
Just as important: understanding your eligibility allows you to quantify the potential benefit. The $10 million exclusion is just a starting point. For many companies, the actual available gain exclusion could be far higher — $20 million, $37 million, or more. That kind of tax asset deserves to be identified, protected, and planned around.
The most important and least defined requirement is whether your company is considered a qualified small business engaged in a qualified trade or business. That determination cannot be made through checklists alone — it demands thoughtful analysis and documentation.
Reference Recent IRS Rulings
If your business falls into a gray area, you may want to review recent IRS rulings that have addressed similar situations. These rulings don't apply beyond the taxpayers involved, but they reveal how the IRS thinks about "qualified" versus "excluded" businesses.
The IRS has offered little formal guidance on what qualifies as a trade or business under Section 1202. Recent rulings suggest the agency may rely on dictionary definitions or broader policy goals when making eligibility determinations — adding another layer of risk for companies in ambiguous categories.
For a breakdown of how the IRS has handled these decisions in real-world cases, read our companion article:What Two IRS Rulings Reveal About Section 1202 Eligibility.
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.
