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  • One golden seat in an empty auditorium surrounded by rows of black seats - QSBS Section 1202 Small Business Tax Exclusion

    A Section 1202 Walkthrough: The Qualified Small Business Stock Gain Exclusion

Section 1202 allows stockholders to claim a minimum $10 million federal income tax gain exclusion in connection with their sale of qualified small business stock (QSBS) held for more than five years.[i]   Assuming a 23.8% federal income tax rate, stockholders selling $10 million worth of QSBS qualify for a $2,380,000 gain exclusion.[ii]  Needless to say, Section 1202’s gain exclusion is the most attractive tax benefits available to founders and venture capitalists.   The failure of the Build Back Better Act and the Inflation Reduction Acts to reduce Section 1202’s benefits has dramatically improved the prospect that QSBS issued today will qualify for Section 1202’s 100% gain exclusion during 2027 and beyond.

This article is intended to serve as a resource for founders and venture capitalists exploring whether to position their business activities and investments to qualify for Section 1202’s gain exclusion.  Along the way, the article bookmarks past in-depth articles and blogs addressing various QSBS planning issues.

This article is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045.  During the past several years, there has been an increase in the use of C corporations as the entity of choice for start-ups.  Much of this interest can be attributed to the reduction in the federal corporate income tax rate from 35% to 21%, but savvy founders and venture capitalists have also focused on qualifying for Section 1202’s gain exclusion.  Legislation proposed during 2021 sought to curb Section 1202’s benefits, but that legislation stalled and then died, along with the balance of the Build Back Better Act. Congress finally passed the Inflation Reduction Act in August, 2022, but that legislation did not adopt the proposed amendments to Section 1202. 

What It Takes To Qualify for Section 1202’s Gain Exclusion.

Section 1202 has a number of issuing corporation-level and stockholder-level eligibility requirements, all of which must be satisfied in order to claim Section 1202’s gain exclusion.  These eligibility requirements are discussed below.

Stock must be acquired directly from a domestic (US) C corporation

Stock is not QSBS unless it is acquired from a C corporation and is sold while the issuer is a C corporation.  Further, the corporation’s C corporation status should be maintained from the date of issuance to the date of sale.[iii]  Obviously, it is a significant “choice-of-entity” decision to commit to operating in a C corporation in lieu of a pass-through entity.  S corporations and QSBS are like oil and water.  An S corporation cannot issue QSBS and any time during which the issuing corporation has an S election in effect counts against satisfying Section 1202’s “substantially all” requirement.

See the article Section 1202 and S corporations.

Section 1202’s gain exclusion cannot be claimed by a corporate stockholder

Any type of stockholder other than a C corporation can qualify for claiming Section 1202’s gain exclusion, including individuals, trusts and pass-through entities such as partnerships (e.g., LPs and LLCs) and S corporations.  But, foreign stockholders (who are not required to file a US federal income tax return) and tax-exempt stockholders (including benefit plans) may not benefit from Section 1202’s gain exclusion because capital gains arising from the sale of their investments in domestic (US) corporation stock are generally excluded from US federal income taxes.  Investing in QSBS through a traditional IRA doesn’t appear to make sense, because while the IRA isn’t taxed on the sale of its stock holdings (so the Section 1202 gain exclusion isn’t necessary), the IRA’s holder will be taxed on distributions (which aren’t protected by Section 1202’s gain exclusion).  Acquiring QSBS through a Roth IRA doesn’t make sense because regardless of whether the stock qualifies as QSBS, the holder isn’t taxed when the stock is sold.  The more tax-advantageous strategy would to use the Roth IRA to invest in non-QSBS and purchase QSBS in a taxable account in order to take advantage of Section 1202’s gain exclusion.  Tax partnerships (LPs/LLCs) and S corporations can invest in QSBS, but the rules regarding ownership through “pass-thru” entities are tricky and preserving all of the available QSBS gain exclusion may be difficult.

See the article How Corporations May Run Afoul of the Accumulated Earnings Tax – A Section 1202 Planning Brief

QSBS must be acquired directly from the corporation for cash, property or services

Cash consideration for QSBS could include $0.001 per share of founder stock or $1,000 per share of convertible preferred stock.  “Property” contributed in exchange for QSBS could include intellectual property contributed by founders.  “Property” (non-cash consideration) would also deemed to be contributed by equity owners upon the conversion of an LLC to a corporation or upon an exchange of membership interests for QSBS.  Stock issued by a corporation as a grant to an employee or director qualifies as QSBS, so long as the stock is vested when issued or the recipient makes a timely Section 83(b) election.  QSBS transferred upon the death of the stockholder or transferred as a gift (for federal income tax purposes) during the stockholder’s life retains its status as QSBS in the hands of the recipient.  QSBS can also be distributed by an tax partnership (LP/LLC) to its partners.   It is important to maintain full documentation of whatever consideration is paid for QSBS.  If the consideration for 100,000 shares of common QSBS is $100, make sure that a check for $100 is actually written and cashed by the start-up.  If the consideration is employee services in exchange for common QSBS, and the stock is worth $100 when issued, regardless of whether the employee pays $0.00 or $100, the issuance should be included on the employee’s individual tax return as compensation (i.e., either $0.00 or $100 per share in compensation income) for the purpose of memorializing that QSBS was issued for services.  The exchange of property for QSBS should be memorialized in a contribution agreement.[iv]

See the article Transfer Planning with Qualified Small Business Stock.

QSBS must be “stock” for federal income tax purposes.

QSBS can be voting or nonvoting common or preferred stock.  Nonvested stock (subject to substantial risk of forfeiture under Section 83) is not treated as “stock” until it vests unless the recipient makes a timely Section 83(b) election.  Stock options and warrants are not “stock” for federal income tax purposes.  Simple agreement for future equity (SAFE) instruments could be “stock” (i.e., treated as equity based on the debt-versus-equity rules), but there is a risk that the IRS might challenge that position.

See the article Can Convertible Debt or SAFEs Qualify as QSBS for Section 1202’s Gain Exclusion?

QSBS must be held more than five years.

If QSBS is sold before a stockholder achieves a five-year-holding period, it is possible to reinvest the proceeds in replacement QSBS under Section 1045.  QSBS can also be exchanged for QSBS or non-QSBS as part of a Section 351 nonrecognition exchange or in Section 368 tax-free reorganization.  The holding period for QSBS typically commences on the date of issuance.  If stock is unvested under Section 83, the holding period commences when the stock vests (or upon issuance if a Section 83(b) election is timely made).  The holding period for QSBS issued upon the exercise of an option or warrant is the date of issuance of the QSBS rather than the date the option or warrant was originally issued.  If a SAFE instrument converts, the holding period for the QSBS commences upon conversion—not when the SAFE instrument was originally issued.  In contrast, upon conversion, the holding period for convertible preferred QSBS tacks onto the holding period for common QSBS.

See the article Recapitalizations Involving Qualified Small Business Stock (QSBS)

QSBS must be sold (for federal income tax purposes) to take advantage of Section 1202’s gain exclusion.

This is an important requirement to consider before electing to operate a business through a C corporation and later when the business enters a sale transaction.  Sometimes a stock sale (with no election to treat the stock sale as an asset sale) versus an asset sale is a difficult sell to potential buyers and may result in lower offering prices.[v]  A stock sale can include a stock redemption or a liquidating distribution.[vi]

With certain specific exceptions, the stockholder originally issued QSBS must also be the seller of the QSBS.

Because QSBS must generally be acquired through an original issuance, and because QSBS retains its status when transferred only if it is a gift during the stockholder’s life, a transfer upon the stockholder’s death, or a distribution by a partnership to a partner, the original holder usually ends up being the ultimate seller.  If QSBS is transferred to a partnership and the partnership subsequently sells the stock, the contribution will be a nonrecognition exchange under Section 721, but neither the partnership nor the contributing partner will be eligible to claim Section 1202’s gain exclusion.[vii]

During the first five years of ownership, stockholders must not have any offsetting short positions with respect to their QSBS

If an offsetting short position is taken with respect to QSBS before the passing of the five-year holding period mark, the stock forfeits its QSBS status.  If an offsetting short position is taken after five years, the stock forfeits its QSBS status unless the stockholder elects to recognize gain as though the QSBS had been sold for its fair market value on the date the short position was established.

For an issuance of stock to qualify as QSBS, the issuing corporation must not have had “aggregate gross assets” in excess of $50 million at any time prior to or immediately after the issuance of the stock (the “$50 Million Test”).

In order for an issuance of stock to qualify as QSBS, the $50 Million Test must be passed immediately after the issuance, taking into account the cash or other property contributed to the corporation in exchange for the stock included in the applicable issuance.  Once the $50 Million Test is satisfied with respect to a particular issuance of QSBS, the subsequent failure of the $50 Million Test will not affect a corporation’s outstanding QSBS.  “Aggregate gross assets” generally means the amount of cash plus the adjusted tax basis of other assets on a corporation’s balance sheet.  If property was contributed to the issuing corporation at any time in or prior to the applicable issuance in a Section 351 nonrecognition exchange, a Section 368 tax-free reorganization or a Section 118 capital contribution, for purposes of calculating aggregate gross assets, those properties would be valued on the proforma “Section 1202 balance sheet” at their fair market values on the dates of contribution (including un-booked goodwill).  In addition, the assets of a more than 50% corporate parent or direct or indirect majority-owned corporate subsidiary would also be aggregated for purposes of the $50 Million Test.  Finally, when identifying those assets to include in the calculation of “aggregate gross assets” immediately after the issuance of the stock being tested for QSBS eligibility, we believe that any inflows and outflows of assets that occur as part of the same transaction should be considered in the calculation of aggregate gross assets.  Addressing whether the $50 Million Test will be flunked may be of critical concern when considering the timing of later-round capital raises or when structuring the conversion of high-value LPs or LLCs for purposes of positioning equity owners to take future advantage of Section 1202.

See the article How Section 1202’s $50 Million Aggregate Gross Assets Test Works.

At least 80% of a corporation’s assets (by value) must be used in the operation of a qualified trade or business during each taxpayer’s entire holding period for the QSBS.  

There are two aspects of this Section 1202 requirement.  First, the corporation must be primarily engaged in one or more business activities that are not excluded business activities under Section 1202(e)(3).  Second, at least 80% of the corporation’s assets (taking into account the assets of any majority-owned corporate subsidiaries) must be used in business activities that are qualified trade or business activities (the “80% Test”).  The corporation must have satisfied these requirements for “substantially all” of the holding period for the applicable QSBS, which likely means at least 70% of a stockholder’s holding period for the applicable QSBS, but most likely means 80% to 95% of the applicable holding period.[viii]  Section 1202(e)(3) provides that the term “qualified trade or business” means any trade or business other than –

  1. any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,
  2. any banking, insurance, financing, leasing, investing, or similar business,
  3. any farming business (including the business of raising or harvesting trees),
  4. any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
  5. any business of operating a hotel, motel, restaurant, or similar business.

In addition, Section 1202(e)(8) provides that “rights to computer software which produces active business computer software royalties (within the meaning of section 543(d)(1)) shall be treated as an asset used in the active conduct of a trade or business.”  Finally, Section 1202(e)(7) provides that “the ownership of, dealing in, or renting of real property shall not be treated as the active conduct of a qualified trade or business.”

Addressing whether a corporation is engaging in an excluded activity is often the most significant issue associated with QSBS planning or with vetting the eligibility of a stockholder to claim Section 1202’s gain exclusion.   Even if the corporation’s principal activities clearly qualify under Section 1202, it is still necessary to make sure that the corporation continuously satisfies the 80% Test.[ix]  This task requires monitoring whether at least 80% of the corporation’s assets (by value) are used in qualified business activities, which excludes assets used in non-qualifying activities, investment assets, non-qualifying real estate and cash not required for working capital needs.[x]  The activities of a majority-owned subsidiary are taken into account in running the 80% Test.  Section 1202 is silent on the issue, but we assume that the activities of at least majority-owned joint ventures, LLCs and LPs would also be taken into account (pro rata with ownership) in running the 80% Test.  Although Section 1202 requires that the corporation issuing QSBS be a domestic (US) C corporation, there is no corresponding limitation with respect to the ownership of a non-domestic subsidiary.

For additional information, see the articles

The corporation must not have held stock or securities of a corporation (other than of a subsidiary which is defined as being a more than 50% owned corporation) with a value aggregating more than 10% of the value of the issuing corporation’s assets (in excess of liabilities).  

Basically, minority stock positions both count against the satisfaction of the 80% Test and can result in the forfeiture of QSBS status if the corporation’s ownership position in minority stock investments exceeds this 10% limitation.

No more than 10% of the total value of the corporation’s assets can consist of real property which is not used in the active conduct of the issuing corporation’s trade or business

Ownership of real property not used in a corporation’s active business can result in the forfeiture of QSBS status if the ownership position exceeds the 10% limit.  Section 1202(e)(7) provides that the ownership, dealing in, or renting of real property is not considered engaging in an active business activity.  Possible permissible real property activities might include the ownership of a warehouse by a manufacturer or distributor, the ownership of an office building used by a software company as office space for its workforce or the ownership of commercial space used in the corporation’s active business activities.

The applicable facts must not bring the stockholder or the corporation within the scope of Section 1202’s “anti-churning” redemption restrictions with respect to the stockholder’s QSBS

A stockholder’s QSBS can forfeit its favorable status if there are redemptions of that corporation’s stock from the stockholder or a related party during the four-year period beginning two years prior to the issuance of the QSBS.  Also, the QSBS status of all shares issued at a particular time can forfeit their favorable tax status if there have been redemptions of that corporation’s stock during the two-year period beginning one year prior to the issuance of the QSBS.  There are exceptions for de minimis redemptions and redemptions from employees that are addressed in the Section 1202 Treasury Regulations.[xi]

Recapitalizations and restructuring involving the corporation that issued QSBS or the QSBS itself can affect QSBS status

In order to avoid forfeiting QSBS status for the corporation’s outstanding stock, any such activity should be vetted to make sure that it fits within an exception in Section 1202(h) for nonrecognition exchanges and tax-free reorganizations.

See the article Recapitalizations Involving Qualified Small Business Stock.

Dealing With Section 1202’s Gain Exclusion Cap.

The $10 million gain exclusion cap

Section 1202 limits the amount of gain that can be excluded tax for any taxpayer in a given year with respect to a particular issuer of QSBS.  Basically, Section 1202 provides that every taxpayer enjoys a minimum $10 million exclusion for gain triggered by the sale of a particular corporation’s stock.  The same taxpayer can also have a gain exclusion cap that exceeds $10 million if the taxpayer paid cash or contributed property in exchange for the QSBS.

The 10X gain exclusion cap.

The “10X gain exclusion cap” provides that a taxpayer’s gain exclusion cap equals 10 times the amount of cash or the value of property contributed to a corporation in exchange for QSBS.  If an LLC with assets worth $30 million incorporates, when the QSBS issued in the conversion sells for $330 million, some or all of the first $30 million would be subject to long-term capital gains tax and the balance of $300 million would be eligible for Section 1202’s gain exclusion.[xii]  Also, if a taxpayer held common stock with a $0.001 tax basis per share and preferred stock with a $1,000 tax basis per share, the taxpayer could sell some of the common stock in year one for $10 million (which would exhaust the first $10 million gain exclusion cap), and taking advantage of the 10X gain exclusion cap, sell the preferred stock in later years.  For stockholders who do not have sufficient tax basis to take advantage of the 10X gain exclusion cap but anticipate that their QSBS will sell for more than $10 million, it is possible to expand the aggregate gain exclusion beyond $10 million through careful structuring of gifts to trusts or individuals.

It’s not always an either/or situation with the $10 million and 10X gain exclusion caps.

Many taxpayers mistakenly believe that it is an either/or situation with the $10 million and 10X gain exclusion caps.  Depending on the ordering of the sale of a stockholder’s QSBS over more than one year, it is possible to take advantage of both gain exclusion caps.  The $10 million gain exclusion cap burns off after the $10 million of QSBS gain exclusion, leaving in subsequent years either no further gain exclusion for a taxpayer or just the potential of the 10X gain exclusion.

See the article Maximizing the Section 1202 Gain Exclusion Amount.

The percentage gain exclusion applicable for a sale of QSBS depends on the date of the QSBS’s issuance.

In order to claim a 100% gain exclusion, the QSBS must have been originally issued after September 27, 2010.  QSBS originally issued after February 17, 2009, and before September 28, 2010, is eligible for a 75% gain exclusion.  QSBS originally issued before February 18, 2009, but after August 10, 1993, is eligible for a 50% gain exclusion.  For QSBS issued prior to September 28, 2010, the portion of the gain not eligible for Section 1202’s gain exclusion is subject to a 28% tax rate, a 3.8% net investment income tax and is included in the computation of the alternative minimum tax.

QSBS Planning in Connection With an M&A Sale Process.

When stockholders have satisfied the five-year holding period requirement.

The critical issue from a planning standpoint is that an M&A transaction must be structured as a sale of the QSBS for federal income tax purposes when target stockholder would qualify for claiming Section 1202’s gain exclusion.  Buyers generally prefer assets acquisitions that will allow for a basis step-up and future goodwill amortization.  In most business sales today, buyers expect stockholders to roll over 20% to 30% of their equity in the transaction.  In most instances, target stockholders expect the rollover to be structured to defer gain and permit the stockholders to claim Section 1202’s gain exclusion when the rollover equity is eventually sold.  In order to accomplish these goals, most rollovers should be structured as Section 351 nonrecognition exchange.  A Section 721 contribution of QSBS to an LP or LLC (i.e., a tax partnership) in exchange for LP or LLC equity will cause the stockholders to forfeit the QSBS eligibility of their rollover equity.[xiii]  An alternative structure involves the target stockholders exchanging all of their QSBS for buyer stock in a Section 368 tax-free reorganization (seen most frequently when the buyer is a public company).[xiv]  Assuming the buyer stock is not QSBS, then the amount of available Section 1202 gain exclusion would be capped at the gain that would have been realized if the exchange were taxable.

When stockholders have not satisfied the five-year holding period requirement.

The options available to stockholders for keeping the door open to claiming Section 1202’s gain exclusion include exchanging QSBS for buyer stock in a Section 351 nonrecognition exchange or a Section 368 tax-free reorganization or selling QSBS in a taxable sale and reinvesting in a transaction governed by Section 1045 in replacement QSBS.

See the articles:

More Resources

Despite the potential for extraordinary tax savings, many experienced tax advisors are not familiar with QSBS planning.  If you have specific questions regarding the applicability and benefits of QSBS as it pertains to your financial planning goals, reach out to the author of this article who has emerged as one of the leading advisors on all things QSBS. You can also visit our Tax Law Defined Blog for more analysis on the latest trends and developments in state, local and federal tax administration. 


[i] References to “Section” are to sections of the Internal Revenue Code of 1986, as amended.  Many but not all states follow the federal income tax treatment of QSBS.

[ii] This assumes a 20% federal capital gains rate, plus a 3.8% federal net investment income tax.  These tax savings don’t account for any gain exclusion at the state level.  Some states follow federal tax treatment of QSBS and allow for a gain exclusion, while other states, such as California, do not permit an exclusion for gain on the sale of QSBS.

[iii] In general, most of Section 1202’s eligibility requirements must be met during “substantially all” of the period during which QSBS is held by a stockholder.  “Substantially all” is not defined in Section 1202, but would likely be determined to fall between 70% and 95% of a stockholder’s QSBS holding period.

[iv] The conversion of the LP/LLC to a corporation would fall within the scope of a Section 351 nonrecognition exchange and generally be governed by Revenue Ruling 84-111, 1984-2 C.B. 88.   If some contributors are contributing property and other contributors are being issued QSBS for cash, the contribution would be a global/overall Section 351 nonrecognition exchange with all contributors counted towards Section 351’s 80% control requirement.

[v] Buyers often value the basis step-up associated with an asset purchase, as they can generally amortize purchased goodwill over 15 years under Section 197.  Also, buyers are better situated to avoid being legally responsible for known and unknown liabilities if a purchase of a business is structured as an asset purchase.

[vi] The redemption must qualify as a sale rather than a dividend under the rules of Section 302.

[vii] It may be possible to remedy the loss of QSBS status if the stock is redistributed back to the contributing partner prior to sale.

[viii] The IRS could take the position that “substantially all” means up to 95% of the applicable time period.

[ix] A corporation can engage in more than one qualified activity either directly or through corporate subsidiaries (where the parent corporation holds a majority of the subsidiary’s equity).  Although Section 1202 doesn’t explicitly address the issue, it certainly seems reasonable that the activities of a majority-owned joint venture would also be taken into consideration in connection with looking at the corporation’s activities, and if the Section 355 regulations are taken into account, the activities of a less than a majority-controlled joint venture (LP/LLC interest) could also be taken into account.

[x] For purposes of the 80% Test, you look at the value of assets, including un-booked goodwill (typically part of a corporation’s enterprise value), rather than the tax basis of assets or the stated value of the assets on financial statements.

[xi] Treasury Regulation Section 1.1202-2.

[xii] This hypothetical assumes, of course, that all eligibility requirements under Section 1202 were met at the time of sale.

[xiii] Another option would be a Section 368 tax-free reorganization, but typically the “rollover” percentage falls below the required 40+ continuity of interest percentage (i.e., the percentage of consideration in the form of buyer stock).

[xiv] The target stockholders often sell there replacement public company stock under Rule 144.  The amount of Section 1202 gain exclusion would be capped at the gain deferred in the exchange of the target company QSBS for the public company non-QSBS.