Qualified Small Business Stock & The Section 1202 Rules

Qualified Small Business Stock, or QSBS, represents a specific class of stock that offers a significant tax benefit upon its sale. Governed by Section 1202 of the Internal Revenue Code, the primary purpose of this legislation is to encourage investment in developing U.S.-based companies. It achieves this by allowing investors to exclude a substantial portion, and in many cases all, of the capital gains realized from the sale of such stock from their federal income tax. This tax incentive is designed to make investing in smaller, riskier enterprises more attractive to individuals and other non-corporate entities.

Shareholder Requirements for the Tax Exclusion

An investor must meet specific personal requirements to benefit from the Section 1202 exclusion. The primary rule is that the shareholder must have acquired the stock directly from the qualifying corporation when it was first issued. This acquisition must be in exchange for money, property other than stock, or as compensation for services rendered to the corporation.

Another requirement for the shareholder is the holding period. To qualify for the gain exclusion, the investor must hold the stock for a period of more than five years, which begins on the date the stock is acquired. Selling the stock before this holding period is met will disqualify the sale from receiving the preferential tax treatment under Section 1202.

Corporate-Level Qualification Rules

For stock to be designated as QSBS, the issuing corporation must satisfy a set of criteria. The issuer must be a domestic C corporation, which means the company is incorporated in the United States and taxed under Subchapter C of the Internal Revenue Code. Stock issued by S corporations or LLCs is not eligible.

A primary financial hurdle is the gross assets test. At the time the stock is issued, the corporation’s aggregate gross assets must not exceed $50 million, a test applied both immediately before and after the issuance. Gross assets include cash and the aggregate adjusted bases of other property held by the corporation.

The corporation must also meet an active business requirement. During substantially all of the shareholder’s holding period, at least 80% of the corporation’s assets must be used in the active conduct of a qualified trade or business. Section 1202 also disqualifies several business types from issuing QSBS, including:

• Any trade or business involving services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.
• Any business where the principal asset is the reputation or skill of one or more of its employees.

Calculating and Reporting the Gain Exclusion

The percentage of gain that can be excluded from federal income tax depends on when the stock was acquired.

• For stock acquired before February 18, 2009, the exclusion is 50%.
• For stock acquired between February 18, 2009, and September 27, 2010, the exclusion is 75%.
• For all QSBS acquired after September 27, 2010, the exclusion is 100%.

The amount of excludable gain from a single corporation is capped at the greater of two figures: $10 million or 10 times the shareholder’s aggregate adjusted basis in the stock sold. The $10 million limit is a lifetime cap for each taxpayer per issuing corporation. For example, an investor who acquired QSBS with an adjusted basis of $700,000 can exclude up to $10 million of capital gains, as this is greater than 10 times their basis ($7 million). If the same investor had a basis of $1.2 million, the 10-times-basis calculation would be $12 million, making that the new exclusion limit.

For stock acquired before September 28, 2010, a portion of the excluded gain is treated as an Alternative Minimum Tax (AMT) preference item. For stock acquired after that date, the excluded gain is not an AMT preference item.

The transaction must be reported on IRS Form 8949, Sales and Other Dispositions of Capital Assets. On this form, the taxpayer must enter code “Q” in column (f) to signify the QSBS exclusion, and the details are then carried over to Schedule D.

Advanced Planning and Special Considerations

Investors who sell QSBS before satisfying the five-year holding period may defer tax liability through a Section 1045 rollover. This provision allows a shareholder to avoid recognizing a capital gain if they sell QSBS held for more than six months and use the proceeds to purchase new QSBS within a 60-day window. The holding period of the original stock is then “tacked on” to the holding period of the new stock, helping the investor reach the five-year requirement.

The favorable federal tax treatment under Section 1202 does not automatically apply at the state level. State tax laws regarding QSBS gain exclusion vary significantly, with some states conforming to federal rules while others offer a partial or no exclusion.

Gifting QSBS can be an effective estate planning strategy. An individual can gift qualified stock to another person or an irrevocable trust, and the recipient inherits the original owner’s purchase date and cost basis. Once the combined holding period of the donor and recipient exceeds five years, the recipient can sell the stock and utilize their own, separate $10 million gain exclusion limit.