What Is Qualifying Small Business (QSB) Stock?

Qualifying Small Business (QSB) stock offers significant tax advantages on capital gains, making it an attractive investment vehicle for those supporting small businesses. Understanding its characteristics, requirements, and benefits is important for investors and small business owners considering equity financing.

Qualifying Small Business Stock Defined

Qualifying Small Business (QSB) stock, often referred to as Section 1202 stock, is a class of equity designed to encourage investment in specific small businesses. It offers investors a significant exclusion from capital gains taxes when they sell qualifying shares, stimulating economic growth.

This stock applies exclusively to shares issued by C corporations. Section 1202, enacted in 1993, provides financial motivation for individuals to invest directly in eligible small companies. This facilitates access to capital for smaller entities.

Requirements for QSB Stock Status

To qualify as QSB stock, both the stock and the issuing corporation must meet several criteria at the time of issuance. The stock must be acquired by the taxpayer at its original issuance, either directly from the corporation or through an underwriter. Purchasing shares on a secondary market from another shareholder generally does not qualify, though exceptions exist for stock received through gifts or inheritance.

The issuing company must be a domestic C corporation when the stock is issued and throughout substantially all of the taxpayer’s holding period. This excludes S corporations, Real Estate Investment Trusts (REITs), Regulated Investment Companies (RICs), and Domestic International Sales Corporations (DISCs).

The corporation’s aggregate gross assets must not have exceeded $50 million at any time from August 10, 1993, up to and including immediately after the stock is issued. For stock issued on or after July 4, 2025, this threshold increases to $75 million. This test is applied at the time of each stock issuance; if the corporation later exceeds this asset threshold, previously issued QSB stock does not lose its status. Aggregate gross assets include cash and the adjusted basis of other property, with property contributed to the corporation valued at its fair market value at the time of contribution.

The corporation must satisfy an active business requirement. During substantially all of the taxpayer’s holding period, at least 80% (by value) of the corporation’s assets must be used in the active conduct of a qualified trade or business. Certain types of businesses are excluded, including:

• Businesses providing services where the principal asset is the reputation or skill of one or more employees (e.g., health, law, accounting, consulting)
• Banking
• Insurance
• Financing
• Leasing
• Investing
• Farming
• Mining
• Operating hotels, motels, or restaurants

Assets held for future research and experimentation or reasonable working capital needs can count towards the active business requirement.

Tax Exclusions for QSB Stock

The percentage of gain that can be excluded depends on when the stock was acquired. For QSB stock acquired between August 11, 1993, and February 17, 2009, 50% of the gain can be excluded. Stock acquired between February 18, 2009, and September 27, 2010, qualifies for a 75% exclusion.

For QSB stock acquired after September 27, 2010, up to 100% of the capital gain can be excluded from federal income tax. This 100% exclusion means the excluded gain is not subject to the Alternative Minimum Tax (AMT) or the 3.8% Net Investment Income Tax (NIIT).

To qualify for any exclusion, the QSB stock must be held for more than five years. If the stock is sold before this five-year period, the gain is not eligible for the exclusion. A per-issuer limitation applies to the amount of gain that can be excluded by a taxpayer. This limit is the greater of $10 million or 10 times the adjusted basis of the stock sold in that taxable year. For stock acquired on or after July 4, 2025, this $10 million cap increases to $15 million.

Investors can defer gains from the sale of QSB stock by utilizing the rollover provision under Section 1045. If QSB stock held for more than six months is sold, and the proceeds are reinvested into other QSB stock within 60 days, the gain can be deferred. This allows investors to reallocate capital into new QSB opportunities while preserving the tax-advantaged status.

Ongoing Conditions and Dispositions

After QSB stock is initially issued, the corporation must continue to meet certain conditions for the stock to retain its qualifying status. A primary ongoing condition is the active business requirement, which mandates that the corporation continues to use at least 80% of its assets in a qualified trade or business during substantially all of the taxpayer’s holding period. This ensures the company remains focused on its operational activities rather than becoming a passive investment vehicle.

When QSB stock is disposed of, the holding period is a significant factor. A sale must occur after the stock has been held for more than five years to qualify for the capital gains exclusion. If the stock is transferred through a gift or inheritance, its QSB status carries over to the recipient, allowing them to benefit from the exclusion based on the original holder’s acquisition date and holding period.

For QSB stock held by pass-through entities like partnerships or S corporations, the gain exclusion can still apply to individual non-corporate taxpayers. Specific rules dictate how the exclusion flows through to the individual partners or shareholders. Losses incurred on QSB stock are treated as capital losses, subject to capital loss rules.