Qualified Small Business Stock (QSBS) Exclusion under Section 1202
Under Section 1202 of the Internal Revenue Code, certain shareholders may exclude all or a portion of the gain on the sale of Qualified Small Business Stock (QSBS) if specific conditions are met. This provision was inserted into the Tax Code in 1993 to incentivize investment in small U.S. businesses, particularly startups. To qualify, the stock must be originally issued by a domestic C-corporation with aggregate gross assets of no more than $50 million at the time of issuance and immediately thereafter, and at least 80% of the corporation’s assets must be used in an active business (IRC § 1202(d)(1); §§ 1202(e)(1)–(3)).
To benefit from the exclusion, the investor must hold the QSBS for more than five years, and the stock must have been acquired at original issuance (not purchased on the secondary market). Depending on when the QSBS was acquired, the exclusion can reach up to 100% of the gain. Taxpayers who acquired QSBS before February 18, 2009, can exclude up to 50% of the gain; for stock acquired between February 18, 2009, and September 27, 2010, the exclusion rises to 75%; and for stock acquired after September 27, 2010, the exclusion increases to 100% under IRC § 1202(a)(1). The maximum gain eligible for exclusion is generally limited to the greater of $10 million or 10 times the taxpayer’s basis in the stock (IRC § 1202(b)(1)).
Importantly, an S corporation or partnership cannot be a QSBS issuer, and taxpayers must carefully document their acquisition and holding period. Furthermore, IRC § 1202(b)(2) mandates that 100% of the exclusion may be taxable to the extent attributable to depreciation allowed or allowable if the business engaged in trade or business using depreciable assets. For high net-worth individuals or family offices seeking long-term investment gains outside the public markets, the QSBS exclusion represents one of the most compelling wealth transfer and exit planning tools available—provided the investment is structured correctly and the five-year holding period is observed.
