Section 1202: A Guide to Qualified Small Business Stock

For entrepreneurs and investors alike, Section 1202 of the Internal Revenue Code offers a valuable opportunity to potentially reduce capital gains taxes. This tax provision, commonly known as the Qualified Small Business Stock (QSBS) exclusion, allows eligible shareholders to exclude a substantial portion of their gains from taxation when selling qualified small business stock. By taking advantage of this beneficial exclusion, investors stand to realize major tax savings on their investment profits.

However, many taxpayers and even some tax professionals remain unaware of it. This article aims to provide a basic overview of Section 1202, who it applies to, and discuss the potential tax benefits.

What is Section 1202 (Qualified Small Business Stock)?

Qualified Small Business Stock (QSBS) refers to specific types of stock issued by domestic C-corporations that meet certain criteria outlined in Section 1202 of the Internal Revenue Code. Non-corporate shareholders (including individuals, trusts, estates) who hold QSBS for more than five years may be eligible to exclude a portion or all of their capital gains upon the sale or exchange of the stock.

The term “small business” in QSBS can be misleading, as the size qualifications are relative. While there are limitations on the corporation’s gross assets, a business does not necessarily have to be small from a layman’s perspective to qualify. 

To be considered QSBS, the stock must meet several key requirements:

• Holding period: The stock must be held for more than five years. 
• Type of business: The corporation must be engaged in an eligible trade or business, excluding certain service-based industries like healthcare, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset is the reputation or skill of one or more employees. 
• Gross assets limitation: The corporation’s gross assets must not exceed $50 million at the time of stock issuance or immediately after the issuance of the stock (i.e. after the transaction where an investor purchased stock). 
• Active business requirement: At least 80% of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses. 
• Stock issuance criteria: The stock must have been originally issued by the corporation for money, property (other than stock), or compensation for services provided to the corporation. 
• Gain asset purchase limitation: For stock acquired after September 27, 2010, the corporation cannot have purchased more than $10 million in eligible gain assets during the year of issuance. 
• Shareholder acquisition criteria: The shareholder must acquire the stock directly from the corporation in an eligible issuance.

For example, let’s say an individual investor acquired $1 million worth of stock in a qualifying C-corporation in 2020. If the investor holds the stock for more than five years and meets all other QSBS criteria, they may be eligible to exclude their capital gains upon the eventual sale of the stock.

Who is Eligible for Section 1202?

The QSBS exclusion is available to non-corporate shareholders, including individuals, trusts, and estates, who hold qualifying stock. 

This provision is relevant across various stages of a business’s lifecycle, making it beneficial for:

• Established businesses preparing for sale: Shareholders of mature companies looking to exit their investment may be able to take advantage of the QSBS exclusion.
• Startups considering new investment or partial sale: Entrepreneurs structuring their business to bring on new investors or partially sell their business can potentially qualify for the exclusion.
• Structuring transactions: Existing shareholders can make informed decisions to maintain QSBS eligibility when undergoing corporate changes or restructuring.

The QSBS exclusion is available to individual investors as well as certain pass-through entities like trusts, estates, partnerships, and S corporations. Eligible shareholders often include angel investors, venture capitalists, company founders, and early employees who received stock as compensation. For instance, a startup founder holding QSBS received as part of their equity package may qualify for the exclusion upon the sale of the company. 

However, some non-corporate shareholders are ineligible, such as foreign investors not subject to U.S. income tax and tax-exempt organizations like pension funds or charities. Additionally, while partnerships and S corporations can potentially qualify, their non-corporate owners must meet specific requirements to claim the exclusion.

Potential Tax Savings and Benefits 

The QSBS exclusion allows eligible shareholders to exclude a significant portion of their capital gains from taxation. Depending on the acquisition date and holding period, the exclusion can range from 50% to 100% of the gain realized when the stock is sold or exchanged.

To illustrate, consider an investor who bought $5 million worth of qualified small business stock (QSBS) in a startup in 2018. By 2024, that startup had doubled in value, and the investor sold their stake for $10 million, realizing a $5 million capital gain. 

Without the QSBS exclusion, this gain would be subject to a 20% federal capital gains tax rate plus the 3.8% net investment income tax, totaling $1.19 million in federal taxes. 

However, if the stock meets all QSBS requirements, the investor could take advantage of up to 100% exclusion. This would allow the entire $5 million gain to be exempt from federal taxes, resulting in a staggering $1.19 million in tax savings.

Proactive tax planning is essential for maximizing crucial to maximize the benefits of the QSBS exclusion because minor changes in facts or circumstances throughout the holding period can potentially disqualify the stock.

For example, let’s say an investor holds QSBS in a company that is considering a merger or acquisition. The investor and their advisors would need to carefully evaluate the proposed transaction to ensure it does not jeopardize the QSBS eligibility and the potential for capital gains exclusion. Your Smith + Howard advisor monitors QSBS implications and can review the potential impact on QSBS eligibility whenever a transaction involving C-corporation stock or a change in circumstances occurs.

Common Misconceptions and Filing Requirements

One common misconception is assuming ineligibility due to the use of the phrase “small business” in QSBS. Despite how it sounds, these size qualifications are relative, and businesses do not necessarily have to be what you might think of as small to qualify.

Many investors also overlook QSBS eligibility altogether, missing substantial tax savings opportunities. Taxpayers and their advisors must remain vigilant in identifying potential QSBS situations and properly claiming the exclusion.

From a filing perspective, there are no additional forms or schedules required specifically for QSBS. However, the exclusion must be disclosed on the individual’s tax return in the year of the sale or exchange. Proper documentation supporting the QSBS eligibility and the claimed exclusion amount is necessary crucial to avoid potential penalties or disputes with tax authorities.

Failing to claim the QSBS exclusion when eligible can result in significant tax overpayments and missed opportunities for substantial savings. For example, if you were to overlook QSBS eligibility and fail to claim the exclusion on a $2 million capital gain, you could end up overpaying taxes by hundreds of thousands of dollars.

Smith + Howard: Experienced Tax Advisors

Section 1202 and the Qualified Small Business Stock (QSBS) exclusion present valuable tax-saving opportunities for investors and entrepreneurs. To take advantage of this opportunity, it’s essential that you proactively consult with knowledgeable tax advisors. 

Smith + Howard can help you navigate the complexities of QSBS, ensure compliance, and maximize potential benefits. With the help of our advisors, you can structure investment opportunities to secure QSBS treatment and maximize tax savings. 

Contact an advisor today to learn more about how we can help you.