The ABCs of I.R.C. Section 1202 Qualified Small Business Stock


Choice of entity is a critical decision that carries many legal and tax consequences. This decision is key to the initial formation of a business, but can also be important when evaluating whether to restructure an ongoing business. Over the last few decades, the limited liability company (LLC) has become the preferred entity designation for many businesses — especially among small and medium-sized organizations. However, as a result of the enactment of the Qualified Small Business Stock (QSBS) exclusion provided in Internal Revenue Code (I.R.C.) Section 1202 and the reduced corporate tax rate as part of the 2017 Tax Cuts and Jobs Act, the C corporation has become a more attractive entity choice for some of these companies.

Generally, the QSBS exclusion permits an eligible taxpayer to potentially exclude up to 100% of the eligible gain realized from the sale of qualifying stock. This bulletin addresses the basics of the I.R.C. Section 1202 QSBS exclusion and the qualification requirements for the corporate entity and its shareholders.

QSBS Benefits

The annual amount of gain eligible for the QSBS exclusion by a taxpayer is equal to the greater of $10 million or 10 times the taxpayer’s adjusted basis in the QSBS being sold. If QSBS is gifted or inherited, this limitation can be multiplied since it is a per taxpayer limitation.

The percentage of gain that a taxpayer can exclude depends on when their QSBS was issued.

  • Stock issued before Aug. 11, 1993, is not eligible for the QSBS gain exclusion.
  • QSBS issued between Aug. 11, 1993, and Feb. 17, 2009, is eligible for a 50% gain exclusion.
  • QSBS issued between Feb. 18, 2009, and Sept. 27, 2010, is eligible for a 75% gain exclusion.
  • QSBS issued after Sept. 28, 2010, is eligible for a 100% gain exclusion.

Notably, the amount of gain that is not excluded from I.R.C. Section 1202 is taxed at a 28% rate¹ and also subject to the 3.8% net investment income tax.²

Corporate Requirements and Limitations

Eligible Issuer of QSBS

Only domestic entities subject to federal income tax as C corporations are eligible to issue QSBS. Such issuance must be in exchange for cash, services, or property. Domestic S corporations cannot issue QSBS. However, an S corporation could transfer or contribute assets — including subsidiary entities — to a new C corporation in exchange for QSBS. Partnerships — including LLCs taxed as partnerships — can also convert to a corporation under state law (i.e., a formless conversion) or perform a separate incorporation transaction in which new C corporation stock is issued. See e.g., Rev. Rul. 84-111. Furthermore, LLCs that make a “check the box” election to be taxed as a C corporation are eligible to issue QSBS.

Qualified Small Business

The issuing C corporation cannot have more than $50 million in aggregate gross assets before or up until immediately after the issuance of the stock. Aggregate gross assets mean the amount of cash and the aggregate adjusted basis of other property held by the corporation, other than contributed property. In the case of the contributed property, it is valued at its fair market value at the time such property is contributed to the corporation, which is different from the adjusted tax basis of that property. Since the aggregate gross assets are evaluated only before and immediately after the stock is issued, a C corporation can subsequently be worth more than $50 million under this test and the issued QSBS will not lose its qualified status.

Active Business Engaged in Qualified Trade or Business During the Holding Period

The issuing C corporation must use at least 80% of the fair market value of its assets in the active conduct of one or more qualified trades or businesses. This must be satisfied for substantially all the shareholders’ required QSBS holding period (discussed below). Specific rules also apply to corporate subsidiaries and joint ventures. A qualified trade or business is defined in I.R.C. Section 1202 to include any business other than:

  • 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 one or more of its employees;
  • Any banking, insurance, financing, leasing, investing, or similar business;
  • Any farming business (including the business of raising or harvesting trees),
  • Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under I.R.C. Section 613 or 613A; and
  • Any business of operating a hotel, motel, restaurant, or similar business.

Additionally, an issuing C corporation will fail to meet this requirement if:

(a) More than 10% of the value of its gross assets consist of real property not used in the trade or business, or
(b) More than 10% of the value of its net assets consist of stock or securities of corporations not qualifying as subsidiaries.

This limitation does not apply to subsidiary corporations in which the business owns more than 50% of the combined voting stock.


Certain redemptions can disqualify otherwise eligible QSBS. Redemptions by the holder or related person that are considered “significant” can make stock ineligible for the QSBS exclusion. There are some exceptions in determining whether the redemption is “significant” enough to disqualify the stock and situations where redemptions of any size are permissible without rending the stock ineligible for favorable QSBS treatment. Additionally, any series of redemptions exceeding 5% of the value of the corporation’s stock can prevent stock issued during a two-year period beginning one year before the redemptions from being eligible for the QSBS exclusion.

Shareholder Requirements and Limitations

Eligible Holder of QSBS

Any entity except a C corporation can hold QSBS. Eligible shareholders of QSBS include individuals, trusts, estates, partnerships, LLCs — taxed as a partnership or single-member — and S corporations. For pass-through entities, additional requirements must be satisfied for the non-corporate owners of the pass-through entity to qualify for beneficial QSBS treatment. For example, when a pass-through entity holds and sells QSBS after the five-year holding period, only the members of the pass-through entity that were members at the time the pass-through entity acquired such stock shall be eligible to claim their proportionate share of the QSBS gain exclusion.

Holding Period

The stock must be held for more than five years before it can qualify for the QSBS exclusion. Generally, the holding period begins when the stock was issued, but there are some particular rules when the stock is issued in exchange for non-cash property or conversion of other stock. This holding period can be “tacked” to previous holding periods where the stock was received as a gift, from inheritance after death, or as a distribution to partners from a partnership.

If this five-year holding period requirement cannot be satisfied and the holder must sell its stock, proceeds from the sale of otherwise eligible QSBS can be rolled over into other QSBS under I.R.C. Section 1045. These rollover proceeds can then qualify for favorable QSBS treatment once they satisfy the five-year holding period requirement.

Original Issuance

The eligible shareholder must have acquired the stock on original issuance (i.e., the stock cannot be purchased from another shareholder). The stock does not have to be issued by the company as part of its initial formation. Additionally, the taxpayer who originally issued the stock must be the holder and ultimate seller of the QSBS for it to qualify for tax exclusion treatment. Much like the holding period requirement, there are exceptions for QSBS received as a gift, from inheritance after death, or as a distribution to partners from a partnership.

Beyond these basic requirements, there are additional nuances for quantifying, claiming, and substantiating a 1202 gain exclusion, which are outside of the scope of this article. If you have any questions about how I.R.C. Section 1202’s requirements apply to a specific scenario, please contact any of the authors or other attorneys in Taft’s Tax practice.

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