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Qualified Small Business Stock Exclusions Simplified

The Qualified Small Business (QSB) stock exclusions aim to incentivize investments in small businesses; however, understanding the rules can be tricky to comprehend. The following explains what QSB stock exclusion is all about, as well as how to qualify for Code Section 1202 benefits.

What Is Code Section 1202?

Under Internal Revenue Code Section 1202, a gain on the sale of qualified small business stock held for five years is partially or entirely excluded from income. QSB stock must be stock in a C corporation. Therefore, Section 1202 is generally not available to exclude the gain on the sale of S corporation stock or partnership interests.

What is the Background on Code Section 1202?

Code Section 1202, part of the Revenue Reconciliation Act of 1993, was to provide relief to investors who risk their funds in new ventures and small business. At the time, the long-term capital gain rate and ordinary income tax rate were both 28%. However, only 50% of the gain was excludable from income, which computes to a 14% effective tax rate on 100% of the gain.

In 1997, the long-term capital gain rate was reduced to 20%, while Section 1202 stock remained at 28%.  When compared to the new 20% long-term capital gain rate, the tax community felt a 6% savings was not worth the effort to comply with Section 1202.

In 2003, Congress later reduced the top capital gain rate to 15% making Section 1202 insignificant.

In 2009, as part of The American Recovery and Reinvestment Act, Congress increased the exclusion percentage to 75% and then increased the exclusion percentage to 100% in 2010. The move to 100% was temporary until The Protecting Americans from Tax Hikes (PATH) Act of 2015.

What are the Requirements to Qualify for Code Section 1202?

The QSBS rules are complex and should be reviewed by a Windes tax advisor.

In general, to qualify for Section 1202, the requirements below need to be met:

  1. Stock must be a domestic C corporation and must be a C corporation during substantially all the time you hold the stock.
  2. Shares must be acquired at original issuance.
  3. Shares must be held for more than five years.
  4. The business’s gross assets cannot exceed $50 million as of the date of issuance and immediately after.
  5. The company must be involved in a qualified active trade or business.
  6. The shareholder must elect QSBS treatment on his or her tax return.

Moreover, you need to keep in mind that states that conform to federal tax will exclude capital gains of small business stock as well. Not all states conform to federal tax laws.

What Is the Amount of the Exclusion and Tax Rates?

QSB stock acquired between August 10, 1993, and February 17, 2009, is eligible for a 50% exclusion. The exclusion is increased to 75% for QSB stock acquired from February 18, 2009 through September 27, 2010, and to 100% for QSB stock issued on or after September 28, 2010.

The taxable portion of a gain originating from selling small business stock has an assessment at the maximum tax rate of 28%.

For QSB stock acquired before September 28, 2010, a portion of any gain excluded under Section 1202 is included in the computation of alternative minimum taxable (AMT).  However, gains from the sale of QSB stock acquired on or after September 27, 2010, are not subject to the AMT adjustment.

Gain from the sale of QSB stock is not subject to the 3.8% net investment income tax.

Is there a Limitation on the Exclusion Amount?

The amount of gain that a single investor can exclude under this section is a maximum of the greater of $10 million or 10 times the adjusted basis of the stock.

Maximize Your Business Profits and Gains

 We hope this simple guide on qualified small business stock and Section 1202 gave you a deeper understanding of how it can affect your business profits and gains. Whether preparing your employee benefit plan for audit or taking a deep dive into the recent business interest deduction limitations, nothing can truly replace the experience of a trusted accounting firm. And if you are in the technology industry, you should take a look at our industry-specific services that can truly elevate your business processes.

So make sure you sign up for our Solutions newsletter to receive the latest tax and audit news for your business.

For more information about this article, please contact Rob Henderson at or toll free at 844.4WINDES (844.494.6337).
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