Unlocking Tax Savings with Section 1202: Your Ultimate Guide to Qualified Small Business Stock Benefits

From a very young age, Elong Muskrat was always passionate about providing solutions to the world’s most difficult problems. Over the years, Elong had founded multiple companies in different industries. Many of them failed. However, some of them were wildly successful.

One day, Elong wanted to provide a solution to help reduce the world’s fossil fuel usage. Since cars contribute heavily to this use, Elong decided to start an electric car company. These electric cars would have all the same features without having to make the trip to the gas station.

After reducing his idea into a business plan, Elong formed Edison Electric Vehicles in 2011, a Delaware C-Corp, where he initially owned 100% of the stock.

In the following decade, Edison manufactured over 1 million electric vehicles. Because car manufacturing is an expensive endeavor, Edison’s gross assets were only worth $40 million.

In 2021, Elong was drawn to another serious issue. He noticed the ubiquity of social media and all of its negative impacts. Titter, a platform where users would constantly exchange a tit for tat, was the primary culprit. Elong wanted to purchase Titter and change its algorithms for the betterment of society. However, he would need to finance the purchase of Titter by selling his stock in Edison.

In 2022, Elong sold his stock in Edison to Riviera Motors, another electric vehicle maker, for $9 million. The gain from the sale would typically be subject to capital gains taxes for federal income tax purposes. He then used that sum to finance his purchase of Titter.

Being an extremely smart person, Elong was curious as to the tax consequences of his stock sale, specifically how much of the gain from the sale would be recognized for federal income tax purposes and whether he could exclude any portion from capital gains taxes. His tax advisor told him that he may qualify for the Qualified Small Business Stock (QSBS) exemption. If he does, he could save millions of dollars in taxes.

Who exactly is eligible for Section 1202?

Like many investors and business owners, you must understand the tax benefits of Section 1202 if you want to make the most of your small business investments. The rules around qualified small business stock (QSBS) are designed to give you powerful tax savings—like excluding capital gains from federal income tax—but only if you meet the specific requirements. This is why we always recommend that you learn these eligibility criteria before you invest. Here's what you need to know:

Qualified Small Business Stock (QSBS)

First and foremost, you need to understand what makes stock qualify for these tax benefits. Your stock must be issued by a qualified small business, which means the company must be a domestic C corporation. At the time they issue your stock, the company cannot have more than $50 million in total gross assets. This is a hard limit that you cannot exceed.

On top of this, the corporation must use almost all of its assets in running an active business. This focus on active business requirements ensures that you get tax benefits only when you invest in companies that are actually operating and contributing to economic growth. If the company is just sitting on assets without actively using them, you won't qualify for the tax savings.

Original Issuance Requirement

Here's something many investors don't realize: you must get your small business stock directly from the corporation when they first issue it. You can pay with cash, property (but not other stock), or get it as compensation for services you provide. If you buy the stock from another investor on the secondary market, you won't qualify for QSBS treatment.

This rule is designed to encourage you to make direct investments in small businesses, rather than just trading existing shares. This is why we recommend that you work directly with the company if you want these tax benefits.

QSBS Holding Period

You must hold your stock for more than five years if it was issued before July 5, 2025. This is a long time, but it's necessary to get the full QSBS tax benefits. However, if your stock is issued after July 4, 2025, you'll face a different system. Here, you can get different levels of tax exclusion based on whether you hold the stock for three, four, or five years.

This long-term holding requirement means you cannot use QSBS for short-term speculation. Instead, you must make sustained investments in small businesses. If you sell too early, you'll lose these valuable tax benefits.

Active Business Requirement

Throughout almost all of the time you hold your stock, at least 80% of the corporation's assets must be used in running an active business. However, certain industries don't qualify as active businesses for QSBS purposes. These include banking, insurance, financing, leasing, investing, farming, and real estate investment trusts (REITs).

This ensures that you get QSBS tax benefits only when you invest in businesses that actively produce goods or services. If the company operates more like a passive investment vehicle, you won't qualify for the tax savings. This is why we always recommend that you check what type of business the company operates before you invest.

Gross Assets Limitation

The corporation cannot have more than $50 million in total gross assets at any time from August 11, 1993, through right after they issue your stock. This is a strict limitation that ensures only genuinely small businesses can issue QSBS.

You need to be careful here because this limit applies to the entire history of the company, not just when you invest. If the company ever exceeded $50 million in assets before issuing your stock, you won't qualify for QSBS treatment. This keeps the focus on supporting early-stage and growth companies.

Redemption Transactions

If a corporation issues stock to you shortly before or after they buy back significant amounts of their own shares, your new stock may lose its QSBS qualification. This rule prevents companies from using QSBS as a way to facilitate buybacks or redemptions, rather than to raise new capital for business growth.

You should be aware of any redemption activity around the time you receive your stock. If the company is buying back shares at the same time they're issuing new ones, you could lose your tax benefits!

Qualified Trade or Business

The business must operate in a qualified field to give you QSBS benefits. Many professional services are excluded from qualification so it is very important to review the qualifications completely. For the sake of this article, some of these qualified businesses include health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and any business where the main asset is the reputation or skill of employees.

This means that if you invest in a law firm or consulting company, you won't get QSBS tax benefits. The intention is to direct tax benefits toward businesses that drive innovation, job creation, and economic expansion, rather than personal service businesses.

Taxpayer Eligibility

Generally speaking, QSBS tax benefits are available to individuals, trusts, and estates. While partnerships and S corporations can hold QSBS, the tax exclusion typically passes through to the individual partners or shareholders, as long as they meet the other requirements.

This focus on non-corporate taxpayers helps encourage you to make direct investments in small businesses. However, if you're investing through a corporation, you won't be able to take advantage of these tax benefits.

By meeting these eligibility criteria, you can take advantage of significant tax savings, including the ability to exclude all or most of your capital gains from federal income tax when you sell qualified small business stock. If you're an entrepreneur or small business owner, understanding these rules is essential for structuring your company and stock issuances to maximize Section 1202 benefits. This is why we always recommend that if you're considering forming a C corporation or planning a stock issuance, you should consult with experienced legal and tax professionals. They can help ensure you meet the active business requirements and other criteria necessary to qualify for these valuable tax benefits.

Qualified Small Business Stock

So what exactly is QSBS? Under Section 1202 of the Internal Revenue Code, a taxpayer may be exempt from paying capital gains tax when selling QSBS stock if they meet certain requirements. Each of these are listed below:

QSBS Only Applies to C-Corp Stock

The stock must be held in a C-Corp. S-Corp stock, LLC units, and partnership interests are not eligible for the QSBS exemption. Pass through entities and pass-through entity structures like partnerships and S corporations do not qualify as issuing corporations, but gains may be allocated to individuals if other requirements are met. Edison was formed as a C-Corp.

-The first requirement is easily met.

The C-Corp shares must be acquired in the original issuance:

The C-Corp shares must be acquired in the original issuance (property contributed to the corporation must be valued at its fair market value at the time of contribution for QSBS eligibility).

-Because Elong owned 100% of Edison’s stock when he formed it, the second requirement is met.

The C-Corp must be a qualified small business:

The C-Corp must be a qualified small business. A qualified small business is an eligible corporation, specifically a domestic C-Corp, which holds gross assets that have never exceeded $50 million. Such corporation must meet the requirements at the time the stock is acquired. Here, Edison’s gross assets were only ever worth $40 million. The aggregate value of the corporation's assets, including property contributed at fair market value, must not exceed $50 million.

-Because of this, Edison meets the definition of a qualified small business.

80% of the firm’s assets must be used in active conduct:

A minimum of 80% of the firm’s assets must be used in active conduct, or in an ongoing business. If stock is acquired in a passive C-Corp, it cannot qualify for the QSBS exemption. Research and experimental expenditures and in house research expenses are treated as used in the active conduct of a qualified trade or business for Section 1202 purposes.

-Because Edison manufactures cars, it easily meets the requirements of active conduct.

The stock cannot be in certain lines of business:

The stock of certain lines of business will not qualify for the QSBS exemption. Some of these include banking, insurance, farming business (specifically, a business involving the raising or harvesting of trees is excluded), leisure and hospitality, and other professional businesses.

-Because Edison manufactures cars, it does not fall into any of the aforementioned categories. It still qualifies for the QSBS exemption.

Redemption transactions:

The combined voting power of stockholders and the classification of outstanding stock can affect whether a corporation qualifies as an eligible corporation for QSBS purposes.

This is all great news for Elong. His stock qualifies for the QSBS exemption because it has met the aforementioned requirements. He can save money by not having to pay the capital gains tax associated with the sale of stock.

However, how much Elong saves depends on when the stock was held and how much the stock sold for.

When the stock was held:

If the taxpayer acquires QSBS stock after September 27, 2010, and holds it for more than 5 years, the taxpayer can exclude 100% of the capital gain upon its sale. If the taxpayer acquires QSBS stock between February 18, 2009 and September 27, 2010, and holds it for more than 5 years, the taxpayer can exclude 75% of the capital gain upon its sale. If the taxpayer acquires QSBS stock between August 11, 1993 and February 18, 2009, and holds it for more than 5 years, the taxpayer can exclude 50% of the capital gain upon its sale. The taxpayer's holding period is critical, as the rules apply to stock acquired at original issuance. Elong formed Edison in 2011 and sold his Edison stock in 2022. Because of this, Elong may exclude 100% of the gain.

Maximum excludable gain recognized:

The IRS sets limits on how much a taxpayer can exclude upon the sale of QSBS stock. The qsbs gain exclusion is limited to the greater of $10 million or 10 times the taxpayer's adjusted basis, and prior taxable years' exclusions are counted toward this limit. The maximum eligible gain that a taxpayer can recognize is capped at the greater of $10 million, or 10 times the aggregate adjusted basis in the stock.

Here, because Elong sold his Edison stock for $9 million, he is able to exclude the entire gain associated with its sale. Only the taxpayer's eligible gain, or the gain attributable to QSBS, is excluded; the taxable portion or taxable gain recognized is subject to capital gains tax and possibly the net investment income tax or alternative minimum tax. Transactions involving substantially identical property or the sale of substantially identical property, such as short sales or options, can cause the taxpayer to recognize gain and lose QSBS status. Federal rules and the tax code define which types of business involving similar business activities or such trade are excluded from QSBS eligibility.

Section 1202 was enacted to encourage investment in small businesses by providing the qsbs gain exclusion.

Conclusion

If they meet the requirements, qualifying for QSBS can be advantageous to taxpayers who acquire and sell stock in smaller C-Corps. For those exploring additional structuring strategies, Q-Subs offer opportunities to protect your business and minimize taxes.