Qualified Small Business Stock Exemption Explained

Find a Wealth Advisor

Author: Morgan Luddeke, Senior Vice President and Director, Business Transition Advisor, Fifth Third Private Bank

Internal Revenue Code Section 1202, also known as the Qualified Small Business Stock (QSBS) exemption, is a powerful tax incentive designed to encourage long–term investments in small, growth–oriented businesses by significantly reducing the tax burden on successful investments. Established in 1993, Section 1202 allows non–corporate investors to exclude up to 100% of capital gains from the sale of qualified small business stock in a domestic C corporation, provided certain conditions are met. This article explores the mechanics of the Section 1202 QSBS exemption, its benefits and its strategic implications for both investors and entrepreneurs.

Key features and benefits

Capital gains exclusion: Investors can exclude a significant portion of their capital gains from the sale of QSBS. The exclusion percentage varies based on when the stock was acquired:

• 50% exclusion for stock acquired before February 18, 2009
• 75% exclusion for stock acquired between February 18, 2009 and September 27, 2010
• 100% exclusion for stock acquired after September 27, 2010

Gain limitation: The exclusion is subject to a maximum limit, which is the greater of $10 million or 10 times the adjusted basis of the stock sold during the taxable year.

Alternative minimum tax (AMT) relief: For stock acquired after September 27, 2010, gains excluded under Section 1202 are not subject to AMT.

Qualification criteria

For an investor to individually benefit from the Section 1202 exemption, both the stock and the issuing corporation must meet specific criteria:

1. Eligible corporation: The stock must be issued by a domestic C corporation classified as a "qualified small business." A qualified small business is defined as a corporation with aggregate gross assets of $50 million or less at the time of stock issuance and immediately thereafter.
2. Qualified trade or business: At least 80% of the corporation’s asset value must be engaged in an active trade or business. Certain service–based businesses (such as those in law, accounting and consulting) and businesses involved in finance, farming, mining and hospitality are excluded from qualifying.
3. Original issuance: The investor must acquire the stock at its original issue, directly from the corporation or through an underwriter, in exchange for money, property (excluding stock) or as compensation for services rendered to the corporation.
4. Holding period: The investor must hold the stock for more than five years to qualify for the exclusion.
5. Asset sale or stock sale: When selling a company, an investor must consider that a stock sale qualifies for the Section 1202 QSBS exemption if all other qualifications are met. In contrast, an asset sale does not benefit from the QSBS exemption, as the gains are taxed at the corporate level and then again upon distribution to shareholders, resulting in potential double taxation.

Client example:^*
Consider the case of Jane, an early–stage investor in a startup called ABC Tech, Inc., which was founded in 2017. Jane purchased 10,000 shares of the common stock directly from the company for $1 million, qualifying her investment as QSBS under Section 1202. By 2024, ABC Tech has grown significantly and is being purchased by a larger company. At this time, Jane’s shares are worth $9 million. If ABC Tech sells its stock to the larger corporation, Jane will be eligible for the QSBS exclusion, which would allow her to exclude up to 100% of the capital gains on the sale.

In this case, the exclusion could cover her entire $8 million gain, making her entire investment potentially tax–free at the federal level. Without the QSBS exclusion, Jane could be subject to a federal capital gains tax rate of up to 20%, plus the 3.8% net investment income tax, leading to a potential tax liability of approximately $1.9 million. By leveraging the QSBS exemption, Jane avoids this tax, retaining her full $8 million gain.

Practical considerations

Timing of stock acquisition: The level of the exclusion (50%, 75% or 100%) depends on the acquisition date. It’s crucial for investors to document the acquisition date accurately to determine the applicable exclusion percentage.

Documentation and compliance: Investors should maintain thorough records of their QSBS transactions, including stock purchase agreements and proof of qualification criteria, to substantiate their claims for exclusion during a potential IRS audit.

Type of sale: Investors should attempt to structure the ultimate sales transaction as a stock transaction as that is generally more advantageous for investors seeking to leverage the tax benefits of the QSBS exemption.

Investment strategy: Understanding and leveraging Section 1202 can significantly enhance investment returns. Investors should consider the potential tax savings when making investment decisions, particularly in the startup and small business sectors.

Strategic benefits for entrepreneurs and investors

For entrepreneurs, issuing QSBS can make their companies more attractive to investors, as the potential tax savings can enhance the overall return on investment. This can be a critical advantage in raising capital, especially in the competitive startup environment.

For investors, Section 1202 offers a unique opportunity to invest in innovative small businesses while enjoying substantial tax benefits. This can lead to a more diversified portfolio with enhanced after–tax returns, incentivizing longer–term investments and fostering sustained economic growth.

Conclusion

Section 1202’s QSBS exemption is more than just a tax provision; it is a strategic tool that drives investment in small businesses and startups, fostering innovation and economic growth. Investors and entrepreneurs alike can leverage this exemption to achieve substantial financial benefits while contributing to a dynamic and thriving business environment.

For more information, speak with your Fifth Third Private Bank advisor.