Tax exemption on selling Qualified Small Business Stocks (Section 1202)

This article will explain all about the Section 1202 exclusion and its details.

It isn’t a secret anymore that small businesses have been the growth engine of the United State’s economy. And because of this, Congress came up with a tax code that offers a lot of tax breaks to those who invest in these small companies.

One such break became permanent after The Protecting Americans from Tax Hikes (PATH) Act passed in late 2015. This tax break, for Qualified Small Business Stock (QSBS), has now become a reason for many venture capitalists, entrepreneurs and investors to invest in small businesses. Basically, there is a complete exemption from the federal income tax on gains from the sale of a specific kind of stock.

There is now a way where investors in small businesses can make investments and qualify for full federal income tax exemption on a subsequent sale. This was deemed Section 1202. This article will explain all about the Section 1202 exclusion and its details.

What is Section 1202?

Section 1202 is also called the Small Business Stock Gains Exclusion and is a part of the Internal Revenue Code (IRC). Its basic aim is to offer capital gains from selected small business stocks that would be excluded from the federal tax. To be clear, Section 1202 is only applied for Qualified Small Business Stock (QSBS) that was obtained after 27th September 2010, and held for more than 5 years.

As mentioned above, the Protecting Americans from Tax Hikes (PATH) Act was passed in 2015 by Congress and signed into law. As per this act, some expired tax provisions have been renewed and it has also helped in permanently extending a few of the other tax benefits. That is where the Small Business Stock Capital Gains Exclusion that was in Section 1202 of the IRC was made permanent.

To explain Section 1202 better, it offers an incentive to non-corporate taxpayers allowing them to invest in other small businesses. Basically, this law is about capital gains exemption from federal income tax when the small business stock is sold. In short, this means that when qualified small business stocks are held for more than 5 years before they are sold completely or a portion of them are sold, all of the realized gains would be excluded from federal tax. Basically, the seller of the stocks would not have to pay any tax for the gains on the QSBS.

What is a Qualified Small Business?

A QSB (Qualified Small Business) is a company that has been incorporated as a domestic C corporation and has gross assets less than $50 million immediately after or just before the corporation issues stock. To explain better, gross assets means the amount of cash and property that the corporation owns all together.

The company has to be engaged in a “qualified trade or business” to fall under this category. To be more specific, a QSB is all companies except those in the field of brokerage services, financial services, athletics, consulting, performing arts, actuarial science, accounting, architecture, engineering, law, health, or any other business where the main asset of the business is the skill or reputation of one or more of its employees. The definition also excludes restaurants, hotels, farming, and banking companies.

One of the companies that have a huge place for the QSBS are the tech startups since they eventually see large increases in value. Additionally, many of the technology based companies are qualifying businesses. Hence, early investors and founders see huge tax free gains in them. Nonetheless, in case you live in a state with income tax, you might not be able to enjoy the same exclusion. For instance, California no longer allows QSBS exclusions.

What is Qualified Small Business Stock (QSBS)?

A QSBS (Qualified Small Business Stock) is a stock that a QSB issues and obtained directly from the business for other property (not stock) or money, or as compensation for services. There isn’t any limit for the amount of money that a QSB can raise. This is true as long as the company does not raise money that takes the gross asset value of the company over the $50 million threshold for QSBS.

And if you are wondering why you should care, from the introduction you might have read about Section 1202. This section offers OSBS with some tax advantages. In short, a purchaser can reduce tax on up to $10 million on the gain of QSBS. Yes, you are reading it right, $10 million tax free. This article would help you understand all about the Tax exemption of QSBS and all its advantages in detail so that you too can benefit from it if possible.

Conditions to Be a Qualified Small Business

With Section 1202, it is obvious that the IRS would not let everyone easily take advantage of the rule. This is one reason why there are some requirements and limitations to this, both for the QSB and the investor. To explain the requirements and limitations of Section 1202 in more detail, the following points have been put together:

The Cap To Tax Savings

To break the suspense, let us talk about the maximum amount that can be tax free in case all the other QSBS requirements are met. The maximum amount a shareholder can exclude from the taxable gain on a sale of the QSBS is $10 million or the greater of 10 times the shareholder’s basis in the shares.

Along with this, there are some important dates that have to be kept in mind for the QSBS as the rules have changed twice since the last one decade. To clarify, different rules are applied based on when the shares were obtained.

Basically, if the shares were obtained before 28th September, there might be an additional cap. And for anyone that obtained the shares before the 18th February 2009, about 50% of the total gain of the shareholders can be excluded from the tax.

If case the Qualified Small Business Stocks were obtained between the dates – 18th February 2009 and 27th September 2010, then about 75% of the total gain of the shareholder could be excluded from tax. It also has to be noted that the rules are the same for the per-issuer basis. This means that the shareholder would get $10 million subject to additional caps, or the greater of 10 times basis for each company that qualifies as a QSB.

Further, this means that if a shareholder owns Qualified Small Business Stocks in four different QSBs, they would be able to enjoy the advantages of the tax exemption of the QSBS four different times. It is important to note that the total gain amount excluded from the percentage limitations noted are not qualified for the 20% long-term capital tax rate and this would be taxed at a rate of 28% instead.

QSBS Shares Must be the Original Issuance

The next important requirement to qualify for the tax exemption for the QSBS under Section 1202 is the QBSB shares have to be directly obtained from a U.S. C corporation or its underwriter in exchange for services, property or money. Plus, this has to be after 1993. This means that the shares should be the initial issuance of shares.

In case the Qualified Small Business Stocks were obtained as a gift or when the original shareholder dies, the shares would be considered as being acquired at original issuance as long the original shareholder acquired the QSBS at the original issuance.

QSBS Should Be Held For Over 5 Years

As mentioned in one of the limitations above, the QSBS have to be held for at least five years by the shareholder for them to be able to enjoy the tax exemption for QSBS as per Section 1202. If the shares get exchanged or converted into another stock of the same company in a tax-free transaction, the holding period of the QSBS shares obtained would also include the holding period of the converted or exchanged stock.

For instance, the holding period of the convertible preferred stock would be added to the common stock that was obtained on conversion. And for any of the QSBS shares obtained through inheritance, as a gift or from a partnership, the holding period would also include the period the decedent, donor or partnership held the stock.

Should Be Active in Trade or Business

Not only this, the tax exemption for QSBS is only available in case most of the assets in the business are used in connection with an active business or trade. Basically, at least 80% of the assets have to be utilized in the active conduct of the QSB.

To be specific, the experimental, startup and research activities that are related to any future qualified business or trade along with the activities performed by small and specialized business investment companies normally qualify as active.

However, a business would fail the active business or trade test in case there is a lot of passive real estate or portfolio stock. In fact, no more than 10% of the value of the assets in the business (that is the total liabilities) can consist of real estate that is not utilized in connection with the active business or trade or of securities or stock in other corporations which are not held as working capital and are not the subsidiaries of the company.

Gross Assets Should be Less Than $50 Million

This point is about the “S” in the QSBS (Qualified Small Business Stocks) with means Small. As per the Section 1202, the tax exemption on QSBS is only for the Qualified Small Businesses. This rule was created to encourage the investment in small companies. That is why the last requirement is that the company’s gross assets should be not more than $50 million to be a QSB.

To be clear, the amount of assets that the company has on sale is completely irrelevant in this case. Moreover, the business would also have to own a proportionate amount of the assets and to also run a proportional amount of the activities of its subsidiaries.

Section 1202

Tax benefits from Section 1202

With all clear about the Section 1202 definition and the requirements to be a QSB, let us understand what are the tax benefits that come under this section. Let us say that you have kept the QSBS shares for at least 5 years and then you decide to sell the shares off to gain a lot of profit.

This gain can be partly or entirely tax exempt. In this case, the left capital gain is then taxed at a rate of 28%. And this is only in case you are in the 15% or 20% bracket for regular long-term capital gains. The maximum gain eligible for being excluded from any tax on any one investment is the one that is greater than $10 million or 10 times the adjusted basis in the stock of the taxpayer.

It should also be noted that the gain excluded from the capital gains tax is not subjected to the 3.8% net investment income tax (NIIT). For you to understand the difference in the savings during the sale of the QSBS and the regular stock, let us take an example.

There is a married couple that has a joint taxable income of $500,000. These people fall under the 20% long-term gain bracket for capital gains tax and are also subjected to the 3.8% NIIT. Now, these people realize a long term capital gain of about $120,000 by selling stocks on 2nd October 2016. Now, the following would explain how the tax varies based on the kind of stock and its purchase date:

Purchase Date of Stock Is the Stock QSBS? Simplified Regular Tax Calculation Federal Tax Due on Gain
29th September 2015 No – the $120,000 is all taxable 23.8% of $120,000 $28,560
16th February 2009 Yes – exclude 50% of $120,000 31.8% of $60,000 $19,080
27th September 2010 Yes – exclude 75% of $120,000 31.8% of $30,000 $9,540
30th September 2010 Yes – exclude 100% of $120,000 31.8% of $0 $0

To explain the table above, the tax rate is just 23.8% (which is 20% + 3.8% NIIT) for the lot purchased in 2015. This is because none of the stock was qualified as the QSBS. As explained above, for the stock that qualifies as QSBS would be taxed at the rate of 31.8% (which is 28% + 3.8% NIIT).

If you are a person who is subjected to the AMT, which is the alternative minimum tax, then things change. The example above is simple where the taxpayer does not have any AMT (as we assumed).

Note: The alternative minimum tax is the supplemental income tax that has been imposed by the US federal government along with the other income taxes for specific people, estates, corporations, and trusts that already have special circumstances or exemptions allowing them to pay a much lower tax than the standard income tax.

However, for many taxpayers, the AMT would be applied. And as Section 1202 excludes parts of the gain from regular tax, it also adds about 7% of excluded gain as the AMT preference item. This is true for all the purchase periods, as mentioned above, except the 100% exclusion window. To explain the federal exclusion of gain on the QSBS:

  • Before 18th February 2009 – 50% of the amount is excluded from the regular tax. And a 7% AMT is added back. (And in case the acquisition took place before 1st January 2000, the add-back AMT is 42%.)
  • From 18th February 2009 and 27th September 2010 – 75% of the amount is excluded from the regular tax. And a 7% AMT is added back
  • After 28th September 2010 – 100% of the amount is excluded from the regular tax. And there is no AMT added

To explain it better, let us take the same example above where the taxpayer is already in AMT before realizing the $120,000 long-term capital gain. Plus, we are assuming that the flat 28% AMT rate is also completely applied in this situation. (It should be noted that the lower income levels might also benefit from a partial AMT exemption. Just to explain the example, we have used a higher limit.)

Let now have a look at the table below to see the various scenarios for the stocks sold:

Purchase Date of Stock Is the stock QSBS? Simplified Regular Tax Simplified AMT Add-Back Federal Tax Due on Gain (Regular + AMT)
29th September 2015 No – the $120,000 is all taxable $28,560 (23.8% of $120,000) NA $28,560
16th February 2009 Yes – exclude 50% of $120,000 $19,080 (31.8% of $60,000) $1,176 (7% of 28% tax on $60,000) $20,256
27th September 2010 Yes – exclude 75% of $120,000 $9,540 (31.8% of $30,000) $588 (7% of 28% tax on $30,000) $10,128
30th September 2010 Yes – exclude 100% of $120,000 $0 (31.8% of $0) NA $0

It can clearly be seen that the AMT reduces the potential advantage of selling the QSBS for every kind of period except for the 100% exclusion window. With this said, you now know what tax benefits are offered under the Section 1202.

Declaring Section 1202 on Your Tax Return

Even though the calculation of how much tax you might have to pay for the QSBS is complex, fortunately the mechanics of making the QSBS election is relatively simple. In fact, the QSBS election is made on Schedule D of the tax return form that you normally fill out at the end of a tax year. Moreover, you would also have to offer proper proof of the Qualified Small Business Stocks from the business. Along with this, you would have to show proof that you had held the same for a minimum of 3 years following the filing of the relevant tax return.

Here are the steps to follow for reporting the Section 1202 gain and the exclusion:

  • Report the complete gain as long-term gain which would be done on the line 8 of the Schedule D on the tax return form
  • Enter the allowable exclusion as a loss below the gain entry
  • Give the label to the entry for the allowable exclusion as: Section 1202 exclusion

How to track your QSBS shares?

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Unfortunately, the state and federal tax authorities sometimes make it very difficult to claim the QSBS benefit. That is why it is important to always be ahead of the game and track your shares in the right way. With the best method of tracking the shares, you would be able to prove that you qualify for the QSBS. Here are the steps you can follow:

how to track your SBQC shares

1. Document your purchase

The very first thing that you need to do is keep proper records of your QSBS shares that you have purchased. The best way to do so is by using an online application or software like Eqvista. You would have to save the following details of the shares and Eqvista can help you with it:

  • The date purchased
  • The amount paid
  • A copy of the share certificate
  • A copy of the canceled check or wire with your account statement showing the funds leaving your account

2. Have your stock certified

When you are about to purchase the stock, ensure that you cross-check everything about the company such as:

  • If it is a domestic C corporation
  • Also, at least 80% of the company assets are used in the active conduct of a qualifying business
  • And that it has $50 million or less in assets immediately after you buy the shares

It should be noted that if you wait for many years before you ask this information, the company might not provide you with it either due to unclear records or staff turnover.

3. Watch the clock

Another thing that you need to do is keep track of the investment that you made and hold on the QSBS shares for at least a five-year period. With a professional software to help you like Eqvista, you would be able to do this as well. Try out Eqvista here to keep track of all your shares and manage them easily.


The tax exemption for QSBS is a great investment option. And with careful planning along with the right QSB to invest in, you can earn a lot of tax-free gains. If you are a startup, it is important that you remind the investors about this advantage. Plus if you are an investor who is about to invest in a QSB, then it is the best choice you would make. Do not forget to keep track of all the shares. Eqvista can help you with it. Check it out here!

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