Understanding Section 1202: The Qualified Small Business Stock Exemption

Wilson Sonsini Goodrich & Rosati

Wilson Sonsini Goodrich & Rosati

The “qualified small business stock” (QSBS) tax exemption under Section 1202[1] allows non-corporate founders and investors in certain emerging growth companies to potentially exclude up to 100% of the U.S. federal capital gains tax incurred when selling its stake in the start-up or small business. Section 1202(a) permits a stockholder to exclude a percentage of the gain recognized on the sale of QSBS held more than five years, capped at the greater of $10 million or 10 times the basis of its initial investment. Alternatively, if QSBS is not held for more than five years, but has been held for at least six months, Section 1045 generally permits a tax-free rollover of gain on the sale of the QSBS if the proceeds are reinvested within 60 days of the sale of the QSBS. These provisions are intended to encourage formation of and investment in certain small, active, operating businesses. What follows below is a brief summary of the potential benefits and the eligibility requirements of QSBS.

Benefits of Qualifying as QSBS

Gain Exclusion. Gain from the sale of QSBS is eligible for 100% exclusion from U.S. federal capital gains tax (or a lower percentage as described below), as well a corresponding 100% exclusion from the alternative minimum tax (AMT) and 100% exclusion from the 3.8% net investment income tax (NIIT). 

Section 1202 provides for a lower percentage of exclusion (generally 50% or 75%) for QSBS issued prior to September 28, 2010. The amount of gain that is not excluded is generally taxed at a 28% rate and is also subject to the NIIT. The excluded portion of any gain is treated as a preference item for AMT purposes.

Table 1 summarizes the applicable effective federal tax rates on gain from the sale of eligible QSBS, depending on the date on which the QSBS was originally issued.

Issue Date

Exclusion Percentage

Effective Maximum Federal Tax Rate

Effective Maximum Federal AMT Rate

Gain Subject to 3.8% NIIT

8/11/93 – 2/17/09





2/18/09 – 9/27/10





9/28/10 – present





The amount of gain excludable from the sale of a single corporation’s QSBS is generally limited, regardless of the exclusion percentage, to the greater of $10 million or 10 times the taxpayer's adjusted basis in the QSBS.[2] 

Rollover. Under Section 1045, if an electing stockholder holds QSBS for more than six months, sells the original QSBS in an otherwise taxable transaction, and purchases new QSBS within 60 days of the sale, such stockholder generally will recognize gain on the sale of the original QSBS only to the extent that the proceeds from the sale exceed the amount invested in the replacement QSBS (QSBS gain rollover). As a result, under these rules, if a stockholder must sell before the five-year holding period has elapsed, such stockholder could still qualify for Section 1202 gain exclusion by purchasing new QSBS. 

QSBS Eligibility Requirements

Stock of a small business may qualify as QSBS if a number of requirements are met, including:

  1. the stock is issued to a non-corporate stockholder (individual or pass-through, including an LLC taxed as a partnership or S-corporation);
  2. the small business is a domestic eligible C corporation at the time the stock is issued;[3]
  3. the stock is acquired directly from the small business at its “original issuance” in exchange for money or other property (not including stock) or as compensation for services;[4]
  4. during substantially all of the time the stockholder holds the stock, the small business is engaged in a qualified trade or business and uses 80 percent (by value) of its assets in the active conduct of one or more qualified trades or businesses (as defined below);
  5. the small business’s aggregate gross assets[5] from inception to the date the stock is issued (including proceeds received in exchange for the stock) is $50,000,000 or less;
  6. with certain de minimis exceptions, the small business has not made any repurchases of stock from any of its stockholders within the two-year period starting one year prior to the date the stock was issued; and
  7. with certain de minimis exceptions, the small business has not repurchased any stock from the taxpayer claiming the QSBS gain exclusion or related parties within the four-year period starting two years prior to the date the stock was issued.

A "qualified trade or business" is generally defined as any trade or business other than: (i) any trade or business involving the performance of services in certain fields, such as accounting, engineering, consulting, financial services, brokerage services, or any other trade or business where the principal asset is the reputation or skill of one or more of its employees; (ii) any banking, insurance, financing, leasing, investing or similar business; (iii) any farming business; (iv) any mining, oil or gas business; and (v) any business of operating a hotel, motel, restaurant, or similar business.


The provisions under Sections 1045 and 1202 can provide an excellent tax planning tool for non-corporate founders or investors forming or investing in small businesses. Assuming the rules described above are satisfied, the potential 100% capital gains exclusion along with the exclusions for NIIT and the AMT provide a significant tax incentive. Moreover, the rollover rules under Section 1045 provide flexibility in the event an investor must exit earlier than the five-year holding period.

[1] All Section references are to the Internal Revenue Code of 1986, as amended, as of October 6, 2020.

[2] For this purpose, the adjusted basis of property (other than money or stock) transferred to a corporation may equal its fair market value at the time of transfer, providing an opportunity for founders and investors who incorporate an existing business.

[3] A C corporation is a corporation taxed under Subchapter C of the Code. An eligible issuer of QSBS is a domestic C corporation that is not (i) a domestic international sales corporation (DISC) or former DISC, (ii)a regulated investment company (RIC), (iii) real estate investment trust (REIT) or real estate mortgage investment conduit (REMIC) or (iv) a cooperative, or, under prior law, a corporation with respect to which an election under Section 936 is in effect or which has a direct or indirect subsidiary with respect to which such an election is in effect. Neither an S corporation nor a partnership for tax purposes (e.g., a multi-member LLC) can issue QSBS.

[4] For purposes of the “original issuance” requirement, QSBS that is received in connection with the performance of services and subject to an election under Section 83(b) is treated as acquired on the effective date of the election.

[5] “Aggregate gross assets” means the amount of cash and the adjusted tax bases of other property held by the issuing corporation (taking into account certain attribution and look-through rules). For this purpose, the adjusted tax basis of property contributed to the issuing corporation is its fair market value at the time of contribution.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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