Qualified Small Business Stock (QSBS) Section 1202 Exclusion

If you’ve ever sat down on a Sunday afternoon to read the tax code, you’re probably familiar with section 1202. If you haven’t, you’ll want to keep reading for a brief overview of how this mere footnote can leave a big footprint on the tax burdens of small business investors. 

Section 1202 is the partial exclusion for gains from qualified small business stock. 

What is Qualified Small Business Stock?

Qualified Small Business Stock (QSBS), sometimes referred to as “section 1202 stock,” is an internal revenue code (IRC) exclusion that can eliminate capital gains tax for long-term investors and other shareholders of qualified small businesses. 

Certain businesses are not eligible for QSB status and in order to qualify, the business must be a domestic C corp and gross assets must never have exceeded $50 million in value after the passing of the Revenue Reconciliation act of 1993.

The partiality of the exclusion has changed significantly over time and stock acquired today will be eligible for 100% tax-exemption in five years — section 1202 should be renamed, “Whole exclusion for gains from qualified small business stock.” 

Here’s an overview of how this section of the tax code has evolved:

Qualified Small Business Stock Requirements

In order to qualify for the tax exemption of section 1202, the business and investors must meet certain requirements. 

Small Business

We’ve mentioned this already but it’s worth reiterating that the business must be incorporated as a C corp, and not another structure. Some industries, sectors, or businesses are not eligible for QSB status, including: 

• Trade or businesses performing services (health, law, accounting, consulting, financial services, brokerage services, performing arts, etc.)
• Banking, insurance, financing, leasing, investing
• Farming
• Hotels, Restaurants, or similar services

This doesn’t mean you can simply incorporate and then five years from now write off 100% of your gains. The business must meet certain operating requirements as an active business for the entire duration of the taxpayer’s five years or more holding period. 

An active business is one in which 80 percent or more of the assets are deployed in the day-to-day operations or research and development. 

Investors

The investors too must meet certain requirements to be eligible for the QSBS tax exemption. For one thing, the stock must have been acquired at its issuance and in exchange for cash, property, or services rendered.

The investor must be an individual shareholder, not an institutional investor unless a qualified specialized small business investment company.

Time-horizon is also a requirement for QSBS because the exemption does not go into effect until five years after the stock is issued. 

What QSBS Means for You

If you’re an individual investor, finding eligible small business investments that qualify can certainly offset future tax burdens. If you’re considering investing in a qualified small business stock offering, you should be extremely thoughtful about the strategy and stick to the plan. 

If the company could grow in much greater excess of $50 million in value, you don’t want the situation where growth is being stifled to avoid disqualification, only to ultimately make the decision to grow outside the QSBS realm, and risk having purposely stunted the company’s growth. 

Either way, it’s worth modeling how much a QSBS return would be projected after tax and find the equivalent breakeven point in an investment that doesn ot qualify as a small business stock, and would therefore be taxed at the normal rate. Ultimately, a QSBS is an amazing section of the tax code for investors and entrepreneurs, but can also place a cap on your potential upside.