Deciding whether to remain in partnership or to incorporate to take advantage of QSBS in the future
Qualified Small Business Stock – Section 1202
Qualified Small Business Stock (QSBS) is one of the most advantageous provisions in the tax code. It refers to stock issued by a qualified small business that meets specific criteria outlined in section 1202 of the Internal Revenue Code. Investors who hold QSBS for more than 5 years may be able to exclude from gross income up from 100% of any capital gain realized on the sale of QSBS. The rules became more generous for stock issued after July 4, 2025, and the changes are summarized below.
What is IRC Section 1202?
Section 1202 provides the full or partial exclusion of capital gain realized on the sale of qualified small business stock (QSBS) that is held for more than 5 years. There are requirements that apply to the Company that issued the QSBS, and requirements that apply to the shareholder that is selling the QSBS. If these requirements are met, then the selling shareholder can exclude from gross income capital gain in an amount equal to the greater of (i) $10 million, or (ii) an annual exclusion of 10 times their basis in the stock sold (for an exclusion amount up to $500 million). There are also specific tax strategies, like stacking and packing, that enable selling shareholders to magnify the tax benefits.
The exact exclusion percentage depends on the date when the selling shareholder acquired the QSBS from the Company, rather than the date on which the QSBS is sold. The percentages range from 50% to 100%, with the latter applicable to QSBS acquired after September 27, 2010.
For stock issued after July 4, 2025, there are three important changes to the QSBS rules: (i) the new regime allows for a 50% exclusion after three years, a 75% exclusion after four years and a 100% exclusion after five years, (ii) the cumulative per-issuer gain limit is increased from $10 million to $15 million, indexed for inflation beginning in 2027, and (iii) the limitation ceiling on a corporation’s “aggregate gross assets” is increased from $50 million to $75 million, indexed for inflation beginning in 2027.
What Are The QSBS Requirements?
There are requirements that apply to the Company that issued the stock, and requirements that apply to the shareholder selling the stock.
- Company must be a domestic C corporation when it issued the QSBS and when the shareholder sells the QSBS.
- Company cannot be an S corporation, mutual fund, REIT, or certain other specified entities.
- Company must be engaged in one or more qualified trades or businesses (QTBs) during substantially all (generally between 70% and 90%) of the taxpayer’s holding period in the stock.
- A QTB is any trade or business except for the following:
- any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees;
- any banking, insurance, financing, leasing, investing, or similar business;
- any farming business (including the business of raising or harvesting trees);
- any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A; and
- any business of operating a hotel, motel, restaurant, or similar business.
- Company must use at least 80% of the value of its assets in the active conduct of a QTB.
- Company’s gross assets when it issues the QSBS, and immediately after, cannot be more than $50 million. For stock issued after July 4, 2025, this threshold is increased to $75 million.
- Company must not have engaged in certain redemption transactions.
- Company must not hold more than 10% of the value of its assets in (i) portfolio stock (generally 50% or less owned subsidiaries) or (ii) real estate not used in its business.
- Company must agree to submit certain information to the IRS and to its shareholders.
- Shareholder must be an individual, trust, estate, partnership, S corporation, mutual fund, or common trust fund.
- Shareholder must hold the stock continuously for more than 5 years without engaging in certain transactions that hedge or minimize the risk of owning the stock. For stock issued after July 4, 2025, the new regime allows for a 50% exclusion after three years, a 75% exclusion after four years and a 100% exclusion after five years.
- Shareholder must hold the stock continuously for more than 5 years without engaging in certain transactions that hedge or minimize the risk of owning the stock.
QSBS Quick Bites
Qualified Small Business Stock (QSBS) is one of the most advantageous provisions in the tax code. It refers to stock issued by a qualified small business that meets specific criteria outlined in Sec. 1202 of the Internal Revenue Code. Withum’s Founders and Tech Executives Services Team is here to help you and your company understand the eligibility requirements for QSBS as well as different strategies you can employ to maximize your tax savings.
Why Withum
Withum’s team is well versed in QSBS requirements and can assist your Company with understanding eligibility and its needs. Withum can help with:
Planning for founders of start-ups to ensure their stock qualifies for QSBS in the future
Assist in determining when and how to inform prospective investors if its stock is QSBS eligible
Advise shareholders that sold QSBS or are about to sell QSBS
Prepare tax returns to properly reflect an exclusion of gain under IRC Section 1202
Assist shareholders in avoiding state taxes that may apply on the sale of their QSBS
Assist shareholders that sold QSBS before the 3-, 4-, or 5-year mark with how they can engage in a “qualified rollover” transaction to preserve QSBS treatment on replacement stock
Prepare tax memos and/or financial analyses to help shareholders if audited by the IRS
Provide tax consulting around other QSBS situations
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