Introduction
Internal Revenue Code Section 1202 is a tax code provision that allows for an exclusion of 50% to 100% of capital gain from a sale of qualified small business stock (QSBS). There are a significant number of requirements to qualify, so it is imperative to do careful planning as soon as possible if the taxpayer wants to consider this exclusion as an option.
The exclusion is tiered from 50% of the gain to 100% of the gain, with the maximum exclusion for each qualified shareholder of $10 million or 10 times the shareholder’s basis in the stock, whichever is greater (for any stock acquired after July 2025, this threshold has increased to $15 million).
- Stock issued and acquired after September 27, 2010 is eligible for 100% exclusion.
- Stock issued after February 17, 2009 and before September 28, 2010 is eligible for 75% exclusion.
- Stock issued after August 10, 1993 but before February 18, 2009 is eligible for 50% exclusion.
Note: To receive the full exclusion for each issued date range above, the QSBS must be held for five years. However, as provided in the One Big Beautiful Bill Act (OBBBA) passed in July 2025, §1202 stockholders may receive a reduced benefit for stock held as little as three years in a tiered benefit for any stock acquired after July 2025. QSBS held for at least three years now receives a 50% exclusion, and QSBS held for four years now receives a 75% exclusion. Any includable gain sold after three or four years is taxed at 28%.
What Is QSBS?
There is an extensive list of requirements to qualify for the benefit as noted in §1202, some of which include the following:
- The company that has issued the stock must be a domestic C corporation.
- The company must be deemed a “qualified trade or business.”
- any trade or business other than: 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 one 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 for depletion, and any business of operating a hotel, motel, restaurant, or similar business.
- The company must be an eligible corporation.
- The company must be considered a “qualified small business,” meaning gross assets are less than $75 million or $50 million for stock issued before July 2025. (This figure was $50 million prior to the OBBBA but was increased as a result of the legislation.)
- The stock of the company must have been issued after August 10, 1993.
- At least 80% of the company’s assets must be used in the active conduct of a qualified trade or business.
- Less than 10% of the company’s assets consist of real estate not used in the active conduct of a qualified trade or business.
- Less than 10% of the total value of the corporation’s assets consist of (or have ever consisted of) stock or marketable securities.
- Certain redemptions of stock have not been made.
Note that the list above is not an exhaustive list.
QSBS & Stock Options
Individuals with stock options in closely held companies should evaluate the granted options’ status as QSBS to receive preferential gain treatment.
- Three-to-Five-Year Holding Requirement: The three-to-five-year holding period could often be overlooked as it relates to stock options. The three-to-five-year clock only begins after exercise of the option into stock of the issuing corporation. A taxpayer could consider exercising the options earlier than they normally would to get the three-to-five-year holding period started and should weigh the immediate income tax impact of doing so with a trusted tax advisor.
- $50 Million/$75 Million Gross Asset Test: Each exercised option is subject to its own $50 million/$75 million gross assets test in addition to the five-year holding requirement.
Permissible Transfers
QSBS has an original issuance requirement; the taxpayer generally must receive the QSBS directly from the issuing corporation.
There are several exceptions:
- Receiving QSBS via testamentary transfers
- Receiving QSBS via gift
- Receiving QSBS partner distributions: if a partner receives QSBS as a transfer by distribution from a partnership whereby the partnership received the stock upon original issuance, the stock will still meet the original issuance requirement in the hands of the receiving partner.
QSBS & Trusts
Due to the $10 million/10x basis ($15 million/10x basis for stock issued after 2025) limitation on gain exclusion per taxpayer, using a nongrantor trust is an effective way to expand the benefit. This technique is referred to as “stacking.” Taxpayers should consider creating one, if not multiple1 nongrantor trusts for the benefit of children or other beneficiaries, and gift QSBS shares to the trust. Practitioners should weigh the pros and cons of using a grantor trust versus a nongrantor trust.
IRC §1045
If a shareholder of QSBS owns the stock for more than six months but for less than the amount of time required to receive gain exclusion (five years), they may reinvest or “rollover” the proceeds (via purchase) into new QSBS. The main difference is that this provides for a gain deferral rather than a gain exclusion.
Importantly, §1045 only provides for a 60-day reinvestment or rollover period, so prompt planning is essential.
If §1045 replacement QSBS is held for five years, and all other §1202 requirements are met, the full §1202 exclusion can be claimed on the replacement property, making a §1045 rollover extremely attractive for taxpayers.
Due to the §1202 expansions in the OBBBA, particularly around the holding period, the continued applicability of §1045 rollovers remains to be seen.
Current Guidance
PLR 202114002 – favorable for the taxpayer. The ruling concluded that a company in the business of finding insurance for its customers was not in the brokerage business and thus, an eligible trade or business for §1202 purposes.
CCA202204007 – unfavorable ruling for the taxpayer. The ruling concluded that a company in the business of identifying and connecting those in the market for new leases, either as a lessor or lessee, was in the brokerage business and thus, not an eligible trade or business for §1202 purposes and not eligible for any future exclusion.
Conclusion
Planners looking to boost client value should be well versed in §1202 and consider this code section as an opportunity to provide tax savings to a client. Reach out to your Forvis Mazars Private Client representative to learn more.
- 1 Planners may want to consider code §643(f) and consider that if multiple trusts have similar terms, they may be collapsed into one.
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