November 14, 2024

Section 1202 of the Internal Revenue Code offers significant tax incentives for investors in qualifying small businesses. Assuming the qualifications are met, Section 1202 excludes up to 100% of the gain realized on the sale or exchange of Qualified Small Business Stock ("QSBS") issued after 2010.^[1] The total exclusion amount is subject to specific limitations, with the maximum exclusion generally set at the greater of: (A) $10,000,000, or ten times (10x) the taxpayer's basis in the QSBS.^[2] To qualify for the benefits under Section 1202, the stock must meet several criteria, including:

1. Original Issuance by a C Corporation in Exchange for Cash, Property or Services. The stock must be acquired directly from a C corporation.^[3] Stock issued by an S corporation or acquired by indirectly by purchase from an existing shareholder can never qualify as QSBS; however, QSBS transferred upon the death of the stockholder or transferred as a gift during the stockholder's life retains its status as QSBS in the hands of the recipient.  QSBS must be issued in exchange for cash consideration, the contribution of property or the performance of services, which should be memorialized in writing at the time of issuance. QSBS can be voting or nonvoting common or preferred stock.  Nonvested stock (subject to substantial risk of forfeiture under Section 83) is not treated as "stock" until it vests unless the recipient makes a timely Section 83(b) election.
2. Issuing Corporation Must Remain a C Corporation. The issuing corporation must remain a C corporation during "substantially all" of the shareholder's holding period and must be a C corporation when the QSBS is sold.^[4]  Any time during which the issuing corporation has an S election in effect counts against satisfying this "substantially all" requirement.
3. Five-Year Holding Period. To be eligible for gain exclusion under Section 1202, the taxpayer must hold the QSBS for more than five (5) years.^[5] The holding period for QSBS typically commences on the date of issuance.  If stock is unvested under Section 83, the holding period commences when the stock vests (or upon issuance if a Section 83(b) election is timely made).  QSBS can also be exchanged for QSBS or non-QSBS as part of a Section 351 nonrecognition exchange or in Section 368 tax-free reorganization and retain its holding period.
4. Qualifying Small Business. The issuing corporation must be a "qualifying small business" at the time of issuance.^[6] A qualifying small business is a domestic C corporation with gross assets not exceeding $50 million before and immediately after the stock issuance.^[7] A qualifying trade or business means any trade or business other than: (A) 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 one or more of its employees; (B) any banking, insurance, financing, leasing, investing, or similar business; (C) any farming business (including the business of raising or harvesting trees); (D) any business involving the production or extraction of oil, gas or minerals; or (E) any business of operating a hotel, motel, restaurant, or similar business.^[8]
5. QSBS Must Be Sold (Not the Underlying Business Assets). To take advantage of Section 1202's gain exclusion, shareholders must sell or dispose of the QSBS (e.g., a stock transaction aor redemption). A sale of the underlying assets of the corporation will not qualify.

Under current law, when considering starting a new business venture, Section 1202 offers significant incentives to conduct business as a C corporation. For C corporations already in business, it is worth reviewing the operational history of the business to see if the shareholders could qualify for Section 1202 treatment prior to engaging in any exit transactions with respect to the business.