what is section 1202 stock: QSBS explained

Section 1202 stock (Qualified Small Business Stock, QSBS)

If you’re asking what is section 1202 stock, this article gives a practical, detailed guide to Qualified Small Business Stock (QSBS) under Internal Revenue Code §1202 — what qualifies, the tax benefits, key rules, common pitfalls, and planning considerations for founders, investors and employees. You’ll learn the issuer and holder requirements, holding‑period rules and tacking, how exclusion limits work, interactions with AMT, NIIT and Section 1045 rollovers, and documentation best practices. The article also cites practitioner reporting as of mid‑2024 to frame recent interpretive and legislative context.

As of 2024-06-01, according to practitioner alerts from WilmerHale and Wilson Sonsini, QSBS remains a high-value tax incentive for qualifying C corporations and their non‑corporate shareholders but is governed by technical rules that benefit from careful structuring and documentation.

Quick answer: what is section 1202 stock? It is stock of a domestic C corporation that meets statutory small business and active trade or business tests at issuance and during a required holding period; eligible non‑corporate taxpayers can exclude a significant portion (up to 100% in many cases) of the gain on sale, subject to per‑issuer caps and other limits.

Overview and purpose

What is section 1202 stock in policy terms? IRC §1202 was adopted to encourage investment into small businesses and startups by providing a favorable capital‑gains exclusion for qualifying stock held by non‑corporate taxpayers. The principal taxpayer benefit is a partial or full exclusion of gain on sale of qualifying C‑corporation stock that meets the statutory requirements and the required holding period. Historically, exclusion percentages and related limits have changed over time; today, in many cases, eligible taxpayers can exclude 100% of qualifying gain, subject to per‑issuer caps and other limitations.

This incentive is aimed at facilitating venture capital and founder investment into early‑stage companies, increasing risk capital availability for job‑creating enterprises.

Key benefits

• Exclusion percentage: For many qualifying QSBS holdings, taxpayers may exclude up to 100% of the gain recognized on sale, depending on the date the stock was issued and applicable transitional rules. Historically, tiers of exclusion (50%, 75%, 100%) have applied to different issuance dates; consult current guidance for precise application to a given issuance.
• Per‑issuer cap: The exclusion is generally subject to a per‑taxpayer-per‑issuer limit equal to the greater of $10 million (historically) or 10 times the taxpayer’s basis in the QSBS sold. Practitioner summaries note that the statutory $10 million cap has been the anchor for many planning strategies.
• Interaction with AMT and NIIT: Excluded gain under §1202 may have special treatment for Alternative Minimum Tax (AMT) and the Net Investment Income Tax (NIIT) depending on issuance date and later guidance. Certain QSBS exclusions historically did not trigger AMT adjustments, but taxpayers should verify current status for their stock.
• Section 1045 rollover: For qualifying taxpayers who sell QSBS before satisfying the holding period, Section 1045 can allow deferral of gain if replacement QSBS is purchased within the statutory 60‑day window and other conditions are met.

Practical effect: For qualifying dispositions, QSBS can substantially reduce or eliminate federal capital gains tax liability on large gains, making it a central consideration in early‑stage company exits and investor planning.

Legislative and regulatory history (high level)

• Enactment and evolution: §1202 was enacted in 1993 and has undergone changes in exclusion percentages and application through subsequent legislation and guidance.
• Tiered exclusions: Over time, statutory provisions have provided differing exclusion percentages tied to the date of issuance (e.g., 50%, 75%, 100% at various times). Practitioners track these dates carefully to determine applicable relief for a given issuance.
• Recent practitioner context: As of 2024-06-01, practitioner firms including WilmerHale, Wilson Sonsini, Holland & Knight and BDO have published client alerts and guidance summaries highlighting that QSBS remains valuable but technical; such sources note that changes in tax legislation and IRS guidance can affect available treatment for later issuances. Readers should consult the cited practitioner analyses and an experienced tax advisor for current specifics.

Eligibility requirements (high level)

Both issuer (corporate) and holder (shareholder) requirements must be satisfied for stock to qualify as QSBS. An otherwise eligible sale may be disqualified if either side fails to meet the rules during the critical tests at issuance and, in many cases, during the holding period.

Issuer (corporation) requirements

Key issuer tests for QSBS at the time of issuance:

• Domestic C corporation: The issuer must be a domestic C corporation when the stock is issued. S corporations, LLC interests, and other pass‑through entity interests generally do not qualify as QSBS.
• Gross assets test: Aggregate gross assets of the corporation (including amounts received for property contributed in exchange for stock) must not exceed $50 million immediately before and immediately after the issuance of the stock. The measurement uses the fair market value of contributed property and cash received for issued stock.
• Active business requirement: At least 80% (by value) of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses for the requisite testing period. Passive investment companies or holding companies that do not meet this test are generally ineligible.
• Excluded business activities: Certain service, finance, and investment businesses are excluded from QSBS treatment. Typical exclusions include banking, insurance, finance, investment management, professional services (law, health, consulting), farming, and extraction of natural resources. The statute and guidance list disallowed activities; careful factual analysis is required.

Note: Subsequent growth after issuance generally does not retroactively disqualify previously issued QSBS if the issuer met the gross asset and active business tests at issuance.

Shareholder / acquisition requirements

Who can claim the §1202 exclusion?

• Eligible holders: Non‑corporate taxpayers such as individuals, estates, and certain trusts can claim the exclusion. Some passthrough entities may pass through benefits to their owners subject to entity‑level rules.
• Original issuance: The taxpayer must generally acquire the stock at original issuance (directly from the corporation) in exchange for money, property (other than stock), or as compensation for services rendered to the corporation. Secondary market purchases generally do not qualify.
• Options, warrants, conversions: Special rules apply to stock acquired upon exercise of options or conversion of convertible instruments; the key inquiry is whether the acquisition can be traced to original issuance and whether the stock is treated as acquired at issuance for §1202 purposes.
• Transfers: Gifts, bequests and certain transfers can preserve QSBS status for the recipient, often allowing tacking of holding periods.

Holding period, tacking, and tiers

• Minimum holding period: A statutory holding period must be met to obtain the §1202 exclusion (commonly five years for many issuances). Holding-period tacking rules can allow recipients of gifted or inherited QSBS, or certain partnership distributions, to use the transferor’s holding period for §1202 purposes.
• Tacking: The holding period of the prior owner may be tacked to the transferee in cases of gifts, bequests, certain partnership distributions, and other specified transfers. For example, if a founder gifts QSBS to a family member who later sells, the donee can often count the founder’s holding period toward the five‑year requirement.
• Tiered holding periods: In past legislative contexts, different holding‑period rules and exclusion percentages applied to stock issued on different dates. Practitioners continue to monitor whether any new legislative changes create tiered regimes for post‑issuance dates; check current guidance for stock issued after key statutory cutoffs.

Amount of exclusion and limits

Two principal numerical measures limit the amount of gain that may be excluded under §1202 for each issuing corporation:

1. Per‑taxpayer per‑issuer cap: Historically, the exclusion was limited to the greater of $10 million or 10 times the taxpayer’s aggregate adjusted basis in the QSBS sold. The $10 million figure is a common planning anchor in practitioner guidance.
2. 10× basis test: Alternatively, a cap computed as 10 times the adjusted basis of the QSBS sold may provide a larger exclusion for small‑basis founders or early investors.

Other practical points:

• Application per issuer: The cap applies per issuing corporation and per taxpayer, which makes family gifting and other distribution strategies a focus of planning to multiply the $10 million caps among family members.
• Previously used exclusions: If a taxpayer previously used QSBS exclusions for the same issuer, that usage reduces the remaining exclusion available for future sales of QSBS from that issuer.

Interaction with other tax rules

Alternative Minimum Tax (AMT) and NIIT

• AMT: Historically, some QSBS exclusions did not produce AMT preference items, but the AMT treatment can depend on issuance date and later regulatory changes. Practitioners advise checking current IRS guidance and tax law to confirm whether the excluded gain is treated as an AMT preference item for the stock in question.
• NIIT: The Net Investment Income Tax (3.8%) may still apply in some cases to gains associated with QSBS depending on whether the gain is excluded for regular tax purposes and on the taxpayer’s status. Careful coordination with AMT and NIIT rules is necessary for exit planning.

Section 1045 rollover

Section 1045 allows certain taxpayers to defer recognition of gain from a QSBS sale by purchasing replacement QSBS within 60 days of the sale. Key points:

• Minimum prior holding: The original QSBS must generally have been held for more than six months to qualify for 1045 rollover treatment.
• Replacement QSBS: The replacement stock must itself qualify as QSBS, and the deferral generally preserves the tax attributes under specific rollover mechanics.
• Practical use: Section 1045 can be used when an investor wishes to swap from one QSBS investment to another while deferring gain recognition, but the 60‑day window and qualification tests require prompt action and documentation.

Transfers, conversions, and special transactions

Gifts, bequests, and inherited stock

Gifts and inheritances commonly preserve QSBS benefits:

• Tacking: Recipients of gifts and bequests usually can tack the donor’s or decedent’s holding period, which can be particularly useful to accelerate satisfaction of the five‑year holding requirement.
• Basis issues: For gifts, the recipient takes the donor’s basis (with potential gift‑tax adjustments); for inherited stock, the recipient generally receives a stepped‑up basis to fair market value at death, which affects the 10×‑basis test and overall exclusion calculations.

Partnership and pass‑through rules

QSBS held by partnerships, LLCs taxed as partnerships, or S corporations raises allocation and tracing issues:

• Flow‑through: Partners or S‑corporation shareholders may be able to claim QSBS benefits to the extent the underlying interest qualifies and the shares can be traced to original issuance.
• Documentation and allocations: Accurate partnership records, K‑1 reporting and legal analysis are required to ensure that partners can establish their QSBS acquisition dates, basis, and percentage allocations.

Stock conversions and reorganizations

Changes in form of stock or reorganizations may preserve QSBS status if the transaction qualifies as a tax‑free reorganization or if statutory tacking rules apply. Generally, converted or reclassified stock will retain QSBS status and tacked holding periods where the transaction is treated as a continuation of the original issuance for tax purposes.

Transfers that can disqualify QSBS (redemptions and buybacks)

Certain issuer transactions can disqualify QSBS treatment:

• Redemption rules: Significant redemptions (issuer repurchases) near the time of issuance can be treated as equivalent to a sale to the issuer and may disqualify the original issuance.
• Constructive purchases: Transactions that, when viewed economically, are issuer purchases or restructure ownership to avoid the original issuance rules can disqualify QSBS.

Valuation and the $50 million gross assets test

• Measurement: The gross assets test uses the fair market value of cash and contributed property to determine whether aggregate gross assets exceed $50 million immediately before and immediately after issuance. For property contributed to the corporation in exchange for stock, practitioners commonly rely on reasonable valuations with supporting documentation.
• Timing: Only the company’s asset level at issuance matters for initial qualification; later growth above $50 million typically does not retroactively disqualify previously issued QSBS.
• Practical valuation issues: Companies and advisors commonly document board minutes, valuation methods, capital table entries, and third‑party valuations where appropriate to support the gross assets computation should IRS inquiry arise.

Documentation, compliance, and practical considerations

Good records help preserve QSBS treatment and support claims on audit. Recommended documentation includes:

• Board and shareholder minutes approving issuances and describing consideration received;
• Capitalization table documenting share classes, original issuances, and transfers;
• Financing and subscription agreements showing amounts received at issuance;
• Valuations or contemporaneous support for property contributed to the corporation in exchange for stock;
• Evidence that the corporation met the active business test (financial statements, descriptions of operations, payroll/expense records showing active business use of assets);
• Legal opinions and tax memoranda when material amounts of potential exclusion are at stake.

Tax and legal teams frequently prepare QSBS due diligence reports, especially in the context of venture financings and exit negotiations.

Common pitfalls and planning traps

• Secondary market purchases: Buying stock on a secondary market typically does not qualify as original issuance and thus fails the basic §1202 acquisition requirement.
• Improper redemptions: Early issuer repurchases or certain structured transactions can invalidate QSBS status.
• Excessive passive assets: Failing the 80% active business test due to high passive asset levels can disqualify the issuer.
• Hedging and derivatives: Using hedging arrangements tied to QSBS can undermine non‑corporate taxpayer treatment and may be treated as constructive sales.
• Options timing and exercise: Improper structuring of option grants or delayed exercise can prevent stock from being treated as acquired at original issuance for QSBS purposes.
• Insufficient documentation: Failure to retain contemporaneous evidence of issuance terms, asset valuations, and active business usage makes it difficult to support QSBS claims on audit.

Defensive strategies include obtaining tax opinions, securing clear documentation at the time of issuance, and planning equity structures and option exercises to preserve original issuance tracing.

Examples and illustrative scenarios

1. Founder sale after holding period

• Scenario: A founder holds original issuance common stock that qualifies as QSBS for more than five years and sells in a liquidity event.
• Result: If issuer and holder tests are met, the founder may exclude a significant portion (potentially up to 100% under applicable rules) of the capital gain associated with the sale, subject to the per‑issuer cap and 10×‑basis rule.

1. Investor selling before five years and using Section 1045

• Scenario: An early investor sells QSBS after two years and wants to defer gain.
• Result: If the investor acquires replacement QSBS within 60 days and the original stock was held more than six months, Section 1045 may allow deferral of recognition by rolling into replacement QSBS.

1. Gifting QSBS to family members to multiply exclusions

• Scenario: A shareholder gifts QSBS to immediate family members before an exit where each recipient qualifies and can tack the donor’s holding period.
• Result: By distributing ownership across multiple taxpayers, a family can potentially multiply the per‑issuer $10 million caps (subject to gift tax and other considerations), increasing total excluded gain across the family group.

These simplified scenarios illustrate mechanics, not tax advice; real‑world outcomes depend on specific facts, issuance dates, and current law.

Policy considerations and criticisms

• Policy goals: QSBS encourages risk capital investment in small businesses and startups by offering tax incentives that reduce the effective cost of capital for founders and early investors.
• Criticisms: The regime is technical and administratively complex, which can produce compliance burdens and planning advantages for sophisticated taxpayers. Critics also note potential inequities between founders/investors who can access QSBS versus workers or investors in non‑qualifying entities, and revenue cost to the tax base.

Frequently asked questions (FAQ)

Q: Can QSBS apply to stock bought on the secondary market?

A: Generally no. To qualify, a taxpayer typically must acquire QSBS at original issuance directly from the corporation in exchange for money, property (other than stock), or services. Secondary market purchases usually fail the original issuance requirement and do not qualify.

Q: Does an S corporation or LLC interest qualify as QSBS?

A: No. QSBS applies to stock of a domestic C corporation. Interests in S corporations, LLC membership interests, and partnership interests are not QSBS.

Q: How is the $50 million gross assets test measured?

A: The $50 million threshold is measured using the fair market value of cash and property held by the corporation immediately before and immediately after issuance. Property contributed to the corporation in exchange for stock is included at fair market value at contribution.

Q: What happens if the company later converts to an S corporation?

A: Later conversion to S status generally does not retroactively disqualify stock that met QSBS tests at original issuance while the issuer was a C corporation. However, conversions can affect future issuances and other tax consequences. Always consult advisers when corporate form changes are contemplated.

Q: Is QSBS relief automatic?

A: No. The burden is on the taxpayer to establish qualification through documentation, and QSBS treatment can be lost if requirements are not met. Taxpayers commonly obtain tax opinions and maintain contemporaneous records.

See also

• IRC §1202
• IRC §1045
• Qualified small business
• Capital gains tax
• Alternative Minimum Tax (AMT)
• Net Investment Income Tax (NIIT)
• C corporation vs S corporation
• Startup tax planning

References and further reading

This article summarizes statutory rules, IRS guidance and practitioner analyses. For deeper, issuer‑ or transaction‑specific guidance consult primary sources and qualified tax counsel. Representative practitioner sources and alerts used to inform this article include WilmerHale, Wilson Sonsini, Holland & Knight, Withum, KSM (Katten? KSM refers to KSM??), BDO, Winstead, JD Supra, Mondaq, and Cummings & Cummings. As of 2024-06-01, these firms continue to publish client alerts and memoranda on QSBS developments; readers should consult the latest practitioner and IRS publications.

Notes and cautions for readers

• The rules governing what is section 1202 stock are technical and time‑sensitive. Statutory changes, Treasury/IRS guidance, and court decisions can affect how the rules apply to a particular issuance.
• This article provides general information and illustrative examples. It does not constitute tax advice. For transaction‑specific planning, consult a qualified tax advisor and legal counsel.

Next steps and Bitget resources

If you found this guide useful and you manage digital assets or want a secure place to store related documentation for your tax and legal records, consider using Bitget Wallet for custody and Bitget for your crypto needs. For legal or tax advice about what is section 1202 stock and how it might apply to your situation, contact a qualified tax professional.

Further exploration: Keep a folder with issuance documents, cap table snapshots, board minutes and valuation support; these items can be critical if you or your counsel need to substantiate QSBS treatment at sale.