May 15, 2024

QSBS Exclusion – What is it?

By Wesley Brooker, Manager, Transaction Advisory Services - Tax

QSBS Exclusion – What is it? Corporate Tax

There has been a lot of discussion among business owners surrounding the benefits of Section 1202 of the Internal Revenue Code Congress. Originally enacted in 1993, Section 1202 was created to encourage investment in small businesses by providing a 50% exclusion of gain resulting from the sale of qualified small business stock (“QSBS”) held for more than five years. At the time of its enactment, the corporate tax rate was at 35%, so shareholders of small businesses often did not see the benefit of holding their business in a C corporation rather than in a flow-through entity such as an S corporation, an LLC, or a partnership.

Where owners wanted to distribute the business’ profits back in 1993, such profits were subject to a maximum corporate-level tax rate of 35% and then an individual-level tax as a dividend at the shareholders’ marginal income tax rate. Lower rates on dividends did not come into play until 2003. Compare that to a flow-through entity which is only subject to one layer of tax at the individual level the tax rate of which was comparable to the corporate tax rate. Even at the lower dividends rates, the math still didn’t work out for most small business owners to operate through a C corporation.

The decision tree got a bit more complicated, however, after the Tax Cuts and Jobs Act lowered the corporate income tax rate to 21% effective after December 31, 2017. All of a sudden, the combined tax rate of holding the business through a C corporation became much more attractive combined with the potential to exclude some or part of their gain on sale of the stock.

What follows are the benefits under Section 1202 and a high-level summary of the shareholder-level and corporate-level requirements.

Benefits of Section 1202

Section 1202 allows for an exclusion of gain realized on the sale of QSBS equal to the greater of:

  • $10 million (reduced by the aggregate gain taken into account by the taxpayer in prior years and attributable to dispositions of stock issued by the corporation), or
  • 10 times the adjusted basis of all qualified stock of the issuer.

The amount of excludable gain depends on when the QSBS was acquired, as follows:

  • 100% gain exclusion for QSBS acquired after September 27, 2010;
  • 75% gain exclusion for QSBS acquired after February 17, 2009, and before September 28, 2010; and
  • 50% gain exclusion for QSBS acquired before February 18, 2009.

Shareholder-Level Requirements

Eligible gain is excludable under Section 1202 for certain shareholders, as follows:

  • The shareholder cannot be a corporation;
  • The shareholder must be subject to U.S. federal income taxes (i.e., foreign taxpayers not subject to U.S. tax are not eligible) or is a tax-exempt (i.e., benefit plans);
  • The QSBS must be held by the shareholder for more than five years before it is disposed; and
  • The shareholder must have acquired the stock when it was originally issued on or after August 10, 1993.

There are special rules where QSBS is owned indirectly through a pass-through entity such as an S corporation, partnership or LLC. Under the rules, foreign non-corporate shareholders that are not subject to U.S. tax do not qualify. Also, shareholders do not qualify under the initial issuance rule where the stock was acquired from another shareholder; rather, the stock must be acquired directly from the corporation in exchange for either money, other property or compensation for services.

Corporate-Level Requirements

In addition to the shareholder-level requirement summarized above, there are several corporate-level requirements that must be met.

  • On the date of issuance, the issuing corporation must be a domestic C corporation (the “C Corporation Requirement”);
  • At all times before and immediately after the date of issuance, the aggregate gross assets of the corporation must not exceed $50 million (the “QSB Requirement,” see below for a further explanation);
  • The stock must be acquired directly from the issuing corporation in exchange for money, property or compensation for services provided to the corporation (the “Original Issuance Requirement,” see below for a further explanation); and
  • The corporation must be an eligible corporation, and at least 80% of the value of the assets must be used in the active conduct of one or more qualified trades or businesses for substantially all of the shareholders’ holding period (the “Active Business Requirement,” see below for a further explanation).

Each of the aforementioned requirements have either definitions or sub-requirements.

Original Issuance Requirement

Generally, the C corporation must have issued the stock to the taxpayer. This means that the stock must have been acquired from the corporation in exchange for money, property or as compensation for services to the corporation rather than purchased from another shareholder. There are exceptions to this general rule with a few of the more well-known exceptions as follows:

  • Acquiring the stock through gift or inheritance treats the shareholder receiving the stock as acquiring the stock in the same manner as the transferor;
  • Stock acquired through exercise of options or warrants; and
  • Stock acquired through distribution by a partnership provided the partner held its partnership interest when the QSBS was acquired (however, contributions of otherwise QSBS by an otherwise qualified shareholder to a partnership in a tax-free contribution immediately disqualifies the stock as QSBS).

Qualified Small Business (QSB) Requirement

A qualified small business can generally be defined as any domestic C corporation with:

  • The aggregate gross assets of the corporation at all times on or after August 10, 1993 and before the issuance of stock did not exceed $50 million; and
  • The aggregate gross assets of the corporation immediately after the issuance of stock (determined by taking into account amounts received in the issuance) did not exceed $50 million.

A corporation’s aggregate gross assets is equal to the amount of cash and adjusted tax basis of other property that it holds. If a corporation owns more than 50% of the stock of another corporation, both the parent and subsidiary are treated as one corporation for the gross asset test.

Active Business Requirement

Section 1202 defines an active business where at least 80% of the assets of the corporation are used in the active conduct of one or more qualified trade or businesses and the corporation is an eligible corporation. A qualified trade or business is generally defined as any trade or business other than:

  • 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; and
  • Any business of operating a hotel, motel, restaurant, or similar business.

An eligible corporation is generally defined as any domestic corporation that is not a DISC or former DISC, regulated investment company, real estate investment trust (REIT) or a cooperative.


As noted in the beginning, this article is only intended to be a high-level summary of the rules and benefits of Section 1202. While the rules on the surface may appear straight-forward, there are many complexities with the rules that require significant analysis based on the facts and circumstances of the shareholders and the corporation. Section 1202 offers significant benefits to those shareholders who qualify, so a thorough examination of the rules is an important step that should be undertaken before taking the exclusion.