Section 1202 “Qualified Small Business Stock”: Top 10 Planning Opportunities (and Traps for the Unwary)
- 4.15.2025
General Background
Under current U.S. federal income tax law, Section 1202 allows a non-corporate taxpayer to potentially exclude up to 100% of the amount of eligible gain realized from the sale or of “qualified small business ” (“QSBS”).1
The amount of gain that is eligible for exclusion by a taxpayer with respect to QSBS held in a particular corporation is subject to an annual limitation equal to the greater of either: (i) $10 million (reduced by the aggregate amount of eligible gain taken into account by the taxpayer in prior taxable years with respect to dispositions of QSBS of such corporation); or (ii) 10 times the aggregate adjusted bases of QSBS issued by such corporation and disposed of by the taxpayer during the taxable year.2
In order to potentially qualify for the benefits of Section 1202, a non-corporate taxpayer must acquire and hold in a qualifying “C-corporation.” The potential benefits of Section 1202 do not directly apply to equity interests acquired and held in “pass-through” entities, such as “S-corporations” or partnerships (or LLC’s taxed as partnerships). However, an individual taxpayer’s allocable share of gain attributable to a sale of QSBS by a pass-through entity may potentially qualify as gain eligible for the Section 1202 exclusion.
Furthermore, assuming a non-corporate taxpayer holds in a C-corporation (either directly or indirectly through a pass-through entity), there are four main requirements that must be satisfied before gain on the sale of is potentially eligible for the exclusion under Section 1202: (i) the must be acquired directly from the relevant corporation at the time of its “original issuance”; (ii) the issuing corporation must be a “qualified small business” (often referred to as the “$50 million aggregate adjusted tax of assets” test); (iii) the issuing corporation must satisfy the “active business requirement” during substantially all of the taxpayer’s holding period; and (iv) the taxpayer must hold the for more than five years.
Assuming an issuing corporation’s shares may potentially qualify as QSBS, there are a variety of planning opportunities and traps for the unwary that may arise at different points in time. What follows below are brief descriptions of some of the most common situations that are typically encountered and often overlooked. However, with proper advance planning, based on each taxpayer’s unique set of facts and circumstances, it may be possible to take advantage of some of these potential opportunities (while hopefully avoiding any of the pitfalls). For additional background information and further detail, including some hypothetical examples designed to illustrate certain key concepts discussed herein, see the following full-length article: Section 1202: Qualified Small Business Stock (April 15, 2025).
Top 10 Planning Opportunities (and Traps for the Unwary)
1. Potential Funding May Exceed $50 Million (Potential Trap)
Pursuant to Section 1202(d)(1)(B), the aggregate gross assets of a corporation are tested “immediately after” the relevant issuance (taking into account amounts received in the issuance). In some situations, a potential investment arrangement may contemplate additional funding that could, under certain circumstances, ultimately exceed the $50 million threshold, even though the $50 million threshold will not be exceeded initially. In these cases, a conservative reading of the statute in light of the potential application of the “step-transaction doctrine”3 would suggest that the specific facts and circumstances must be carefully evaluated in order to determine whether the “immediately after” requirement will be satisfied.
2. Low Tax In Assets Relative to Equity Value (Potential Opportunity)
Pursuant to the statutory language of Section 1202(d)(2)(A), the term “aggregate gross assets” generally means the amount of cash and the aggregate adjusted tax of any other pre-existing property already held by the corporation. In the case of property that is newly contributed to a corporation, the current fair market value of such property must be used as its adjusted tax in accordance with Section 1202(d)(2)(B). In addition, for purposes of these rules, it should be noted that the concept of “aggregate gross assets” does not generally depend upon, or necessarily correlate to, either the pre-money or post-money equity valuation of a corporation. As a result, in certain situations where a corporation has a relatively low aggregate adjusted tax in its assets, as compared with the current fair market value of the corporation’s outstanding equity, a new investor may be able to obtain the benefits of Section 1202 even though both the pre-money and post-money equity value of the corporation is in excess of $50 million.4
3. Parent-Subsidiary Aggregation Rules (Potential Trap)
For purposes of the aggregate gross asset test of Section 1202(d)(1), certain aggregation rules under Section 1202(d)(3)(A) provide that corporations that are part of a “parent-subsidiary controlled group” shall be treated as one corporation. In turn, Section 1202(d)(3)(B) defines a “parent-subsidiary controlled group” as any controlled group of corporations as defined under Section 1563(a)(1) (except that “more than 50%” shall be substituted for “at least 80%” in each place where it appears and Section 1563(a)(4) shall not apply). As a result of these relatively complex rules (which may, for example, attribute held by a partnership to a corporate partner), a corporation that does not undertake to inquire as to any upper-tier ownership structures, or that fails to inquire as to any potential relationships that may exist as between different shareholders, may be unexpectedly disqualified from Section 1202.
4. QSBS Subsequently Transferred to a Partnership (Potential Trap)
In general, pursuant to Section 1202(g)(2), held by a partnership may potentially qualify as QSBS if, among other things, the is QSBS in the hands of the partnership (determined by treating such partnership as though it was an individual). As a result, a partnership, like an individual, must acquire at “original issuance” within the meaning of Section 1202(c)(1)(B), such that qualifying QSBS which is subsequently transferred to a partnership becomes “tainted” and can no longer qualify.5 This rule often serves as a significant trap for the unwary, particularly in a case where a group of individual shareholders that each hold QSBS may want to consolidate ownership and control within an upper-tier partnership (or LLC taxable as a partnership), or would like to rollover QSBS to an acquiring partnership (or LLC taxable as a partnership), in connection with a new investment being made by an unrelated shareholder.
5. Holding Companies (Potential Opportunity or Trap)
It is clear that Section 1202 generally contemplates the potential use of a “holding company” type structure, such that shareholders of a holding company may receive QSBS that qualifies for the benefits of Section 1202.6 However, taxpayers should generally exercise caution in a situation where the use of a particular holding company structure may potentially subvert an otherwise operative provision of Section 1202 or a clear policy imperative, such that a transaction may, for example, be subjected to challenge under Section 7701(o) (which clarifies the “economic substance doctrine”) or perhaps the judicial “substance over form doctrine.”7
6. Held In S-Corporations (Potential Trap)
In general, for purposes of Section 1202, if a taxpayer acquires in a corporation that has a valid “S” election in effect pursuant to Section 1362(a), it seems clear that such cannot qualify as QSBS. Such cannot qualify as QSBS because Sections 1202(c)(1) and (c)(1)(A), when read together, generally state that QSBS means “any in a C corporation” which is originally issued after the date of enactment of the Reconciliation Act of 1993 (August 10, 1993) if, as of the date of issuance, such corporation is a “qualified small business” (as defined in Section 1202(d)). In turn, Section 1202(d)(1) defines a “qualified small business” as any domestic corporation “which is a C corporation…” With respect to an S-corporation that subsequently revokes its S-election and converts to C-corporation, it also seems clear that subsequent issuances by the new C-corporation may potentially qualify as QSBS (i.e., there is no general prohibition with respect to issuances by former S-corporations).
7. Partnership Incorporations (Potential Opportunity)
Section 1202(i)(1) provides that when a taxpayer transfers property (other than money or ) to a corporation in for in such corporation, such : (i) shall be treated as having been acquired by the taxpayer on the date of such ; and (ii) the of such in the hands of the taxpayer shall in no event be less than the fair market value of the property exchanged. This “fair market value” rule is designed to prevent holders from using Section 1202 to exclude pre-contribution gain from income.8
As a result, Section 1202(i) operating in tandem with the greater of $10 million or 10 times aggregate adjusted provisions of Section 1202(b)(1), may have the effect of creating a substantial amount of excludable eligible gain for taxpayers that incorporate a partnership by transferring their interests in the partnership (or possibly the partnership’s property) to a newly formed corporation in for QSBS.9
8. Primary Issuance Followed by a (Potential Trap)
If some of the proceeds of a new funding round will be used to provide to pre-existing shareholders by undertaking a primary issuance followed by a , then the rules under Section 1202(c)(3) should be carefully evaluated in order to determine their potential impact upon any prior, current, or future share issuances.10
9. Secondary Sale Followed by a (Potential Opportunity)
As compared with a primary issuance followed by a , sometimes a secondary purchase will be followed by a of the purchased shares in a transaction treated as a under Section 368(a)(1)(E). In such a case, the form chosen by the parties does not involve a and so the rules under Section 1202(c)(3) would not appear to potentially apply, absent a possible assertion by the IRS that a fictional “deemed ” may have somehow occurred. However, notwithstanding the fact that the IRS could conceivably attempt to challenge the actual form chosen by the parties based on one or more broad judicial doctrines (such as the “step-transaction” or “substance over form” doctrines), there is strong authority that could potentially be relied upon to prevent the IRS from trying to “invent” a deemed that never occurred.11
10. Use of Reorganization to Satisfy 5-Year Holding Period (Potential Opportunity)
In a case where a target shareholder has not yet satisfied the five-year holding period requirement of Section 1202(b)(2), it may be possible to structure the terms of an acquisition transaction as a non-taxable under either Section 368 or Section 351, such that the shareholder can use the provisions of Section 1202(h)(4) to effectively “rollover” any potential QSBS benefits and pre-acquisition holding period into shares of the acquiring corporation.
1 All “Section” references are to the U.S. Internal Code of 1986, as amended, or applicable Treasury Regulations promulgated thereunder. It should also be noted that the state and local income tax treatment of QSBS varies by jurisdiction. For prior coverage of the potential state income tax consequences associated with a disposition of QSBS, see: State Taxation of QSBS (June 14, 2023).
2 For example, if an individual held so-called “founder shares” with a tax of zero ($0), the potential QSBS exclusion would be up $10 million. By comparison, if an individual paid $5 million in cash for QSBS, the potential QSBS exclusion would be up to $50 million.
3 In general, the judicially created “step-transaction doctrine” permits a series of formally separate steps to be potentially collapsed and treated as a single transaction if the steps are, in substance, integrated, interdependent, and focused toward a particular result. See, e.g., Penrod v. Comm’r, 88 T.C. 1415, 1428 (1987).
4 For purposes of determining the aggregate adjusted tax of a corporation’s assets, care should be taken to account for the recent changes under Section 174 which may require the of certain research and experimental expenditures for tax years beginning after December 31, 2021.
5 See generally, Treas. Reg. § 1.1045-1(i), Example 12 (QSBS originally acquired by an individual and subsequently transferred to a partnership does not qualify as QSBS in the hands of the partnership).
6 See generally, Section 1202(e)(5) (allowing a “look-through” rule for purposes of satisfying the “active business requirement” of Section 1202(e) in the case of an issuing corporation that owns more than 50% of a subsidiary corporation, as determined by vote or value).
7 See generally, Gregory v. Helvering, 293 U.S. 465, 469-470 (1935) (“The substance over form doctrine applies when the transaction on its face lies outside the plain intent of the statute and respecting the transaction would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.”).
8 See generally, House Report No. 2264, at p. 603 (1993).
9 For example, if a taxpayer transferred a partnership interest (or partnership property) worth $10 million and with a zero ($0) tax in for of a newly-formed C-corporation that was QSBS eligible, the received may potentially enable the taxpayer to obtain up to a $100 million dollar exclusion under Section 1202 for any amount of gain realized above the initial built-in gain of $10 million.
10 See generally, Sections 1202(c)(3)(A) and (B) containing rules relating to from either a taxpayer or a related person (over a specified 4-year period) and so-called “significant ” (over a specified 2-year period), respectively.
11 See, e.g., Esmark v. Comm’r, 90 T.C. 171 (1988), aff’d per unpublished order, 866 F.2d 1318 (7th Cir. 1989); Tracinda Corp. v. Comm’r, 111 T.C. 315 (1998).
