Section 1202 of the Internal Revenue Code permits stock owners to exclude the gain from selling Qualified Small Business Stock (QSBS) from their taxable income. The greater of $10 million or ten times the stockholder's adjusted basis in the stock—usually the amount they paid to buy it—avoids capital gains tax entirely. A maximum 28% tax rate applies to any excess gain.
What is Qualified Small Business Stock (QSBS)?
Qualified Small Business Stock, (QSBS) only includes stock in a qualified small business (QSB). QSBs satisfy all the following tests:
- C corporation. No other entity qualifies. Certain special types of C corporations also fail to qualify.
- Aggregate gross assets. The adjusted basis of the company's assets never exceeded $50 million before or immediately after it issued the QSBs.
- Active business. The corporation uses at least 80% of its assets in a trade or business. This specifically excludes professional services—law, accounting, banking, finance, etc.—plus farming, resource extraction, hotels, and restaurants. Start-up activities as well as research and development for a future active business count towards this requirement.
Stock in a QSB must meet several other criteria to earn QSBS status. Only individuals, trusts, and pass-throughs—not corporations—may hold the stock. The investor must acquire the stock at original issuance in exchange for money, property, or services. Five years from the acquisition date must pass before the investor sells the stock.
Additional rules apply to redemptions and conversions of the corporation's stock, businesses owning or owned by other companies, corporate reorganizations, and other specific situations. A CPA or other tax professional can verify whether a business's stock will qualify.
Among all requirements, C corp. status often presents the biggest hurdle. Business owners tend to prefer passthroughs to avoid double taxation. C corporations pay tax themselves, as do their owners when they receive dividends. This meant that few small companies claimed the exclusion until recently.
The Tax Cuts and Jobs Act (TCJA) made C corporations significantly more attractive by lowering the corporate tax rate from 35% to 21%. Passthroughs still often prove the more tax-advantaged choice, but not always. Avoiding capital gains tax through section 1202 offers a compelling argument in favor of C corporations.
Business owners and their advisors must weigh a host of tax and non-tax factors to choose the best entity for their company. The simplified example below illustrates how tax advisors determine whether the QSBS exclusion makes a C corp. worthwhile.
Qualified Small Business Stock Example
Jane intends to form either a C corp. or an S corporation, contribute $100,000 to it in exchange for stock, then sell the company in six years. Her CPA reviewed all the relevant facts and determined that the C corp. stock would likely qualify for the section 1202 exclusion from capital gains tax.
Jane estimates that the business will sell for $500,000 after six years, resulting in a gain of $400,000. She expects yearly pre-tax profit of $50,000, to distribute $50,000 to herself every year, and to pay the top individual, dividend, and capital gains tax rates.
C Corp. Taxes @ 21%
C Corp. Owner Taxes @ 20%
S Corp. Owner Taxes @ 37% (20% for sale)
The combined C corp. entity and owner taxes equal $123,000—a savings of $68,000 compared to the S corp. Jane and her company would pay $203,000—$12,000 more than the S corp. structure—without the $80,000 exclusion of capital gains tax on the C corp.'s QSBS.
This analysis excludes many potentially crucial factors for simplicity which could change the result. Both entities have tax advantages and disadvantages not calculated here.
Using Section 1202 allows business owners to avoid capital gains tax when selling their QSBS, a potentially enormous tax savings. Consult a tax professional to determine whether stock will qualify, and which type of entity best suits the business given the potential savings.