Section 1202 of the Internal Revenue Code (IRC) was intended to incentivize investments in small businesses and other new ventures, and it does so by providing an exclusion for certain gains from sales or exchanges of qualified small business stock (QSBS). As tax benefits go, a complete exclusion from taxation may seem “too good to be true.” But the so-called “One Big Beautiful Bill Act” (OBBBA) recently expanded IRC § 1202 benefits and relaxed certain qualification requirements (https://tinyurl.com/trxb52df).
This article will summarize the changes made by OBBBA, describe § 1202 generally, and highlight some planning considerations that can maximize its benefits.
OBBBA Changes
Prior to OBBBA, IRC § 1202 generally allowed noncorporate taxpayers to fully exclude qualifying gains from sales or exchanges of QSBS acquired after September 27, 2010, capped (on a per-issuer basis) at the greater of either a cumulative fixed-dollar limitation of $10 million ($5 million for married individuals filing separately), or 10 times the aggregate adjusted basis of QSBS disposed of within the taxable year. Partial exclusions applied for QSBS issued from August 11, 1993, to September 27, 2010. As discussed below, section 1202 required stock to meet various requirements for QSBS treatment. One such requirement limited the issuing corporation’s aggregate gross assets [generally measured by fair market value (FMV) and including assets held in the same parent-subsidiary controlled group as the issuer] at the time of issuance to $50 million. In addition, stock generally must be acquired by the taxpayer at its original issuance (directly from the issuer or through an underwriter) to qualify as QSBS.
OBBBA § 70431 made three principal changes to IRC § 1202:
- It introduced new 50% and 75% exclusions for QSBS held at least three or four years (respectively), while keeping the 100% exclusion for QSBS held for five years or more, effective for QSBS issued after July 4, 2025.
- It increased the cumulative fixed-dollar limit to $15 million ($7.5 million for married individuals filing separately), effective for stock acquired after July 4, 2025, and provided for that limitation to be indexed for inflation.
- It increased the issuer gross asset limit to $75 million, effective for stock issued after July 4, 2025, and provided for that amount to be indexed for inflation.
QSBS Overview
As noted above, IRC § 1202 generally allows noncorporate taxpayers to exclude gain from sales of QSBS held throughout the required holding period, subject to two separate limitations. Those separate limitations enable planning to maximize § 1202 benefits. For example, taxpayers can time dispositions to “fill up” the fixed-dollar limitation amount in one taxable year and preserve additional gains for exclusion (subject to the basis-based limitation) in subsequent periods. Moreover, taxpayers who own multiple blocks of QSBS can sometimes structure dispositions to further increase § 1202 benefits. Taxpayers disposing of stock before the holding period has been satisfied can sometimes preserve § 1202 benefits by “rolling over” proceeds or structuring the disposition as a qualifying exchange for other stock.
Broadly speaking, QSBS is stock issued by a domestic C corporation (with certain exclusions) that meets the following requirements:
- The taxpayer must generally have acquired it from the issuing corporation upon its original issuance in exchange for property (not including stock) or as compensation for services.
- The aggregate FMV of the issuing corporation’s assets at the time of issuance cannot exceed a fixed amount (now $75 million).
- The issuing corporation must meet an active business requirement throughout substantially all of the taxpayer’s holding period. Under this requirement, the corporation must use at least 80% of its assets (by FMV) in actively conducting one or more qualifying business. Such a qualifying business is defined as any trade or business other than: 1) one that performs services in specified fields, including health, law, accounting, consulting, financial services, and brokerage, or where the business’s principal asset is the reputation or skill of employees; 2) banking, insurance, financing, leasing, investing, and similar businesses; 3) farming (including timber-related); 4) extraction; and 5) hospitality, including food and lodging. Further limitations apply regarding the holding of real property.
- The issuing corporation must not have engaged in certain redemptions or stock repurchases within prescribed periods. Such transactions include 1) redemptions from the taxpayer (or persons related to the taxpayer) within two years before or after issuance and 2) significant redemptions (generally, redemptions from all shareholders representing more than 5% of the issuer’s aggregate stock value) within one year of issuance.
Selected Planning Considerations
S corporations cannot issue QSBS, and post-issuance subchapter S elections will generally preclude subsequent QSBS treatment. Taxpayers may, however, be able to utilize a § 1202 exclusion for QSBS held indirectly through S corporations, partnerships, and certain other pass-through entities (i.e., owners may exclude their respective shares of disposition gain, subject to separate exclusion limits). Such treatment can only apply where 1) the pass-through entity satisfies the § 1202 holding period requirement and 2) the taxpayer holds its interest in the passthrough entity at all times when the entity holds the stock. Taxpayers and tax professionals should keep the original issuance requirement in mind for planning involving pass-through entities.
Preferred stock can qualify as QSBS. When using preferred stock, tax professionals should take care to ensure that the shares qualify as equity for tax purposes.
Advisers should carefully apply the qualifying business requirement, keeping in mind IRS interpretations, which have generally been taxpayer-friendly. Moreover, while merger and acquisition aspects are beyond the scope of this article, § 1202 benefits can often apply to businesses acquired in asset purchases, whereas acquired stock will generally fail to meet the original issuance requirement mentioned above.
Because the § 1202 fixed-dollar and basis-based limitations apply separately to taxpayers on an issuer-by-issuer basis, taxpayers can sometimes maximize benefits by segregating businesses into separate corporations or spreading stock ownership among family members and entities. The latter approach works well if multiple members of a founder’s family participate in the business, because stock provided as compensation for services can qualify as QSBS. Note that employees and other service providers who receive nonvested QSBS will typically benefit from making IRC § 83(b) elections to start their § 1202 holding periods. Where desired, taxpayers can use nonvoting stock to concentrate control with a founder or key shareholders. Planning with gifts and trusts is beyond the scope of this article, but advisers and taxpayers should take owners’ family and wealth transfer planning objectives into account when considering these approaches.
As mentioned above, taxpayers can sometimes maximize § 1202 benefits by timing dispositions to take advantage of the separate fixed-dollar and basis-based limitations. For example, an owner may be able to dispose of sufficient shares of QSBS in an initial taxable year to generate gain in the amount of the fixed-dollar limitation and then dispose of additional QSBS shares in later taxable years. Owners and advisers should take the following considerations into account:
- Where an owner has multiple blocks of stock, they can sometimes maximize benefits by disposing of low-basis shares in earlier taxable years.
- Owners should remember that blocks of stock may have different holding periods, and they should be prepared to establish the holding periods for shares in each block.
- The fixed-dollar limitation for gains on QSBS issued after July 4, 2025, will likely increase after 2026, when indexation starts. Once an owner’s gains on eligible dispositions of QSBS issued by a corporation exceed that limit, they will no longer benefit from indexation adjustments regarding that issuer. But it might be possible, subject to law then in effect, to take advantage of future increases by delaying dispositions or initially disposing of slightly less stock than necessary to reach the fixed-dollar limit.
The basis of stock received for contributed property is never treated as less than the property’s FMV at the time of contribution for purposes of applying § 1202. Thus, taxpayers can sometimes increase § 1202 benefits by creating or transferring assets to an issuing corporation after the qualifying business has been commenced or acquired and its assets have increased in value. Those potential additional benefits should be balanced against the unavailability of the § 1202 exclusion for such appreciation and the resulting delayed start of the taxpayer’s QSBS holding period.
Qualifying businesses that wish to raise additional capital or participate in an acquisition, either by or in combination with other businesses or entities, often face additional planning opportunities and pitfalls.
Taxpayers and their advisers should be careful to avoid hazards that might lead to a loss of § 1202 benefits. Potential pitfalls include the following:
- Redemptions (from the taxpayer or others) that might preclude QSBS treatment under the rules noted above. Noncontrolling investors can sometimes obtain contractual protection to reduce that exposure.
- Cash, real estate positions, and minority investments. Taxpayers and advisers should manage the former carefully, particularly for companies that receive borrowings for purposes such as ramping up operations or acquiring assets.
- Short positions and other arrangements that reduce risk of loss regarding QSBS.
- Failure to maintain and preserve ongoing records establishing that all requirements for § 1202 treatment are satisfied. This could include documents regarding relevant property contributions or any incentive compensation, including copies of W-2s or § 83(b) elections. Sellers of QSBS should negotiate for access to records and buyer cooperation should it become necessary during an audit.
A Great Incentive
The OBBBA has increased the already powerful § 1202 incentive for forming and financing certain businesses, and it will likely continue to affect entity selection decisions for many new and existing enterprises. With careful planning, taxation on gains from dispositions of interests in qualifying businesses might not be inevitable.
