Section 1202 provides one of the most powerful tax incentives in the Code: investors who hold qualified small business stock for more than five years may exclude 100% of their capital gain from federal income tax, subject to a per-issuer limit of the greater of $10 million or 10 times the taxpayer's basis in the stock. For a founder or early investor in a successful startup, this exclusion can shelter millions of dollars of gain from federal tax entirely. But the requirements are strict - the company must be a C-corporation, it must meet an active business test that excludes many service businesses, and the stock must be acquired at original issuance directly from the company.
C-corporation: The issuing company must be a domestic C-corporation at the time of issuance and during substantially all of the taxpayer's holding period. S-corporations, LLCs, and partnerships do not qualify. A company that converts from C-corp to another form after issuance may disqualify existing QSBS.
Gross assets test: The corporation's aggregate gross assets must not have exceeded $50 million at any time before or immediately after the stock issuance. This is a facts-and-circumstances test that includes cash raised in the funding round that creates the QSBS.
Active business test: At least 80% of the corporation's assets (by value) must be used in the active conduct of one or more qualified trades or businesses. Excluded businesses include: professional services in law, health, engineering, financial services, and consulting; banking and insurance; hotels and restaurants; and any business where the principal asset is the reputation or skill of its employees.
Original issuance: The stock must be acquired at original issuance directly from the corporation in exchange for money, property, or services. Secondary market purchases do not qualify.
Five-year holding period: The stock must be held for more than five years. Gain recognized before the five-year mark is taxable (subject to the §1045 rollover option).
The exclusion percentage depends on when the stock was acquired. Stock acquired after September 27, 2010 qualifies for a 100% exclusion of eligible gain. Stock acquired between February 18, 2009 and September 27, 2010 qualifies for a 75% exclusion. Stock acquired before February 18, 2009 qualifies for a 50% exclusion under the original §1202 rules. For startup founders and investors acquiring stock today, the 100% exclusion applies.
Federal §1202 exclusion does not guarantee state tax exclusion. California does not conform to §1202 and taxes QSBS gains at the full California income tax rate (up to 13.3%). A California-resident founder who excludes $20 million of federal QSBS gain pays zero federal tax but still owes California income tax on the full $20 million - potentially $2.66 million in California state tax. Other states that do not conform to §1202 include Pennsylvania and New Jersey. Planning for the state tax impact before a QSBS exit is essential for residents of non-conforming states.
If QSBS is sold before the five-year holding period is complete, §1045 allows the taxpayer to roll the proceeds into new QSBS within 60 days and defer the gain. The new QSBS inherits the holding period of the old QSBS for purposes of the five-year test. An investor who holds QSBS for 3 years, sells, and reinvests in new QSBS under §1045 only needs to hold the new QSBS for 2 more years (not another full 5 years) to qualify for the 100% exclusion. The §1045 rollover is available only to non-corporate taxpayers and requires the reinvestment to be in QSBS of a different corporation.