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Planning Options to Increase the Section 1202 Gain Exclusion Far Beyond the $10 Million Cap

Planning Options to Increase the Section 1202 Gain Exclusion Far Beyond the $10 Million Cap

By Anthony Diosdi

I. Introduction to Internal Revenue Code Section 1202

This article is designed to provide an overview of the federal income tax incentives available to non-corporate holders of “qualified small business stock” (“QSB stock”). As discussed below in more detail, Section 1202 of the Internal Revenue Code permits investors in QSB stock to exclude up to $10 million in taxable gains. Despite the Section 1202 tax incentive, in the past, many investors shied away from QSB stock because of the inherent double tax consequence of subchapter C corporations.  However, that may soon change, due to the reduction of the corporate marginal tax rate to 21 percent  under the Tax Cuts and Jobs Act of 2017. Later in this article we will discuss how a “taxpayer” can increase the gain exclusion far beyond $10 million. 

Internal Revenue Code Section 1202 was originally enacted in 1993. It was enacted as an incentive for the public to invest in small businesses. Currently, Internal Revenue Code Section 1202 allows taxpayers to exclude up to 100 percent of the gain realized from the sale or exchange of QSB stock held for more than five years. However, the amount of taxable gain which is excludable depends largely on the year that the QSB stock was issued. If the QSB was issued before February 18, 2009, the gain exclusion is 50 percent. If the QSB stock was issued between February 18, 2009 and September 27, 2010, the gain exclusion is 75 percent. QSB shares issued after September 27, 2010 may qualify for a 100 percent exclusion of the total taxable gain.  

Section 1202 limits the “eligible gain” to the greater of:

  1. $10 million reduced by any amount an individual excluded from the sales of exchange of QSB stocks from the same issuer in prior years; or
  2. 10 times the aggregate adjusted basis of the QSB stocks issued by the corporation disposed of by the individual taxpayer during the taxable year, as measured on the original issue date. 

The amount of gain excluded by Internal Revenue Code Section 1202 is also not subject to the 3.8 percent Medicare tax and is not subject to the Alternative Minimum tax. It should be noted that a number of state taxing jurisdictions do not follow Section 1202 such as California and New York. Besides the tax benefits of Section 1202 discussed above, Internal Revenue Code Section 1045 permits investors to possibly roll-over gains from the sale of QSB stock that has been held for more than six months. 

II. Requirements of Section 1202

Investors should know that four requirements must be met in order to exclude gains from the sale of stock under Section 1202. Below, each of these requirements are discussed in detail. If the four requirements mentioned below are not satisfied, the stock will not qualify for Section 1202 treatment.

1. Stock of a Subchapter C Corporation Acquired at an “Original Issuance”

Sections 1202(c)(1) and 1202(c)(1)(B) of the Internal Revenue Code state that QSB stock is stock in a C corporation which is originally issued after the enactment of the Revenue Reconciliation Act of 1993, if such stock is acquired in exchange for money or other property, or as compensation for services performed for such a corporation. According to Internal Revenue Code Section 1202(c)(1)(B), QSB stock must be acquired at “original issue” (directly or through an underwriter) in exchange for money or other property, or as compensation for services performed for such corporation. In other words, the original purchaser of the QSB stock must be the seller claiming the Section 1202 tax benefit. 

Section 1202 provides that QSB stock must generally be required by the holder of the original issue for cash, certain other property or services. This requirement means that shares of QSB stock must be acquired directly from the issuer in exchange for money or other property, or as compensation for services performed from the issuing corporation. The definition of money is straightforward. For Section 1202 purposes, “property” is generally defined to include most tangible and intangible assets. This includes cash, capital assets, inventory, accounts receivable, patents, and, in certain circumstances, nonexclusive licenses and industrial know-how.  Stock issued as compensation for services (i.e. subject to the rules promulgated under Internal Revenue Code Section 83) may also qualify as QSB stock.  

2. Qualified Small Business Requirement

Sections 1202(c)(1) and 1202(c)(2)(A) provide that as of the date of issuance, the issuing corporation must be a “qualified small business.” Internal Revenue Code Section 1202(d)(1) defines a “qualified small business” as a domestic corporation if: 1) the aggregate gross assets of such corporation, at all times on or after the date of the enactment of the Revenue Act of 1993 and before the issuance of the stock being tested for potential qualification as QSB stock, do not exceed $50 million; 2) the aggregate gross assets of such corporation immediately after the issuance of the stock being tested for potential qualification as QSB stock do not exceed $50 million; and 3) such corporation agrees to submit to the IRS and its shareholders and “reports” that the IRS may “require to carry out for the purposes of Section 1202.” 

The corporation issuing the QSB stock must be a qualified small business immediately prior to and immediately after the issuance of the QSB stock. This means that the issuing corporation must not have aggregate gross assets in excess of $50 million. The term “aggregate gross assets” discussed above means the sum of the amount of cash and the aggregate value of all property of the corporation. Stock that otherwise qualifies as QSB stock as of the date of issuance will not lose that status solely by virtue of the fact that a corporation exceeds $50 million at a future date. However, once a corporation’s aggregate gross assets exceed $50 million, the corporation cannot issue QSB stock, even if the aggregate gross assets fall below $50 million. It should also be noted that for purposes of aggregate gross asset test of Section 1202(d)(1), corporations that are part of a “parent-subsidiary controlled group” shall be treated as one corporation.

3. Active Business Requirement

Internal Revenue Code Section 1202(c)(2) provides that stock in a corporation cannot be treated as QSB stock unless, during substantially all of the taxpayer’s holding period, such a corporation meets the “active business requirements” of Internal Revenue Code Section 1202(e) and such corporation is a subchapter C corporation. For purposes of Internal Revenue Code 1202(c)(2)(A), a corporation shall be treated as satisfying the “active business requirement” of section 1202(e) for any period if during such period (i) at least 80 percent of the assets of such corporation are used by such corporation in the active conduct of one or more ‘qualified trades or businesses’ and (ii) such corporation is an ‘eligible corporation.’

Under Section 1202(e)(3), the term “qualified trade or business” means any trade or business other than:

  1. 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 one or more of its employees; 
  2. Any banking, insurance, financing, leasing, or similar business;
  3. Any farming business.
  4. Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under Section 613 or 613A; and
  5. Any business of operating a hotel, motel, restaurant, or similar business. 

Just about any trade or business with the exception of the practice of law, accounting practices, medical practice, brokerage services, banking, investing, leasing, insurance, farming, oil and gas extraction, or operating a hotel or restaurant will be considered an active trade or business for the purpose of Internal Revenue Code Section 1202. Internal Revenue Code Section 1202(e)(2) also provides an exception to start-up business. Under Section 1202(e)(2), activities associated with a “start-up” business such as research or experimental activities will be classified as an active trade or business. However, in order to satisfy the active trade or business test, a corporation issuing QSB stock must make sure that at least 80 percent of its assets are involved in an active trade or business. 

A corporation will fail the 80 percent asset test if its aggregate investment assets (i.e. stocks and cash) plus non-trade assets make up more than a certain percent of the issuing corporate assets. Section 1202 provides a special working capital rule which does not necessarily utilize the above discussed 80 percent threshold. For example, Internal Revenue Code Section 1202(e)(7) states that a corporation shall not be treated as being in the active trade or business if more than 10 percent of its value is real estate. 

4. Five Year Holding Period

Internal Revenue Code Section 1202(b)(2) requires that QSB stock must be held for at least five years in order to exclude gains. In most cases, satisfying the five-year holding period will be simple. This is because, in general, the holding period of QSB stock begins on the date of issuance whether or not the QSB stock was received in a taxable or non-taxable transaction. Special tacking rules, however, apply to the computation of the holding period if the QSB stock is converted into other stock of the same corporation, or if the stock is acquired as a gift, by inheritance, or as a transfer from a partnership. 

III. Section 1202 Basis Rules 

If an investor acquires QSB shares through a cash transaction, the investor’s taxable basis will be the value of the money transferred in exchange for the QSB stock. When an investor acquires QSB stock through the transfer of property, the investor’s basis in the QSB shares will be the fair market value of the property exchanged.  One important fact that must be considered by any investor who elects to exchange appreciated property is that the like-kind exchange rules do not apply to the acquisition of QSB shares. For example, suppose A receives $100 of QSB stock in exchange for his asset with a $10 basis, Section 1202(i) will require A to recognize $90 of realized gain.    

IV. Section 1045 Rollover Rules

Internal Revenue Code Section 1045 allows an investor to defer recognition of taxable gain from the sale or exchange of QSB stock if he or she acquires replacement of the QSB stock within a 60-day period beginning on the date of the sale of the shares. The following elements must be satisfied in order to defer the recognition of QSB stock: 1) gain recognition from the sale of QSB stock is limited to the extent to which the amount realized (i.e., gross proceeds) on the sale exceeds the cost of replacement QSB stock purchased by the taxpayer, and 2) the replacement QSB stock is reduced by the amount of the unrecognized gain. 

Section 1045 also specifically mentions special basis rules in Section 1202.  Under this special basis rule, the amount of any gain attributable to periods prior to the receipt of the QSB stock is not eligible for roll over and these taxable gains must be recognized at the time of the sale or exchange of the shares. In other words, only gains that accrued after the time the shares can be classified as QSB stock can be deferred for federal income tax purposes. Internal Revenue Code Section 1045 also incorporates the special tacking rules of Section 1202. This means that the six-month holding period will be extended when the QSB stock is received upon conversion, by gift, by death, or from a former QSB shareholder.

V. QSB Planning Considerations

A. Pre-Investment Planning

A wide range of factors (both tax and non-tax) must be considered in deciding whether or not to invest in QSB stocks. Investing in QSB shares will only make sense when: i) a five-year holding period is possible; ii) the aggregate gross asset value of the business is expected to be equal to or less than $50 million; iii) the business operations is such that the “active business requirement” of Section 1202(e) can be satisfied. Furthermore, once a decision has been made to affirmatively structure an investment with a view of obtaining the benefits of Section 1202, the investor should consult with their tax and other advisors to ensure that all the QSB requirements are satisfied. For example, a third-party valuation of the business would generally be advisable to ensure that the $50 million aggregate asset value threshold is not exceeded and to establish the fair market value of any property contributions made. 

In addition, pre-QSB planning should be considered. Businesses anticipating substantial funding should consider the potential impact of cash investments on the corporation’s eligibility to issue QSB stock under the $50 million gross asset test. In some cases, it will make sense to organize a business as an LLC taxed as a partnership, allowing for the pass-through of losses to certain investors. Before the funding, the LLC can be converted into a subchapter c corporation before the fair market value of the business exceeds $50 million. The five-year holding period requirement will always add an element of uncertainty to a choice of entity analysis. If shares are issued in connection with an LLC taxed as a partnership, the five-year time period does not start running until the date of incorporation of the subchapter S corporation. However, in some cases it may make more sense to hold off on incorporation to utilize valuable losses.

B. Tax Filing Requirements and Document Retention

As a final note, an individual taxpayer claiming the benefits of Section 1202 should generally do so by following the instructions for Schedule D (“Capital Gains and Losses”) on IRS Form 1040. Furthermore, taxpayers should be certain to retain all documents that may be potentially relevant to a request by the IRS for reports and information pursuant to Section 1202(d)(1)(C).

VI. Dividing the QSB Stock Exclusion Cap Among Multiple “Taxpayers”

Providing all the requirements of Internal Revenue Code Section 1202 are satisfied, the QSB stock is eligible for exclusion. Where QSB stock is held in partnerships, non-grantor trusts, LLCs, or S corporations, the $10 million gain exclusion may be applied at the shareholder (i.e., investor) level to each investor. Consequently, investors in partnerships or certain other entities may be able to claim a gain exclusion that is far greater than the $10 million cap. Founders may also structure the ownership of a QSBS to include a spouse, children, or family members to increase the $10 million cap.

An individual may also be able to increase the $10 gain exclusion amount by gifting some QSB stock to family members prior to the sale of such stock. Gifting QSB stock is allowed under Internal Revenue Code Section 1202 as an exception to the general rule that the original holder must sell QSB stock in order to take advantage of the Section 1202 gain exclusion. As such, a founder may gift QSB stock to an unlimited number of individuals, each of whom will have their own $10 million exclusion cap. Founders may even gift QSB stock to non-grantor trusts in order to use the $10 million exclusion cap as part of a vehicle for future start-ups and venture financing planning.


The Section 1202 exclusion cap on the sale of QSB stock is designed to incentivize investors to invest in small businesses. Section 1202 planning may permit founders and investors in QSB stock to significantly increase the $10 million cap. With that said, Section 1202 planning must consider federal, gift, estate, and state tax consequences associated with transferring QSB stock. Founders and investors in QSB stock should consult with a qualified tax attorney that has a solid understanding of QSB stock planning.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on international and domestic tax planning. He advises multinational companies, closely held businesses, and individuals on a host of complicated tax matters. Anthony has authored numerous articles on international and domestic tax planning.

Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.

Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.