Sec. 1202: Small Business Stock Capital Gains Exclusion

By Tina M. DeSanty, CPA, Fort Lauderdale, Fla.

Editor: Kevin D. Anderson, CPA, J.D.

Gains & Losses

Congress has provided a variety of incentives to encourage taxpayers to invest in small businesses. In the past several years, Congress has made these incentives more generous, to the point where a complete exemption from federal income tax on gains from the sale of certain stock is possible. Although the more generous of these incentives have been enacted on a temporary basis, there is still an opportunity for investors to make investments that could qualify for a full federal income tax exemption on a subsequent sale. This item explores the nature of the Sec. 1202 exclusion and identifies some recent changes to the exclusion.

Qualified Small Business Stock

For taxpayers other than corporations, Sec. 1202 excludes from gross income at least 50% of the gain recognized on the sale or exchange of qualified small business stock (QSBS) that is held more than five years. As described more fully below, for qualifying stock acquired after Feb. 17, 2009, and on or before Sept. 27, 2010, the exclusion percentage is 75%, and for qualifying stock acquired after Sept. 27, 2010, and before Jan. 1, 2014, the exclusion percentage is 100%. The amount of the exclusion is 60% in the case of the sale or exchange of certain empowerment zone stock that is acquired after Dec. 21, 2000, and sold before 2015.

Sec. 1202 was enacted in 1993, before the maximum capital gain rate for noncorporate taxpayers was reduced in 1997 to 20% and then in 2003 to 15% (for 2013, it is back up to 20%, but only for taxpayers in the 39.6% income tax bracket). The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), P.L. 108-27, eliminated virtually all of the tax rate benefit related to the Sec. 1202 gain exclusion. However, the ability to roll over gains on Sec. 1202 stock remains an advantage.

For most taxpayers, QSBS is a capital asset subject to capital gain tax rates. Most taxpayers to whom Sec. 1202 applies are subject to a lower effective tax rate than would have been the case had Congress not provided for partial gain exclusion for QSBS. However, a taxpayer is not entitled both to partial gain exclusion under Sec. 1202 and to the reduced capital gain rates that otherwise would be available. The taxable portion of the gain is taxed under the normal rules and subject to a maximum rate of 28% on capital gains. This makes the maximum effective rate on the gain from the sale of QSBS 14%. The potential application of the alternative minimum tax (AMT) further erodes the benefits of investing in QSBS.

The gain eligible to be taken into account for purposes of this exclusion is limited to the greater of $10 million or 10 times the taxpayer’s basis in the stock (Sec. 1202(b)(1)). The limitation is computed on a per-issuer basis, with lower limits applying to married individuals filing separately. In the case of married individuals filing joint returns, gain excluded under this provision is allocated equally between the spouses in applying the exclusion in later years. Gain excluded under this provision is not used in computing the taxpayer’s long-term capital gain or loss, and it is not investment income for purposes of the investment interest limitation. For purposes of the modifications to income for computing a noncorporate taxpayer’s net operating loss deduction, the partial exclusion is not allowed (Sec. 172(d)(2)(B)).

Sec. 1045 Rollovers

The Taxpayer Relief Act of 1997, P.L. 105-34, enacted Sec. 1045 to permit rollover treatment for sales of QSBS occurring after Aug. 5, 1997. As originally adopted, Sec. 1045 applied only to individual taxpayers. The Code was later amended by the Internal Revenue Service Restructuring and Reform Act of 1998, P.L. 105-206, to apply to taxpayers other than corporations, harmonizing Sec. 1045 with Sec. 1202. Both the gain rollover election of Sec. 1045 and the partial gain exclusion of Sec. 1202 apply only to QSBS (Secs. 1045(b)(1) and 1202(c)). Section 1202(c) defines QSBS for purposes of both provisions.

Gain on sales of QSBS held more than six months is not currently taxed to the extent the sales proceeds are invested in QSBS within 60 days of the sale under Sec. 1045. Under Sec. 1397B, a taxpayer can also elect to roll over, or defer the recognition of, capital gain realized from the sale or exchange of any qualified empowerment zone asset purchased after Dec. 21, 2000, and held for more than one year, where the taxpayer uses the proceeds to purchase other qualifying empowerment zone assets in the same zone within 60 days of the sale of the original zone asset. The taxpayer must reduce the basis in the QSBS acquired by any deferred gain.

Qualifying Small Businesses

The issuing corporation must be a qualified small business as of the date of issuance and during substantially all of the period that the taxpayer holds the stock. A qualified small business is a subchapter C corporation other than a domestic international sales corporation (DISC) or former DISC; a corporation with respect to which an election under Sec. 936 is in effect or that has a direct or indirect subsidiary with respect to which such an election is in effect; a regulated investment company; a real estate investment trust; a real estate mortgage investment conduit; or a cooperative. The corporation also generally cannot own (1) real property that is not used in the active conduct of a qualified trade or business with a value exceeding 10% of its total assets; or (2) portfolio stock or securities with a value exceeding 10% of its total assets in excess of liabilities.

To qualify as QSBS, the stock must be:

  • Issued by a domestic C corporation with no more than $50 million of gross assets at the time of issuance;
  • Issued by a corporation that uses at least 80% of its assets (by value) in an active trade or business, other than in certain personal services and types of businesses described in more detail below;
  • Issued after Aug. 10, 1993;
  • Held by a noncorporate taxpayer (meaning any taxpayer other than a corporation);
  • Acquired by the taxpayer on original issuance (there are exceptions to this rule); and
  • Held for more than six months to be eligible for a tax-free rollover under Sec. 1045 and more than five years to qualify for gain exclusion.

The $50 million standard is fixed and is determined by reference to the amount of cash and the aggregate adjusted bases of other property held by the corporation. For a corporation’s stock to be QSBS, the following must apply:

  • At all times after Aug. 10, 1993, and before it issues the stock, the corporation must have aggregate gross assets that do not exceed $50 million (Sec. 1202(d)(1)(A)).
  • Immediately after it issues the stock, the corporation must have aggregate gross assets that do not exceed $50 million. For this purpose, amounts received in the stock issuance are taken into account (Sec. 1202(d)(1)(B)).

A company may pass into and out of those standards, but there are consequences. If a corporation satisfies the gross asset limitation on the date the stock was issued but later exceeds the $50 million asset threshold, stock that otherwise qualifies as QSBS does not lose that character solely because of the later event. However, once a corporation (or a predecessor corporation) exceeds the $50 million asset threshold, it can never again issue QSBS.

At least 80% (by value) of the corporation’s assets (including intangible assets) must be used by the corporation in the active conduct of a qualified trade or business (Sec. 1202(e)(1)). If in connection with any future trade or business, a corporation uses assets in certain startup activities, research and experimental activities, or in-house research activities, the corporation is treated as using such assets in the active conduct of a qualified trade or business. Assets that are held to meet reasonable working capital needs of the corporation, or are held for investment and are reasonably expected to be used within two years to finance future research and experimentation, are treated as used in the active conduct of a trade or business. If a corporation has been in existence for at least two years, only 50% of these working capital assets will qualify as used in the active conduct of a qualified trade or business. In addition, certain rights to computer software are treated as assets used in the active conduct of a trade or business.

A qualified trade or business is any trade or business other than those 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 other trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees. The term also excludes any banking, insurance, leasing, financing, investing, or similar business; any farming business (including the business of raising or harvesting trees); any business involving the production or extraction of products of a character for which percentage depletion is allowable; or any business of operating a hotel, motel, restaurant, or similar business.

A corporation that is a specialized small business investment company (SSBIC) is treated as meeting the active business test. An SSBIC is defined as any corporation (other than certain nonqualified corporations) that is licensed by the Small Business Administration under Sec. 301(d) of the Small Business Act of 1958, P.L. 85-699, as in effect on May 13, 1993.

Qualifying Entities

A taxpayer does not have to own stock directly to benefit from the QSBS rules. Nonrecognition of gain is possible through a partnership, S corporation, regulated investment company, or common trust fund if the following apply:

  • All eligibility requirements with respect to QSBS are met;
  • The entity held the qualifying stock for more than five years; and
  • A taxpayer sharing in the gain held the interest in the passthrough entity at the time the taxpayer acquired the qualifying stock and at all times thereafter.

In addition, a partner, shareholder, or participant cannot exclude gain received from an entity to the extent that the partner’s, shareholder’s, or participant’s share in the entity’s gain exceeded the partner’s, shareholder’s, or participant’s interest in the entity at the time the entity acquired the stock. To be eligible, the stock must be acquired by the taxpayer after Dec. 31, 1992, at the original issuance (directly or through an underwriter) in exchange for money, other property (not including stock), or as compensation for services provided to the corporation (other than services performed as an underwriter of the stock).

The American Recovery and Reinvestment Act of 2009, P.L. 111-5, provided an extra incentive for investment in small businesses. The Sec. 1202 exclusion was increased from 50% to 75% (a 60% exclusion remained the same for the sale or exchange of certain empowerment zone stock) for any gain from the sale or exchange of QSBS acquired after Feb. 17, 2009, and before Jan. 1, 2011, and held for more than five years (Sec. 1202(a)(3)).

Temporary 100% Exclusion

The Small Business Jobs Act of 2010, P.L. 111-240, made additional changes to the exclusion rules related to certain small business stock. For QSBS acquired after Sept. 27, 2010, and before Jan. 1, 2011, the exclusion percentage increased to 100%.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, extended by one year the application of the 100% exclusion for QSBS, so that it applied to otherwise qualifying stock acquired before Jan. 1, 2012. The American Taxpayer Relief Act of 2012 (ATRA), P.L. 112-240, retroactively extended for two more years the 100% exclusion of the gain from the sale of QSBS, so that it applies to otherwise qualifying stock acquired before Jan. 1, 2014. The other requirements, including the five-year holding period requirement, were not changed.

AMT Implications

The AMT regime recaptures certain tax savings by requiring high-income individuals or corporations to modify their regular taxable income and take into account certain preference items and adjustments. Tax preference items, which include portions of deductions or exclusions from income, are added back to the taxpayer’s taxable income in computing alternative minimum taxable income (AMTI), which is the basis on which taxpayers compute the tentative minimum tax. For stock sales before May 6, 2003, 42% of the gain realized on QSBS was a tax preference item in determining AMTI. Also for sales occurring before May 6, 2003, if the holding period of the stock began after Dec. 31, 2000, the amount of this preference was 28% of the excluded gain rather than 42% (Sec. 57(a)(7), prior to amendment by JGTRRA).

JGTRRA amended Sec. 57(a)(7) to provide that 7% of the gain excluded on the sale of QSBS for regular tax purposes is a preference that must be added back to income in determining AMTI (Sec. 57(a)(7), as amended by JGTRRA, effective for dispositions on or after May 6, 2003). The Small Business Jobs Act of 2010 removed the 7% tax preference for QSBS eligible for the 100% gain exclusion (Sec. 1202(a)(4)(C)). Thus, none of the gain was subject to AMT for stock purchased after Sept. 27, 2010, and before Jan. 1, 2011. The favorable AMT treatment of gain from the sale of QSBS was further extended in connection with the extension of the 100% gain exclusion provisions, so that the AMT preference does not apply to gain from dispositions of QSBS acquired after Sept. 27, 2010, and before Jan. 1, 2014.

Replacement QSBS

The federal rollover provision, Sec. 1045, provides for the deferral of gain from the sale of QSBS where replacement QSBS is acquired. A taxpayer may elect to defer the gain on acquiring QSBS within 60 days from the sale. A taxpayer seeking the rollover benefits under Sec. 1045 must make an election on or before the due date (including extensions) for filing the tax return for the tax year in which the QSBS is sold. A Sec. 1045 election is revocable only with the IRS’s prior written consent, which must be obtained by submitting a request for a private letter ruling.

Reporting Requirements

Treasury may require a taxpayer to submit a report to carry out the purpose of Sec. 1202. A penalty is imposed if the taxpayer fails to file a properly executed report as required by Sec. 1202(d)(1)(C) in connection with the gain exclusion. A taxpayer that fails to file a report must pay a penalty of $50 for each report for which there was a failure. That amount increases to $100 for a failure due to negligence or intentional disregard of the rules or regulations (Sec. 6652(k)).

Planning Considerations

With the reduced capital gain tax rates being permanently extended for taxpayers situated below the 39.6% tax bracket, the QSBS exclusion does not provide the significant tax benefit to all taxpayers that was intended when it was enacted in 1993. However, with ATRA’s retroactive extension of the 100% gain exclusion and the inapplicability of any tax preference item for AMT purposes, Sec. 1202 stock deserves a closer look. Taxpayers should carefully analyze and compare the implications of paying the 15% or 20% tax on any includible gain versus the cost of the sophisticated tax planning and legal advice that would be required to qualify for the exclusion.


Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.

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