Practical considerations of Sec. 1202 in M&A transactions

By Heath Wang, E.A.



  • Stock purchased after Sept. 27, 2010, and held for five years that meets the requirements to be qualified small business stock (QSBS) may qualify for exclusion of 100% of gain on its sale.
  • The enactment of the 100% gain exclusion for QSBS, changes made by the Tax Cuts and Jobs Act to corporate tax rates, and possible changes in the offing to tax rates and rules have combined to make QSBS a more attractive option than in the past.
  • Among the requirements for stock to be QSBS is that the stock is of a C corporation acquired by noncorporate taxpayers in an original issuance for money, property, or as compensation for services. The C corporation must meet an active-trade-or-business requirement and a $50 million aggregate-assets requirement.
  • For purposes of the aggregate-asset requirement, money or property contributed to the corporation in exchange for stock is included in the corporation's assets. Therefore, careful planning is needed to ensure that QSBS treatment is not lost because the $50 million aggregate-asset limit is exceeded.
  • QSBS transferred for different stock in Sec. 351 contributions and Sec. 368 reorganizations will qualify for QSBS treatment. If the stock received does not otherwise qualify as QSBS, the Sec. 1202 exclusion is limited to the built-in gain of the QSBS surrendered.
  • Stock redemptions may qualify for gain exclusion under Sec. 1202. Rules regarding the timing and amount of the stock redeemed must be carefully observed to avoid voiding QSBS treatment for the redeeming shareholder's stock or possibly all the stock of the corporation.
  • Sec. 1202 provides that transfers by gift, death, or from a partnership to a partner (with limitations) will generally not cause the transferred stock to fail the original-issuance requirement. The treatment of other transfers is uncertain due to a lack of guidance from the IRS.

Sec. 1202 of the Internal Revenue Code provides a tremendous tax saving opportunity on the sale of C corporation stock for noncorporate taxpayers. Subject to an overall limitation, Sec. 1202 allows founders and investors of corporations to exclude up to 100% of their capital gains derived from the sale of qualified small business stock (QSBS) held for more than five years. The gain exclusion percentage for a shareholder depends upon the QSBS issuance date. The exclusion percentage is 50% for QSBS issued from Aug. 11, 1993, to Feb. 17, 2009;1 75% for QSBS issued from Feb. 18, 2009, to Sept. 27, 2010;2 and 100% for QSBS issued after Sept. 27, 2010.3 (Stock issued before Aug. 11, 1993, does not qualify for any gain exclusion under Sec. 1202.)

Sec. 1202 was underused for years, largely because the nonexcludable portion of the Sec. 1202 gain is taxed at 28%,4 which is much higher than the reduced tax rates applicable to capital gains from the sale of non-QSBS. Using a 50% exclusion, which was in effect for QSBS until Feb. 17, 2009, half of the gain would have been taxed at 28% and result in an effective tax rate of 14% when the long-term capital gains rate was 15% (before 2012), thus limiting much of the benefit that was otherwise intended. It was not until recent years that Sec. 1202 attracted the attention of founders and investors, as the 28% special tax rate becomes moot if 100% of the gain is excluded. The importance of Sec. 1202 was increased by the passage of the law known as the Tax Cuts and Jobs Act (TCJA)5 in 2017 and may gain more relevance under President Joe Biden's administration.

The TCJA reduced the corporate tax rate from 35% to 21%. Although the individual tax rate was also reduced, from 39.6% to 37%, under the TCJA, individuals may be able to further reduce their effective tax rate to 29.6% if their income is eligible for the Sec. 199A 20% qualified business income deduction. Even with the reduced corporate tax rate, founders and investors still prefer to operate businesses through partnerships and S corporations, largely because C corporations are subject to double taxation. The double taxation results in a combined corporate and shareholder tax approaching 40%, which is still much higher than 29.6%. Sec. 1202 could fundamentally change the choice-of-entity dynamic if founders and investors can sell QSBS tax-free.

The Biden administration has announced a number of changes it is considering to U.S. federal tax law. If these tax proposals are enacted, Sec. 1202 will become even more popular. For example, long-term capital gains of high-income individual taxpayers are currently taxed at 20%, but the Biden administration is considering an increase in the tax rate to 39.6% for taxpayers with taxable income exceeding $1 million (and the rate could go up to 43.4% when taking into account the net investment income tax of 3.8%). If this proposal is enacted, Sec. 1202 will offer a federal tax saving of 43.4% for founders and investors. And it should be noted that the Biden administration's plans do not include a proposal to change Sec. 1202, as doing so would arguably discourage startup businesses.

While tax savings under Sec. 1202 are not without limits, the limitations that have been provided are generous. Sec. 1202(b) provides that the amount of capital gain eligible for income exclusion is limited to the greater of $10 million or 10 times the basis of the QSBS sold in a given year. Note that this limitation is on a per corporation and per shareholder basis, meaning that each shareholder has a separate limitation for each corporation in which he or she invests. Although not the focus of this article, planning techniques could result in the stacking of the $10 million limitation through transfers to recognized trusts, which could increase the overall limitations. Moreover, each partner in a partnership and each shareholder in an S corporation is entitled to his or her own $10 million limitation if the partnership or the S corporation disposes of QSBS.

While it is not the intention of this article to thoroughly introduce the Sec. 1202 qualification requirements, to discuss the practical considerations of the provision in merger-and-acquisition transactions, a review of some of the relevant requirements is helpful. QSBS must be originally issued to the shareholder by the issuing corporation (the original-issuance requirement) for money or other property (not including stock) or as compensation for services.6 Therefore, a secondary purchase from existing shareholders would not qualify. At all times from Aug. 10, 1993, to the stock issuance date and immediately after the stock issuance, the aggregate assets of the corporation and its subsidiaries may not exceed $50 million (the $50 million requirement).7 Significantly, proceeds the corporation received in the stock issuance are included for purposes of the $50 million test.8 Sec. 1202 also contains an active-trade-or-business requirement, which provides that during substantially all of the shareholder's holding period, at least 80% (by value) of the assets of the corporation be used in the active conduct of one or more qualified trades or businesses (as defined under Sec. 1202(e)(3)).

Only noncorporate shareholders, such as individuals, partnerships, trusts, and S corporations, are eligible for the gain exclusion under Sec. 1202 — shareholders that are C corporations do not qualify.9 The stock must be originally issued by a C corporation and, during substantially all of the shareholder's holding period, the issuing corporation must remain a C corporation.10 As such, ownership in partnerships and S corporations will not generally qualify for Sec. 1202 benefits.

Given that Sec. 1202 went largely unused until recent years, Treasury and the IRS have not issued extensive guidance on it. It is also not surprising that very little Sec. 1202 case law has developed. However, with Sec. 1202 appearing on investors' radars in recent years, regulations and other guidance that address some of the uncertain issues discussed in this article are expected.

Stock acquisition

As mentioned above, C corporation stock acquired from a secondary purchase (shareholder to shareholder) will not be QSBS in the hands of the purchaser, although the seller of that stock may be eligible for Sec. 1202 benefits if all the requirements are met. As such, buyers may be even more likely to acquire the assets of a target through a NewCo instead of purchasing stock directly from a seller. In an asset purchase, not only can the purchaser receive a basis step-up for the target's assets, but also, if the purchaser contributes cash to a NewCo in exchange for originally issued stock and then has NewCo purchase the target assets, the NewCo stock the purchaser received may be QSBS if all the other requirements are met.

Sellers may insist upon a stock sale to avoid the corporate-level tax imposed by an asset sale. Although less certain, the NewCo stock received by the purchaser could still be considered as QSBS even if NewCo is being used as a holding company by the purchaser to acquire target stock. Note, however, that a stock sale is unlikely to offer any asset basis step-up unless an election under Sec. 338 or Sec. 336(e) is allowed. The purchaser often has business reasons for using a holding company to purchase target stock. For example, in a leveraged buyout, creditors may prefer a holding company structure for purposes of granting acquisition financing. Further, investors often prefer to use a holding company to block the target's historical earnings and profits. No language in Sec. 1202 or other guidance from the IRS would prevent NewCo stock from being QSBS in this situation; thus, there is the potential for abuse.

On the other hand, if NewCo purchases only a minority interest in target stock, NewCo stock likely will not be considered as QSBS because it may fail to meet the active-trade-or-business requirement. In particular, Sec. 1202(e)(5)(B) provides that a corporation will be treated as failing the active-trade-or-business requirement for any period during which more than 10% of the value of its net assets consists of stock in other corporations that are not subsidiaries of that corporation. The target is not considered as a subsidiary of NewCo for Sec. 1202 purposes if NewCo only acquires a minority interest.

Raising capital

Sec. 1202 has recently become a due diligence item when investors are seeking startups in which to invest. Before the issuing corporation initiates any capital raise, it is advisable for it to review the $50 million requirement because the incoming cash will be included for measurement purposes. If the issuing corporation has aggregate assets of $30 million, a capital raise of $20 million and $1 will likely disqualify any stock issued for the capital raise from being QSBS. It is imperative to note that if the investor contributes noncash assets (not including stock) to the issuing corporation in exchange for stock, the fair market value of those noncash assets is taken into account for purposes of the $50 million test, regardless of whether the exchange qualifies for Sec. 351 or other tax-free provisions. An actual or a deemed contribution of assets is common when making a change in entity classification from a sole proprietorship or limited liability company taxed as a partnership to a corporation.

In this situation, questions arise as to whether the $50 million requirement could be satisfied if the investor contributes cash in multiple tranches. The investor could first contribute $19 million in exchange for stock so that the $50 million requirement is met and then contribute the remaining amount on a later date. Could the IRS take the position that multiple tranches of cash contribution under the same plan would be combined for purposes of the $50 million test? Although the answer to this question is uncertain, the following considerations may be helpful to analyze the position: business purpose for multiple contributions, intent of the issuing corporation and the investor, length of time between multiple contributions, and whether the investor made a binding commitment for cash contribution on a later date or whether the investor had the freedom of action to make additional contributions down the road.

It is not uncommon that in conjunction with a capital raise, founders and other shareholders seek to cash out a portion of their shareholding through secondary transfers. As established above, a secondary purchase will not provide the purchaser with QSBS status since the corporation did not originally issue it. In an attempt to circumvent this issue, a sophisticated investor may propose that, in lieu of a secondary transfer, the selling shareholders should redeem their stock from the issuing corporation in exchange for cash; the investor will then purchase stock directly from the issuing corporation to qualify for the original-issuance requirement. As discussed in more detail under the "Distribution and Redemption" section below, not only will this arrangement not do any good for the investor, but it also could harm other shareholders of the issuing corporation.

It is equally ineffective for the investor to first acquire the stock through a secondary transfer followed by a conversion of the purchased stock into another class of the issuing corporation's stock. Sec. 1202(f) provides that if any stock in a corporation is acquired solely through the conversion of other stock in that corporation that is QSBS in the hands of the taxpayer, the stock so acquired will be treated as QSBS. In other words, when old stock is converted to new stock, new stock would only be treated as QSBS if the old stock is QSBS.

Secs. 351 and 368

When shareholders exchange stock in one corporation for stock in another corporation, if the exchange does not qualify as a transaction under Sec. 351 or a reorganization under Sec. 368, it would likely be a taxable transaction, and any QSBS benefits will be exhausted at that time. However, if the exchange does qualify for tax-free treatment under Sec. 351 or Sec. 368, the stock received will be treated as QSBS, provided that the stock surrendered by the shareholders is QSBS, even if the stock received would not otherwise qualify. However, if the stock received by the shareholders would not otherwise qualify as QSBS, upon future sale of that stock, the capital gain eligible for the Sec. 1202 exclusion is limited to the built-in gain of the stock surrendered at the time of the exchange. The limit does not apply if the stock received in the exchange is also QSBS.

Example: On Jan. 1, 2015, shareholder A was issued stock in corporation X, which is QSBS. On Jan. 1, 2017, when A has held the X stock for two years, A exchanged X stock for stock in corporation Y in a transaction that qualifies as an exchange under Sec. 351 or a reorganization under Sec. 368. At the time of the exchange, X stock had built-in gain of $1 million. On Jan. 1, 2021, A sold Y stock realizing a total capital gain of $5 million. If Y stock is also QSBS, then the entire $5 million gain A realized is eligible for Sec. 1202 gain exclusion. If, however, Y stock is not otherwise QSBS, Y stock would nonetheless be treated as QSBS, but only $1 million of the gain realized by A is eligible for Sec. 1202 gain exclusion. One notable benefit of treating Y stock as QSBS, even if it would not otherwise qualify, is that the shareholder is able to combine the holding periods of X and Y stock for purposes of the five-year holding period requirement.

Practically, when target stock is acquired, founders and management of target may be required by the purchaser to roll over a portion of their shareholding in target. This is often achieved through a holding company structure. In particular, the private-equity investor would set up a HoldCo, contributing cash in exchange for HoldCo stock, while founders and management contribute target stock to HoldCo in exchange for cash and HoldCo stock. Although cash received by founders and management would be taxable boot, the entire transaction generally qualifies as an exchange under Sec. 351, thus offering tax deferral for shares rolled over by founders and management.

If the target stock is QSBS in the hands of founders and management, the taxable boot may be excludable from income under Sec. 1202 since boot represents gain recognized in the exchange; moreover, the HoldCo stock that the founders and management received would be treated as QSBS regardless of whether it actually qualifies, subject to the limit mentioned above. Sec. 1202 does not limit the number of Sec. 351 or 368 transactions under which QSBS is preserved, but when QSBS is exchanged for non-QSBS, the amount of capital gain eligible for Sec. 1202 exclusion is locked at the time of the exchange.

Distribution and redemption

When a C corporation makes a distribution to its shareholders, Sec. 301(c)(3) provides that the portion of the distribution that is not considered a dividend, to the extent that the distribution exceeds the adjusted basis of the stock, will be treated as gain from the sale or exchange of property. Since Sec. 301(c)(3) makes it clear that the gain is deemed from "the sale or exchange of property," it is reasonable to conclude that the gain can be excluded from taxable income under Sec. 1202, provided the stock with respect to which the distribution is made qualifies as QSBS. A similar conclusion can be drawn for Sec. 302 redemptions, as Sec. 302(a) provides that if a corporation redeems its stock, and the redemption would not be recharacterized as a distribution under Sec. 301, the redemption will be treated as a distribution in partial or full payment in exchange for the stock.

Although a stock redemption may offer gain exclusion under Sec. 1202, the redemption may jeopardize other QSBS issued to the redeeming shareholders and, if the redemption amount is large enough, all other shareholders of the corporation. In particular, stock issued to a shareholder is not QSBS if, during the four-year period beginning on the date two years before the issuance of stock, the corporation redeems more than a de minimis amount of stock from the shareholder and its related parties.11 For this purpose, stock acquired from the shareholder or its related parties exceeds a de minimis amount only if the aggregate amount paid for the stock exceeds $10,000 and more than 2% of the stock is held by the shareholder and its related parties.

Additionally, stock issued to any shareholder is not QSBS if, during the two-year period beginning on the date one year before the issuance of the stock, the corporation redeems more than a de minimis amount of its stock and the stock has an aggregate value (as of the time of the respective redemptions) exceeding 5% of the aggregate value of all of the corporation's stock as of the beginning of that two-year period.12 For this purpose, stock exceeds a de minimis amount only if the aggregate amount paid for the stock exceeds $10,000 and more than 2% of all outstanding stock is purchased.

Traps for the unwary

Sec. 1202 offers limited exceptions under which a transfer of stock would not imperil the original-issuance requirement. Sec. 1202(h)(2) provides that a transfer by gift, at death, or from a partnership to a partner would generally retain the original-issuance status of the transferred stock, although a transfer from a partnership to a partner has its limitations, specified under Sec. 1202(g) for determining each partner's share of adjusted basis.

Until such time that additional guidance is published by Treasury and the IRS, the following transfers likely will jeopardize the original-issuance status of QSBS:

  • A distribution of QSBS from an S corporation to an S corporation shareholder;
  • A contribution of QSBS by a partner to a partnership;
  • A contribution of QSBS from a shareholder to a corporation that does not qualify as an exchange under Sec. 351 or a reorganization under Sec. 368; or
  • A gift of equity interests in a partnership or an S corporation that owns QSBS.

Investors beware

Unsurprisingly, Sec. 1202 is attractive among investors and tax practitioners given the tremendous tax savings it can offer. Sec. 1202 continues to be an important consideration for choice-of-entity determinations. With the right set of facts and proper planning, founders and investors may find it more tax-efficient to conduct business through C corporations than passthrough entities. While tax practitioners' Sec. 1202 expertise has grown over the years, complicated structures have emerged in M&A transactions in an attempt to obtain the benefits of Sec. 1202. As discussed in this article, applying the rules under Sec. 1202 may pose traps for the unwary, and the nuance to the rules may be counterintuitive. Careful consideration should be given if a transaction is contemplated with Sec. 1202 in mind, so as not to jeopardize the potential Sec. 1202 benefits for the existing shareholders and, potentially, incoming investors.

Taxpayers may be able to find clear guidance from Sec. 1202 if the fact patterns involved are relatively straightforward. One could argue that the Sec. 1202 rules are not yet sufficiently clear to address complicated M&A situations, and the language under Sec. 1202 contains uncertainty and ambiguity. As Sec. 1202 continues to grow in popularity for investors and more controversies arise, it is probable that regulatory, judicial, and administrative guidance will soon be developed.


1Sec. 1202(a)(1).

2Sec. 1202(a)(3).

3Sec. 1202(a)(4).

4Sec. 1(h).

5P.L. 115-97.

6Sec. 1202(c)(1)(B).

7Sec. 1202(d)(1)(A).

8Sec. 1202(d)(1)(B).

9Sec. 1202(a)(1).

10Secs. 1202(c)(1) and (2).

11Sec. 1202(c)(3)(A); Regs. Sec. 1.1202-2(a).

12Sec. 1202(c)(3)(B).



Heath Wang, E.A., is a senior manager with the National Tax Office of BDO USA LLP in Boston. For more information about this article, contact


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