Gray areas of Sec. 1202 warrant regulatory guidance

Editor: Mo Bell-Jacobs, J.D.

Through Sec. 1202, Congress granted taxpayers a significant boon to encourage new investment in developing companies. The provision allows qualifying investors in certain C corporations to exclude up to 100% of the capital gain realized upon the sale of their stock.

The applicability of Sec. 1202 and the benefit to taxpayers has become even more favorable for stock issued after July 4, 2025, the enactment date of H.R. 1, P.L. 119–21, known as the One Big Beautiful Bill Act (OBBBA) (see also Fonseca, “Revisiting Sec. 1202: Strategic Planning After the 2025 OBBBA Expansion,” 56–12 The Tax Adviser 13 (December 2025)). The OBBBA amendments introduced a tiered holding period structure, expanded the size of C corporations that could qualify, and increased the amount of the capital gain exclusion. However, the amendments did not address the ambiguities in the language and application of the provision.

The lack of guidance has created uncertainty for taxpayers, the government, and advisers. Though Treasury has provided some guidance for taxpayers concerning the active–business requirement of Secs. 1202(c)(2) and (e), as many advisers have commented, there are still many gray areas. This item lays out some of these ambiguities that the IRS and Treasury should consider clarifying.

Holding companies as issuing corporations

One ambiguity involves using a new corporate holding company to issue stock. As more founders and investors become aware of the Sec. 1202 benefit, they are intentionally structuring their investments to take advantage of it. To qualify, shareholders must purchase shares directly from the issuing corporation (the original–issuance requirement). Many target entities may fit the qualified small business (QSB) profile — an operating domestic C corporation that satisfies the active–business requirement and aggregate–gross–assets test under Sec. 1202(d)(1); however, a direct acquisition of target stock from a selling shareholder, as opposed to the issuing corporation, would not satisfy the original–issuance requirement. Similarly, a direct cash investment for newly issued shares followed by a redemption of exiting shareholders would likely run afoul of Sec. 1202(c)(3) as a significant corporate repurchase. As an alternative structuring, taxpayers may consider forming a holding company, as in the following example:

Example 1: Acquiring shareholders create a corporate buyer (B) and fund it with $60 million in cash. B then uses the $60 million to acquire target (T). Considering the parent–subsidiary group, assume that combined, B and T satisfy all the requirements of a QSB immediately after the transaction.

Given that stock acquired in a secondary purchase would not qualify as QSB stock, is the creation of a new corporation to acquire the stock of T in hopes of obtaining QSB status problematic? It would seem not, given the aggregation rules under Sec. 1202(d)(3). Alternatively, B could have acquired T assets instead of stock, and the acquisition would have resulted in the issuance of QSB stock.

For purposes other than Sec. 1202, holding companies are frequently created as acquisition vehicles for nontax purposes (e.g., financing, future acquisitions, and management functions). Further, in looking at other provisions where a holding company controls another corporation within the meaning of Sec. 368(c), the corporate subsidiary’s business assets are aggregated with its parent corporation when applying the active–trade–or–business test under Sec. 355(b) (see alsoRegs. Sec. 1.355–3(b)(1) to determine whether a corporate distribution of stock of a controlled corporation is a nonrecognition event). Another example of parent–subsidiary aggregation is for determining when startup activities end when taking a deduction under Sec. 195. Therefore, forming a new corporate holding company to make an acquisition would not appear contrary to either normal business practices or the intent of Sec. 1202.

Example 2: Acquiring shareholders form B and fund it with $60 million in cash. B then uses the $60 million to acquire 51% of T. The nonselling shareholders intend to retain their 49% interest in T, as they believe they hold QSB stock. Looking at the parent–subsidiary group, assume B satisfies all the requirements of a QSB.

In this scenario, the question often arises of whether the retained T stock remains QSB stock once T becomes part of a parent–subsidiary group. It seems appropriate for the retained 49% to keep its QSB stock status following the acquisition. Moreover, assuming B has met the aggregate–gross–assets test immediately after the transaction, the stock issued to B shareholders in the transaction would also qualify as QSB stock. It would be beneficial for Treasury to confirm that retained T shares remain eligible even when T becomes the subsidiary of a parent–subsidiary controlled group as defined under Sec. 1202(d)(3)(B) and that B qualifies as a QSB.

Aggregation of an operating partnership

Partnerships (and limited liability companies (LLCs) taxed as partnerships) are common forms of joint business ventures. Questions therefore arise as to whether an issuing corporation can satisfy the active–business requirement and the aggregate–gross–assets test where that corporation operates its business through a partnership.

Active–business requirement: Sec. 1202(e)(5)(C) provides that an issuing corporation may look through and attribute to itself its ratable share of its corporate subsidiary’s assets and business activities if it owns more than 50% of the vote or more than 50% of the value of that subsidiary. The statute does not provide the same attribution rules for partnerships. However, for purposes of satisfying the Sec. 355 active–trade–or–business test and the Sec. 368 continuity–of–business–enterprise requirement, a corporation may claim its share of a partnership’s business. Under Sec. 368, the partner needs only to own a 331/3% interest (or as low as 20%, if the partner is actively managing the business) for the attribution rules to apply (see Regs. Sec. 1.368–1(d)(5), Examples (8) and (10)).

Based on those provisions and the common use of partnerships, it appears reasonable to allow attribution from a partnership to an issuing corporation. However, is a 331/3% interest in a partnership sufficient for attribution to apply, or should it apply only if the issuing corporation owns more than 50% of the partnership? Absent guidance, taxpayers and their advisers are left to their own extrapolations.

Aggregate–gross–assets test: To qualify as a QSB, at the time that it issues stock, a corporation cannot exceed either $50 million or, if the shares are issued after July 4, 2025, $75 million in aggregate gross assets (Sec. 1202(d)). Gross assets are generally measured as the aggregate tax basis in the corporate assets or, if those assets are contributed to the issuing corporation, the assets’ fair market value (Sec. 1202(d)(2)(B)). Assuming that an issuing corporation can aggregate the assets of a partnership, should aggregation be limited to the issuing corporation’s ratable share of the partnership, or should the corporation need to include the partnership’s total assets?

Example 3: Acquiring shareholders create B on Jan. 1, 2026, and fund it with $40 million in cash. B then uses the $40 million to acquire a 60% interest in T LLC, a partnership for tax purposes. Assuming T has no liabilities and $40 million in inside asset basis, B would have a $40 million basis in its T interest. Assume further that the acquisition generates a Sec. 743 adjustment of $16 million (the inside basis of B’s assets in T is $24 million).

In this example, whether you look at B’s basis in T ($40 million) or T’s total basis in assets ($56 million, including the Sec. 743 adjustment), in each scenario, the combined entities appear to fall under the $75 million threshold.

Example 4: Acquiring shareholders form B on Jan. 1, 2026, and fund B with $60 million in cash. B then uses the $60 million to acquire a 60% interest in T LLC, a partnership for tax purposes. Assuming T has no liabilities and $40 million in inside asset basis, B would have a $60 million basis in its T interest. Assume further that the acquisition generates a Sec. 743 adjustment of $36 million (the inside basis of B’s assets in T is $24 million).

In Example 4, if one looks to just B’s basis in T, the aggregated assets fall under $75 million. However, looking at the total assets of the partnership ($76 million, including B’s outside basis via Sec. 743), B exceeds the $75 million threshold.

The above example requires the taxpayer to reach a conclusion based on several interdependent interpretations of the statutory language. The statute does not address how to apply the test to a corporation operating through a partnership. First, a taxpayer must conclude that the corporation can qualify as a QSB through holding a partnership interest. Then, based upon that interpretation, the taxpayer must subsequently conclude how aggregation would apply. Allowing the corporation to look solely at its ratable share of T’s assets could lead to abuse, may be contrary to intent, and would likely necessitate a related–party or coordinated–acquisition anti–abuse rule.

Intersection of QSB stock issuance and the active-business requirement

For a shareholder’s stock to qualify as QSB stock, an issuing corporation must meet the active–business requirement for substantially all of that shareholder’s holding period of such stock (Sec. 1202(c)(2)). Further, the active–business requirement requires that the issuing corporation use 80% of its assets, based on value, in its qualifying trade or business. Sec. 1202(e)(2) provides a special rule where certain passive assets, such as cash, are treated as active assets if used in certain specified activities. These activities include, among others, startup activities and research and development related to any future qualified trade or business.

The statutory language is unclear as to how the startup activity allowance and the “substantially all” holding period interact. Does the “substantially all” holding period language coincide with this allowance for the active–business requirement beyond that of the startup activities? Said differently, does the corporation need to have any activity when it issues its stock if ultimately it had an active business during substantially all of the shareholder’s holding period?

Example 5: Acquiring shareholders create B on Jan. 1, 2026, and fund it with $75 million in cash. B uses $2 million of the cash over the next 18 months looking for potential targets (with $1 million representing startup activities). B ultimately identifies a target in a qualified business and acquires T’s assets for $73 million. B operates T for the next 6.5 years and sells on Jan. 1, 2034.

In Example 5, is B a QSB that issued QSB stock on Jan. 1, 2026? Assume that 6.5 out of eight years (81.25%) is substantially all the shareholders’ holding period. Does the fact that B did not operate a business or engage in substantial startup activities for 18 months following the issuance of stock affect the QSB/QSB stock determination?

The answer could hinge on how the IRS and Treasury interpret the statute and legislative intent. A plain reading of the statute does not appear to require any activity upon issuance but only that the requirement is met during substantially all of the shareholder’s holding period.

Example 6: Acquiring shareholders create B on Jan. 1, 2026, and fund it with $50 million in cash. B uses the cash to acquire a business, but the business is not a qualified business (e.g., insurance). B operates T for the next 18 months and then transitions into insurance claims management and sells on Jan. 1, 2034. It is unclear what the gross assets of B were at the time the business transitioned into a qualifying business.

In Example 6, did B issue QSB stock on Jan. 1, 2026? Assume that 6.5 years out of eight years (81.25%) is substantially all of the shareholders’ holding period. Does the fact that B did not operate a qualified business for the 18 months following the issuance of the shares affect the QSB/QSB stock determination?

While this situation is uncommon, a benefit as significant as the Sec. 1202 exclusion could drive business decisions for a company in terms of how it operates its business and whether to expand or change its operations.

The impact of AI advances on the active-business requirement

As artificial intelligence (AI) rapidly advances, an increasing number of companies that perform professional services are using it to enhance their productivity and cost–effectiveness. Generally, professional services companies cannot qualify under Sec. 1202; the statute excludes from its scope, among other things, “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees” (Sec. 1202(e)(3)(A)). But what happens if such a firm begins to rely extensively on AI?

Because AI large–language models offer the ability to answer questions, draft written content and code, and prepare complex computations, AI is increasingly capable of performing tasks traditionally performed by licensed professionals. If a professional–services company uses AI to perform most or all of its tasks and no longer needs a licensed professional, is there a point where the use of AI supersedes the skill of an employee as the principal asset of a business? Would the company’s business no longer be excluded under Sec. 1202(e)(3)(A) if an employee inputs certain information into an AI tool that fully conducts the analysis? Or, if a trained professional (ostensibly) reviews the AI’s analysis, does the business still ultimately depend on the skill of its employees? Alternatively, does it ultimately depend on the nature of the final output delivered to the client, regardless of who or what performs the analysis?

Redeeming QSB stock that has been contributed to a partnership

For purposes of Sec. 1202, a partnership must purchase stock directly from the issuing corporation as if it were an individual for that stock to be eligible QSB stock. Further, legislative history explicitly tells us that “if qualified small business stock is transferred to a partnership and the partnership disposes of the stock, any gain from the disposition will not be eligible for the exclusion” (H.R. Rep’t No. 103–111, 103rd Cong., 1st Sess. 430 (1993)). However, a partnership may distribute QSB stock to its partners, and that stock retains its QSB status under Sec. 1202(h)(2)(C). If QSB stock contributed to a partnership is distributed out to the same contributing partners, could that stock regain its QSB status? Based on the letter of the law, the selling shareholder would be the original purchaser of the stock as prescribed under Sec. 1202. Or is that stock forever tainted?

Guidance is needed

As illustrated by the questions raised above, there are many nuances and gray areas in interpreting the provisions of Sec. 1202. The amendments to Sec. 1202 under the OBBBA are driving increased interest by investors, including from private equity. Though the IRS has issued several rulings, none is precedential. Guidance from Treasury and the IRS is warranted and needed.

Editor

Mo Bell-Jacobs, J.D., is a senior manager, Washington National Tax, with RSM US LLP and a member of the AICPA Tax Executive Committee.

For additional information about these items, contact Bell-Jacobs at Mo.Bell-Jacobs@rsmus.com.

Contributors are members of or associated with RSM US LLP.