IRC Section 1202 Ignites Investor Interest

Amy Bloom, CPA
Published Date:
Apr 1, 2020

Alan Patricof, a vanguard in the venture capital industry, was instrumental in the enactment of IRC section 1202 as part of the Revenue Reconciliation Act of 1993 in order to encourage investment in small businesses. IRC section 1202 only applies to stock in C corporations, and initially it did not receive a lot of attention. Since its enactment, though, it has undergone several changes. The 2017 Tax Cuts and Jobs Act (TCJA), however, reduced the corporate tax rate from 35% to 21%, making operating as a C corporation more attractive to investors. The benefits realized from issuing qualified small business stock (QSBS) has not gone unnoticed. Currently, IRC section 1202 provides a 100% exclusion of gain on QSBS held for more than five years.

When enacted, IRC section 1202(a) provided a 50% gain exclusion for any stock acquired before Feb. 18, 2009, and a 75% gain exclusion for any stock acquired between Feb. 18, 2009, and Sep. 27, 2010. Prior to Sep. 27, 2010, there was also an alternative minimum tax (AMT) preference item for 7% of the excluded gain and a 3.8% net investment income tax on the taxable portion. After Sep. 27, 2010, the gain exclusion became 100%.

Qualifying as QSBS

To qualify as QSBS, as defined under IRC section 1202(c), certain requirements must be met at the time of the stock’s issuance, while other requirements must be met during substantially the entirety of the shareholder’s holding period of the stock.

First, the stock must be issued by a corporation that, on the date of issuance, is a small business corporation. A small business corporation is a domestic C corporation with aggregate gross assets totaling $50 million or less, at all times from Aug. 10, 1993, until date of issuance [IRC section 1202(d)(1)]. Aggregate gross assets are cash plus the fair market value of any property at the time of contribution.

Second, the stock must be issued by a corporation that meets the active business requirement when the stock was issued and during the period stock was held. To be an active business, at least 80% of the value of corporation’s assets are used in a qualified trade or business (QTB), per IRC section 1202(e)(1). Assets held to meet the reasonably required working capital needs of a QTB and assets held for investment that are reasonably expected to be used within two years to finance research and experimentation in a QTB or to finance increases in a QTB’s working capital needs are also treated as used in an active conduct of a QTOB [IRC section 1202(e)(6)].

Note that under IRC section 1202(e)(3) a QTB is any trade or business other than—

  • one involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services;
  • one where the principal asset of the trade of business is the reputation or skill of one or more of its employees;
  • any banking, insurance, financing, leasing, investing, or other similar business;
  • any farming business;
  • any business involving the production of extraction of products for which depletion is allowable; and
  • any business of operating a hotel, motel, restaurant or similar business.

Third, the stock must be acquired in an original issuance in exchange for money or property (but not stock) or as compensation for services. If the stock is transferred by gift or at death, the transferee is treated as having acquired the stock in the same manner as the transferor and as having held the stock during any continuous period preceding the transferor during which the transferor qualified for exclusion under IRC section 1202. Stock acquired through the exercise of options or warrants, or through the conversion of convertible debt, is treated as acquired at original issue on the exercise date. The issued stock is eligible for the IRC section 1202 exclusion, provided the company is a qualified small business (QSB) at the time of exercise and the holding period of five years is met. Cashless options would still qualify for QSB treatment.

Gain Limitation

IRC section 1202(b)(1) limits the amount of gain eligible for exclusion to the greater of 10 times the taxpayer's aggregate adjusted basis in the stock that is sold, or $10 million reduced by eligible gains that had been considered in prior tax years for dispositions of stock issued by the corporation. Any gains in excess of the limitation amount are taxed under the normal rules for capital gains. There are no carryover provisions for gains in excess of this limitation.

Stock Acquired on Conversion of Other Stock

IRC section 1202(f) provides that any stock of a corporation that is acquired solely through the conversion of other stock and the converted stock is QSBS in the hands of the taxpayer, the acquired stock will also be treated as QSBS. Tack on holding period will apply, which treats the newly acquired stock in the conversion as having been held for the period during which the converted stock was held [IRC section 1202(f)]. If a shareholder exchanges QSBS for other stock in a transaction described under IRC section 351 or IRC section 368, the shareholder may preserve QSBS status for the newly acquired stock, even if it not otherwise QSBS [IRC section 1202(h)(4)(A)]. QSBS treatment will be limited to the amount of gain accrued when rolled over into nonqualified small business stock. The IRS has issued private letter rulings that certain corporate structure adjustments do not impact eligibility for small business stock treatment (PLR 201636003 and PLR 201603014).

Stock Acquired in a Pass-through Entity

IRC section 1202(g) permits taxpayers to hold QSBS through any partnership, S corporation, regulated investment company (RIC), or common trust fund. Any QSBS held via a pass-through entity is subject to the same requirements as if held directly. The noncorporate partner of a pass-through entity that recognizes gain on the sale of QSBS will receive the benefits of IRC section 1202 if the QSBS qualifies as QSBS in the hands of the pass-through entity and the pass-through entity has held the QSBS for at least five years. In addition, the noncorporate partner must have been a partner in the pass-through entity at the time the QSBS was acquired by the pass-through entity until the disposition of the stock. If a noncorporate partner acquires additional interest subsequent to the pass-through entity’s purchase of QSBS, the exclusion applies only to the gain attributable to the noncorporate partner’s share in the pass-through entity at the time the pass-through entity acquired the QSBS.


If the corporation buys back shares and the shareholder later wants to repurchase the shares, there are some requirements that need to be satisfied for QSBS treatment. If at any time during the four-year period beginning two years before the stock is issued, the corporation purchased (directly or indirectly) any of its stock from the taxpayer or a related person, the stock will not qualify for QSBS treatment. Furthermore, the exclusion does not apply if, during the two-year period beginning one year before the stock is issued, the corporation made one or more purchases of its stock with an aggregate value exceeding 5% of the aggregate value of all its stock [IRC section 1202(c)(3)]. For example, if the aggregate value of a corporation's stock is $1 million on Jul. 1, 2000, stock issued on Jul. 1, 2001, is disqualified if more than $50,000 of stock is redeemed from any shareholder during the period of Jul. 1, 2000, through Jun. 30, 2002. It is not relevant whether the amount received by the corporation for the newly issued stock is more or less than the amount paid for the redeemed stock. A de minimis exception applies if the amount paid for the redeemed stock is $10,000 or less, or if not more than 2% of the stock held by the taxpayer and related persons is redeemed. A redemption of more than a de minimis amount of the newly issued stock within two years after issue disqualifies 100% of the stock not redeemed.

IRC section 1202(b)(1) limits the amount of gain eligible for exclusion to the greater of 10 times the taxpayer's aggregate adjusted basis in the stock that is sold, or $10 million reduced by eligible gains that had been considered in prior tax years for dispositions of stock issued by the corporation. Any gains in excess of the limitation amount are taxed under the normal rules for capital gains. There are no carryover provisions for gains in excess of this limitation.


With the passage of the TCJA in 2017, corporations are receiving more notice, and entity choice to be a C corporation is becoming more favorable. When considering a business’s entity choice, whether on formation or conversion, the potential tax benefits under IRC section 1202 may be significant. The requirements may seem cumbersome, but with careful planning, the gain from the disposition of QSBS can be permanently excluded from income taxation.

Amy Bloom, CPA, has more than 15 years of experience providing tax planning and compliance services for corporations and partnerships in various industries, as well as high-net-worth individuals. She provides corporate, partnership, individual, and multi-state income tax planning and compliance. She represents clients before the IRS and state tax authorities, advises on implications of foreign structuring for US purposes and foreign reporting requirements and provides tax due diligence services for mergers and acquisitions.

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