Section 1202 of the Internal Revenue Code allows non-corporate taxpayers to exclude up to 100 percent of capital gains, up to $10 million or 10 times the stock’s basis, whichever is greater, from the sale of Qualified Small Business Stock. Meeting the QSBS eligibility requirements is not automatic. Both the issuing corporation and the stockholder must satisfy strict criteria, and missing any one of them forfeits the benefit entirely.
Issuing Corporation Requirements
The first set of QSBS eligibility requirements applies to the corporation itself. It must be a domestic C corporation at the time of stock issuance and during substantially all of the stockholder’s holding period. S corporations, LLCs, partnerships, and foreign corporations are ineligible under any circumstance.
The corporation’s gross assets must not exceed $50 million at all times before and immediately after the stock is issued, including cash and assets valued at their original cost. At least 80 percent of the corporation’s assets, by value, must be used in the active conduct of a qualified trade or business during substantially all of the holding period. Several categories of business are excluded from meeting this active business requirement, including professional services such as health, law, engineering, architecture, accounting, consulting, and financial services, along with banking, insurance, leasing, investing, farming, mining, oil and gas extraction, and hospitality businesses like hotels and restaurants.
Asset composition is restricted as well. No more than 10 percent of assets may consist of real property not used in active business operations, or stock and securities in other corporations, excluding majority owned subsidiaries.
Stock Requirements
The QSBS eligibility requirements also govern how and when the stock itself was acquired. Stock must be acquired directly from the corporation, not through secondary markets, in exchange for cash, property other than stock, or services.
The stock must be held for more than five years before sale, and the holding period clock starts at issuance, not at exercise for stock options, a distinction that catches many equity holders off guard. Stock must also have been issued after August 10, 1993, and stock acquired after September 27, 2010 qualifies for the full 100 percent exclusion.
Stockholder Requirements
Only individuals, trusts, estates, or pass-through entities such as partnerships and LLCs qualify under the QSBS eligibility requirements. C corporations cannot claim the exclusion themselves. Additionally, the corporation cannot repurchase significant stock shortly before or after issuance, since redemption transactions like this may disqualify the stock entirely.
Key Exclusions and Limitations
The exclusion itself is capped at the greater of $10 million or 10 times the taxpayer’s adjusted basis in the stock. It is also worth noting that some states do not conform to federal QSBS rules, meaning state tax liabilities may vary even when the federal QSBS eligibility requirements are fully met.
Documentation and Compliance
Meeting the QSBS eligibility requirements on paper is not enough without proper documentation. Records proving eligibility, including stock issuance dates, asset valuations, and corporate structure, should be maintained throughout the holding period. Obtaining a QSBS attestation letter from the corporation can help validate compliance in the event of an audit.
Failure to meet any single requirement forfeits the tax benefit entirely. Given the complexity involved, particularly around convertible notes, mergers, or entity conversions, consulting a tax professional is strongly advised before assuming QSBS treatment applies.
