Section 1202: A Path to Substantial Tax Savings for Business Owners
- Trevor Cobb
- Jun 27
- 5 min read
Updated: Jun 29

Section 1202 of the IRS code presents a significant opportunity for eligible business owners to save millions of dollars in taxes. Despite its potential, this provision remains underutilized due to a lack of awareness among entrepreneurs.
At its core, Section 1202 allows business owners to exclude a portion of the gains from the sale of Qualified Small Business Stock (QSBS) from their taxable income. This exclusion can amount to substantial savings, potentially reaching up to $10 million or ten times the adjusted basis of the stock, whichever is greater. This tax benefit represents a critical advantage in maximizing financial outcomes for those eligible.
The Qualifications and Benefits of Section 1202
Eligible Shareholder
Eligible shareholders are individuals, trusts, estates, and in some circumstances a partnership or S corporation. In the case of partnerships or S corporations additional requirements must be met and careful consideration with a qualified accountant or tax lawyer is recommended. To qualify for QSBS treatment, shares must be acquired directly from a "qualified small business," defined as a C-corporation engaged in active trade or business with assets under $50 million at the time of issuance. This provision is particularly advantageous for early investors and employees who receive stock in exchange for their contributions.
Holding Period
The holding period for QSBS is at least five years to qualify for the exclusion. In general, the holding period begins on the date the stock was issued and this is also true for the date of the exchange if non-cash property was exchanged for stock. The same is true for the conversion date if debt or the exercise of options was converted to stock. in some instances, such as inheritance, gifts, and partnership distributions, a share holder can add on previous holding periods.
Entity Requirements
The corporation must be either a domestic C corporation or an LLC that is taxed as a C corporation. The key here is that there should be a corporate level tax element so a S corporation or an LLC filing taxes as a partnership or passthrough entity will not qualify. There can be some exceptions for REITs and some other structures. it may be worth asking a qualified accountant or tax lawyer with experience in these situations. We are happy to make a recommendation.
The corporation may not at anytime have more than $50 million of tax basis in its assets between August 11, 1993 until immediately after the issuance of the stock. This test is applied at the time of each stock issuance and it is not tested for that issuance again. Thus, it is possible for a holder to have some stock that is QSBS and some that is not. It is important to remember that this is tested on a tax basis in the assets. This allows for some planning by the corporation and its advisors.
Qualified trade or business
There are many exclusions as noted in the table below. If a business is deemed to be on this excluded list, then the stock will be disqualified. 80% of the fair market value of the assets of the business must be in the active conduct of a qualified trade or business. This must be met during substantially all of the holding period. Further, only up to 50% of the assets of the business may be in working capital. These terms are not well defined in the code which leaves them open to some interpretation by both the taxpayer and the IRS.
Finance | Farm | Oil, gas, & mining | Hospitality | Real Estate | Personal Services |
Banking, insurance, leasing, financing, investing, or similar | Farming, gardening, growing, or similar | Drilling, mining, or extraction business | Hotel, motel, restaurant, or other similar | Ownership of, dealing in, or renting of real property | Health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, or any business in which the principal asset of the business is the reputation or skill of the one or more of its employees |
A common disqualifying pitfall
The rule is written to encourage investment in small business corporations and thus seeks to prohibit the issuance of stock to fund the redemption of other shareholders. This is one of the easiest ways to disqualify otherwise qualified small business stock. Any redemptions of size withing the year before or after a stock issuance would disqualify those shares. "size" in this case is generally 5% or more. A second test also applies for a two year before or after window for redemptions of 2% or more. There are exemptions here for death, disability, or termination.
Planning for the Future
One significant planning error that entrepreneurs often make is neglecting to consider the QSBS exemption until the point of sale, potentially missing out on significant tax advantages. Strategic planning and awareness of QSBS provisions can ensure that business owners are well-positioned to capitalize on these tax savings when the opportunity arises.
Stock Issuance starting | Stock Issuance Ending | 1202 Exclusion | 1202 Effective tax rate* | Tax Rate without 1202 | 1202 Savings |
Aug. 11, 1993 | Feb, 18, 2009 | 50% | 15.9% | 23.8% | 7.9% |
Feb. 19, 2009 | Sept. 27, 2010 | 75% | 7.95% | 23.8% | 15.85% |
Sept. 28, 2010 | - | 100% | 0% | 23.8% | 23.8% |
*Note: stock subject to the 50% and 75% exclusion, any gain within this section 1202 limitation that is not excluded from income is subject to a 28% capital gains tax rate plus the net investment income tax of 3.8%. Any gain in excess of the Section 1202 limitation is subject to standard capital gains rates. An alternative minimum tax preference equal to 7% of the excluded gain is impose for the stock eligible for the 50% of 75% exclusion, which has not been factored into the effective tax rate. 1
Looking Ahead
As more entrepreneurs and investors become informed about the benefits of Section 1202, we may see a shift towards greater pre-liquidity planning and a more strategic approach to capitalizing on long-term tax benefits. By understanding and adhering to the requirements outlined in Section 1202, business owners can navigate tax complexities and potentially save millions, ultimately enhancing their financial success.
In conclusion, Section 1202 offers a valuable avenue for business owners to optimize tax outcomes, provided they meet the specific criteria laid out in the IRS code. By taking proactive steps to understand and implement these provisions, entrepreneurs can unlock substantial tax savings and pave the way for greater financial security.
Sources and Disclosures:
https://bdo.com/insights/tax/section-1202-eliminating-the-double-tax-bias-for-small-c-corporations
IRS Publication 550 - Investment Income and Expenses: This publication provides detailed information about capital gains and losses, which includes explanations related to QSBS and the Section 1202 exclusion.
IRS Form 8949: This form is used to report sales and other dispositions of capital assets, including QSBS, where the Section 1202 exclusion might apply.