Section 1202 QSBS Exclusion Rules: Capital Gains Exclusion Percentages

Section 1202 of the Internal Revenue Code offers a significant tax advantage for investors in small businesses, allowing for the exclusion of a substantial portion, and sometimes the entirety, of capital gains derived from the sale of Qualified Small Business Stock (QSBS) from federal income tax. This guide delves into the nuanced rules of Section 1202, focusing on exclusion percentages, holding period requirements, per-issuer limitations, and basis considerations, providing a valuable resource for sophisticated investors and tax professionals.

Exclusion Percentages: The Key Benefit

The ability to exclude capital gains under Section 1202 is contingent upon the acquisition date of the stock and the duration it is held. The legislative framework of Section 1202 is designed to incentivize long-term investment in small businesses, a critical engine of economic growth and innovation. The exclusion percentages serve not only as a tax benefit but also as a stimulus for sustained investment in the small business sector.

Stock Acquired on or Before the Applicable Date (July 4, 2025)

For QSBS acquired on or before July 4, 2025, the exclusion percentage is primarily determined by the holding period exceeding five years:

• 50% exclusion for stocks held more than 5 years [IRC §1202(a)(1)(A)].

Historically, the exclusion percentages have varied to encourage investment during different economic periods:

• 75% exclusion for stocks acquired between February 18, 2009, and September 27, 2010, if held for more than 5 years [IRC §1202(a)(3)].

• 100% exclusion for stocks bought after September 27, 2010, and on or before July 4, 2025, if held for more than 5 years [IRC §1202(a)(4)].

Stock Acquired After the Applicable Date (July 4, 2025)

For stocks purchased post-July 4, 2025, the exclusion percentage is progressively scaled based on the specific holding period:

• 50% exclusion for stocks held for at least 3 years but less than 4 years.
• 75% exclusion for stocks held for at least 4 years but less than 5 years.
• 100% exclusion for stocks held for 5 years or more [IRC §1202(a)(1)(B), (a)(5)].

This tiered structure post-2025 reflects a policy shift towards rewarding increasing levels of long-term investment, aligning tax incentives with economic longevity.

Table: Exclusion Percentages by Acquisition Date and Holding Period

Acquisition Date	Holding Period	Exclusion Percentage
On or before Feb 17, 2009	More than 5 years	50%
Feb 18, 2009 - Sept 27, 2010	More than 5 years	75%
Sept 28, 2010 - July 4, 2025	More than 5 years	100%
After July 4, 2025	3-4 years	50%
After July 4, 2025	4-5 years	75%
After July 4, 2025	5+ years	100%

Holding Period Requirements

The holding period plays a pivotal role in determining eligibility for the QSBS exclusion. For stocks acquired on or before the noted applicable date:

• A minimum holding period of more than 5 years is required [IRC §1202(a)(1)(A)].

For stocks acquired after the applicable date:

• The minimum holding period starts at 3 years for a 50% exclusion, extending to 5 years for a 100% exclusion [IRC §1202(a)(1)(B), (a)(5)].

This progressive structure underscores the legislative intent to encourage longer holding periods, which ostensibly leads to more stable investment in small businesses and fosters sustained economic growth.

Holding Period Calculation:

• The holding period generally starts the day after acquisition.
• Section 1223 rules are typically applied to determine holding periods.
• Special rules are enacted for stocks received via gifts, inheritances, and certain corporate restructures.

Per-Issuer Dollar Limitations

The exclusions are also subject to per-issuer limitations that cap the total amount of gain that can be excluded per small business issuer:

Stock Acquired on or Before the Applicable Date

• Limit: $10 million (or 10 times the taxpayer's adjusted basis in the QSBS, if greater) per issuer [IRC §1202(b)(4)(A)].

Stock Acquired After the Applicable Date

• Limit: $15 million (or 10 times the taxpayer's adjusted basis in the QSBS, if greater) per issuer [IRC §1202(b)(4)(B)].

Beginning in 2027, the $15 million cap will be subject to inflation adjustments [IRC §1202(b)(5)].

How the Limit Applies:

The limitation applies to "eligible gain," which is the gain from the sale or exchange of QSBS held for the requisite period (at least 3 years post-applicable date or more than 5 years pre-applicable date) [IRC §1202(b)(2)].

Married Individuals

For married individuals filing separate returns:

• The $10 million limit is reduced to $5 million per issuer for pre-applicable date stock [IRC §1202(b)(3)(A)(i)].
• For post-applicable date stock, the limit is halved to $7.5 million [IRC §1202(b)(3)(A)(ii)].

For joint filers, the exclusion amount is evenly split between spouses for subsequent taxable years [IRC §1202(b)(3)(B)].

Basis Considerations

The exclusion focuses on gain, not the gross proceeds from the sale [IRC §1202(a)]. This distinction is crucial as it emphasizes the tax relief on the actual economic gain rather than the total transaction value.

Example:

• Purchase price (basis): $100,000
• Sale price: $1,000,000
• Gain: $900,000
• If within the per-issuer limit and held for the requisite period, a 100% exclusion could apply, resulting in no taxable income on the $900,000 gain.

Adjusted Basis Determinations:

• For the per-issuer limitation, the adjusted basis is calculated without considering any post-issuance capital contributions [IRC §1202(b)(1)].

Basis Rules for Property Exchanges:

• If stock is exchanged for property (other than cash or stock), the stock's basis cannot be less than the fair market value of the exchanged property [IRC §1202(i)(1)].

Capital Contributions:

• Adjustments to the basis of QSBS due to capital contributions post-issuance must reflect the fair market value of the contributed property on the contribution date [IRC §1202(i)(2)].

Active Business Requirement

To qualify as QSBS, the issuing corporation must adhere to stringent active business requirements throughout the substantial portion of the taxpayer's holding period [IRC §1202(c)(2)(A)]. This includes:

• Utilizing at least 80% of its assets, by value, in active conduct of qualified trades or businesses.
• Maintaining status as an eligible domestic C corporation, excluding certain types of corporations like DISCs, RICs, REITs, REMICs, and cooperatives.

Failure to meet these criteria at any point can retroactively negate the QSBS status, highlighting the need for ongoing compliance.

Eligible Gain

"Eligible gain" refers to the gain from the sale or exchange of QSBS that meets the minimum holding period requirements:

• At least 3 years for post-applicable date stocks.
• More than 5 years for pre-applicable date stocks [IRC §1202(b)(2)].

Only eligible gain is considered for the exclusion, underscoring the emphasis on long-term holding.

Ordinary Income Portion

If any part of the gain from QSBS sale is classified as ordinary income, it does not qualify for the Section 1202 exclusion. This distinction ensures that the tax benefit is strictly applied to capital gains, reinforcing the policy goal of promoting equity investment over other forms of income.

Short Positions

Special provisions under Section 1202(j) address situations involving offsetting short positions. Generally, the exclusion is forfeited if the taxpayer holds a corresponding short position unless:

• The stock was held for the required duration as of the first day of the short position, and
• The taxpayer opts to treat the stock as sold on that day for its fair market value [IRC §1202(j)(1)].

This rule aims to prevent abuse of the QSBS provisions by disallowing speculative practices that could undermine the long-term investment intent of the statute.

State Tax Considerations

It is crucial to note that Section 1202 pertains solely to federal tax regulations. State conformity to these rules varies:

• Some states adopt the federal QSBS exclusion framework.
• Others, like California and New Jersey, do not, necessitating state tax payment on gains excluded at the federal level.

Taxpayers must consult local tax laws to fully understand their tax obligations concerning QSBS.

AMT Considerations (Historical)

Historically, for stock acquired before September 28, 2010, the excluded gain was considered an Alternative Minimum Tax (AMT) preference item. However, subsequent legislative changes have removed this treatment for stock acquired after September 27, 2010, enhancing the exclusion's value by eliminating potential AMT complications.

Legislation in Public Law 119-21 has further refined the AMT implications, applying changes retroactively for certain periods.

Key Takeaways

1. Exclusion percentages vary: Depending on the acquisition date and holding period, exclusions can range from 50% to 100%.
2. Holding period is critical: Eligibility hinges on meeting minimum holding periods of 3-5 years based on the acquisition timeline.
3. Per-issuer limits apply: Caps of $10 million pre-applicable date and $15 million post-applicable date are set per issuer, with an alternative limit of 10 times the adjusted basis.
4. Active business requirement: Continuous compliance with active business criteria is essential throughout the holding period.
5. State taxes may still apply: Despite federal exclusions, state tax liabilities can vary.
6. Ordinary income excluded: Only capital gains qualify for the exclusion, excluding any ordinary income portion.
7. Short positions could disqualify: Holding offsetting short positions can jeopardize the exclusion unless specific conditions are met.

Sources and Citations

• IRC Section 1202: Partial exclusion for gain from certain small business stock
• IRC Section 1202(a): Exclusion provision and percentages
• IRC Section 1202(b): Per-issuer limitations
• IRC Section 1202(i): Basis rules
• IRC Section 1202(j): Short positions
• Pub. L. 119-21: Legislation establishing applicable date (July 4, 2025) and related changes

Verification Date: January 2025

Note: This page reflects the law as of January 2025. Tax law changes frequently, and this information should not be construed as legal or tax advice. Consult with a qualified tax professional regarding your specific situation. Exclusion percentages and limits are subject to change based on acquisition dates and holding periods.