Section 1202 allows stockholders to claim a minimum $10 million federal income tax gain exclusion in connection with their sale of qualified small business stock (QSBS) held for more than five years.[i] Assuming a 23.8% federal income tax rate, stockholders selling $10 million worth of QSBS qualify for a $2,380,000 gain exclusion.[ii] Needless to say, Section 1202’s gain exclusion is the most attractive tax benefits available to founders and venture capitalists. The failure of the Build Back Better Act and the Inflation Reduction Acts to reduce Section 1202’s benefits has dramatically improved the prospect that QSBS issued today will qualify for Section 1202’s 100% gain exclusion during 2027 and beyond.
This article is intended to serve as a resource for founders and venture capitalists exploring whether to position their business activities and investments to qualify for Section 1202’s gain exclusion. Along the way, the article bookmarks past in-depth articles and blogs addressing various QSBS planning issues.
This article is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045. During the past several years, there has been an increase in the use of C corporations as the entity of choice for start-ups. Much of this interest can be attributed to the reduction in the federal corporate income tax rate from 35% to 21%, but savvy founders and venture capitalists have also focused on qualifying for Section 1202’s gain exclusion. Legislation proposed during 2021 sought to curb Section 1202’s benefits, but that legislation stalled and then died, along with the balance of the Build Back Better Act. Congress finally passed the Inflation Reduction Act in August, 2022, but that legislation did not adopt the proposed amendments to Section 1202.
What It Takes To Qualify for Section 1202’s Gain Exclusion.
Section 1202 has a number of issuing corporation-level and stockholder-level eligibility requirements, all of which must be satisfied in order to claim Section 1202’s gain exclusion. These eligibility requirements are discussed below.