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How To Use Qualified Small-Business Stocks

Sailun Tires

Small business owners, including a founder entrepreneur as well as any outside inventors, must eventually determine the tax treatment for selling their stakes in a company. A large tax saving is possible when following the provisions of a tax code section that is seldom appreciated.

Small business owners can raise capital by turning to external sources like traditional bank loans, online business loans, or grants. However, careful planning for small business ventures will permit owners to capture a lot of financial gain by avoiding a big tax consequence.

What are Qualified Small-Business Stocks (QSBS)?

A taxable gain is realized when founders or investors sell their ownership in a small business. This includes outside investors selling their company interests to the founder or to new investors. Section 1202 of the Tax Code allows taxpayers to exclude from tax a percentage of gain from the sale. The key to escaping some or all of the tax is rooted in the concept of qualified small business stock.

Not just any venture has qualified small business stock. Only a business set up with specific features meets the qualifications defined in the tax rule. Here are the main features of qualified small business stock.

  • The company must be established as a C corporation in the United States. (It must not elect treatment as an S corporation.)
  • The corporation must operate an active business at all times, not merely function as a passive holding company.
  • The corporation cannot be a business operation involving personal services, such as healthcare, law, accounting, architecture, engineering, investments, or consulting. The fields of banking, insurance, farming, and mining are also excluded. Nor may the business operations comprise a hotel, motel, or restaurant. 
  • The corporation must have assets of $50 million or less during its existence up to and immediately after issuing the stock. At least 80% of the value of assets must be used for operation of the business.
  • Stock in the corporation must have been acquired in exchange for cash or property.
  • The shares must be issued by the corporation rather than purchased from another investor. But stock still qualifies if acquired by gift or inheritance from investors in original corporate share issues.

These are only a few of the factors described in Section 1202. Expert advice is recommended for assuring compliance with the discrete elements of every requirement. For example, some ventures in the healthcare field may be eligible for issuance of qualified small business stock. The company is eligible for Section 1202 when it merely provides support to healthcare providers or patients without actually conducting health services.

Another point of confusion entails the asset test. The general rule is that the tax basis of assets should not exceed $50 million. The fair market value of the assets is typically not relevant. However, a different standard applies for property contributed to the business instead of cash. In those cases, the fair market value of the non-cash property at the time of the contribution is included in the corporation’s gross asset determination.

How QSBS Works

When all the requirements of Section 1202 are met, the gain realized from selling the qualified small business stock is eligible for exclusion from tax. The stock must have been held for more than five years.

The maximum gain that each shareholder may exclude from tax is $10 million or ten times the person’s cost for the stock, whichever is more. The $10 million limit is imposed for the qualified small business stock of each corporation. The limit is therefore reduced by any gain excluded in prior years for sales of the same corporation’s stock.

The amount of excludable gain depends on when the stock was acquired.

  • If the stock was purchased on or after September 28, 2010, the entire gain up to the maximum limit is excluded from tax.
  • Stock acquired on or after February 18, 2009, and before September 28, 2010, is eligible for excluding 75% of the gain.
  • The exclusion of gain from tax is 50% of the gain for stock purchased on or earlier than February 17, 2009.

Another factor to consider is that the excludable gain on sale of qualified small business stock acquired before September 28, 2010, applies only to regular taxable gross income. Investors who purchased their stock earlier than that date must add 7% of the gain to their income calculation under the Alternative Minimum Tax system.

Benefits of QSBS

Qualified small business stock is a powerful tax-planning tool for entrepreneurs. Not only do business founders minimize or eliminate tax when selling their companies, they are also more likely to attract outside investors to their enterprises.

Qualified small business stock even delivers an incentive for investors in the corporation after its formation. As long as the requirements in Section1202 are fulfilled, the corporation may issue qualified small business stock at any time to investors who will qualify for the tax exclusion.

The Section 1202 tax exclusion is generally limited to individuals. However, an individual is entitled to the exclusion from tax when the stock shares were acquired by a pass-through entity in which he was the owner. The pass-through entity could be, for example, a partnership. The partner’s tax exclusion is his percentage interest in the partnership at the time it acquired the stock.

The partnership structure is frequently utilized when the gain on selling a qualified small business stock will exceed the $10 million limit. Each partner is eligible for excluding up to $10 million. Hence, ten partners could all qualify for excluding a $100 million gain.


Any capital-intensive business is likely to benefit from issuing qualified small business stock. This is a particularly vital consideration for a business owner that is planning to raise capital from outsiders. Forming a C corporation is merely an initial step. Obtaining advice is crucial for assurance that all conditions of qualified small business stock are met. The requirements of Section 1202 must be carefully analyzed for assurance that every nuance has been assessed.


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