Internal Revenue Code Section 1202 provides for the exclusion for noncorporate taxpayers of gain on the sale of qualified small business stock (QSBS) held for more than five years. For stock acquired after September 27, 2010, the exclusion is 100%. The exclusion is subject to a per-issuer cap: generally, the greater of $10 million or 10 times the taxpayer's basis in the stock. QSBS is C corporation stock acquired by the taxpayer at original issue or in certain nonrecognition exchanges. The corporation must meet active business asset tests through substantially all of the taxpayer's holding period for the stock. Eligibility also depends on the corporation's aggregate gross assets not exceeding $50 million at the time of issuance. This provision is frequently used by venture capital and private equity funds and is considered along with other factors in making choice of entity decisions for startup businesses.
The One Big Beautiful Bill Act signed into law by President Trump on July 4 enhances the QSBS gain exclusion by providing a tiered gain exclusion for QSBS acquired after the date of enactment (July 4, 2025). In particular, the provision allows a 50% exclusion after three years, 75% after four years and 100% after five years for stock acquired after the date of enactment. The amount of gain that is excluded under this provision expressly is not a preference item for alternative minimum tax purposes. Also, the Act increases the per-issuer dollar cap to $15 million for post-enactment shares, indexed to inflation beginning in 2027. For stock issued after the date of enactment, the corporate-level aggregate-asset ceiling is increased to $75 million, indexed to inflation beginning in 2027.
The One Big Beautiful Bill Act will increase interest in QSBS structuring. Because QSBS must be issued by a C corporation, structuring to take advantage of this provision is not for everybody. C corporation income is subject to double tax – corporate income tax on the corporation and a second tax when distributed as dividends to shareholders. However, if the plan is to reinvest net profits in the business and sell the company after five years (now maybe three or four years) as is often the case with venture capital and private equity investors, structuring to utilize this exemption may be beneficial. The active business tests are technical and stock may be disqualified as QSBS for the corporation's failure to meet these tests. In addition, there are technical rules intended to prevent circumvention of the original issue requirements.
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