What startup founders and employees need to know about Qualified Small Business Stock (QSBS) and the potential to exclude up to 100% of capital gains under Section 1202.
Section 1202 of the Internal Revenue Code offers one of the most powerful tax benefits available to startup founders and early employees: the ability to exclude up to 100% of capital gains on the sale of Qualified Small Business Stock (QSBS). For those who qualify, this can mean millions of dollars in tax savings.
Eligibility Requirements
To qualify for the QSBS gain exclusion, several conditions must be met. The stock must be in a C-corporation with gross assets under $50 million at the time of issuance. The shareholder must have acquired the stock at original issuance (not through secondary purchase) and held it for at least five years. The corporation must use at least 80% of its assets in the active conduct of a qualified trade or business.
The exclusion amount is the greater of $10 million or 10 times the shareholder's adjusted basis in the stock. For founders who received stock at incorporation for minimal consideration, the 10x basis calculation may be less relevant, but the $10 million floor provides significant protection.
Strategic Considerations
QSBS planning should begin at company formation. The choice of entity structure (C-corp vs. LLC), the timing of stock issuances, and the management of corporate assets all affect QSBS eligibility. Founders should work with tax counsel to ensure their company's structure preserves QSBS eligibility from day one, as retroactive fixes are often impossible.
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