Explaining enhanced Section 1202 benefits

Enacted in 1993, Section 1202 provides an exclusion from a taxpayer’s gross income of proceeds from the sale of “qualified small business stock” (QSBS). Newly enacted P.L. 119-21, known as the One Big Beautiful Bill Act (OBBBA) and signed into law July 4, 2025, has expanded this section to provide further benefits to owners of certain small businesses, providing new opportunities for such entities.

For stock issued after 1993 and prior to 2009, this allowed exclusion is 50%. For stock issued between 2009 and 2010, it is 75%, and for stock issued after 2010 but prior to July 4, 2025, the exclusion is 100%. This exclusion was historically limited to the greater of $10 million or 10 times the taxpayer’s adjusted basis in their stock. 

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Under the new law, stock issued after July 4, 2025, is treated in a revised manner, allowing taxpayers to exclude up to 50% of the gain from the sale of QSBS held for longer than three years, 75% of the gain from holdings longer than 4 years, and 100% of the gain from holdings longer than five years. Additionally, the bill has increased the base limitation from $10 million to $15 million and indexes this amount for inflation in tax years after 2026.

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To qualify as QSBS, stock sold by a taxpayer must satisfy several statutory requirements at both the shareholder and entity level.

Corporate-level requirements

For stock to qualify as QSBS, the underlying entity must satisfy the following requirements:

1. The entity must be classified as a domestic C corporation for U.S. federal income tax purposes.
2. The adjusted tax basis of the assets of the corporation must have been less than $50 million at all times before the issuance of the stock. The OBBBA increased this ceiling to $75 million.

The entity must be engaged in one or more qualifying trades or businesses and use at least 80% of its assets in the conduct of such trade(s) or business(es). Section 1202 does not provide a list of qualifying trades or businesses but rather provides a list of trades or businesses that do not qualify. These include:

1. Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees
2. Any banking, insurance, financing, leasing, investing, or similar business
3. Any farming business (including the business of raising or harvesting trees)
4. Any business involving the production or extraction of minerals
5. Any business of operating a hotel, motel, restaurant, or similar business

Shareholder-level requirements

If stock of an entity satisfies the requirements outlined above, there are also several shareholder-specific requirements that must be satisfied for a taxpayer to claim the Section 1202 exclusion:

1. The shareholder must not be a C corporation.
2. The shareholder must have received their stock directly from the corporation.
3. The shareholder must have received their stock in exchange for cash, property (other than corporate stock) or services.
4. For issuances before July 4, 2025, the shareholder must have held their stock for at least five calendar years. See above for a description of the holding period requirements for stock issued after that date.
5. The stock must have constituted QSBS for substantially all of the shareholder’s holding period, typically between 85% and 95% of the total holding period of the stock.

Section 1045

If a taxpayer sells QSBS prior to satisfying either the historical or new holding period requirements, they may instead be eligible to defer gain realized from the sale of QSBS held for at least six months. To claim this tax deferral, the seller of QSBS must roll over the proceeds of the sale of the QSBS into the purchase of newly issued QSBS within 60 days of the sale of the original stock.

Key takeaways for taxpayers

Section 1202 has historically provided significant benefits to owners of small businesses, and with the increased in the limit for both the qualification for QSBS as well as the per-taxpayer limit on exclusion and modified holding requirements, it is more critical than ever to analyze the qualification for Section 1202 treatment and discuss with your tax advisor potential new opportunities to utilizing this benefit.