A Refresher on Qualified Small Business Stock

By holding qualified small business stock (“QSBS”), noncorporate shareholders of qualifying C corporations can sell their stock tax free after a five-year holding period. Tax benefits associated with QSBS are nothing new. However, until recently, planning with QSBS has been neglected. The Tax Cuts and Jobs Act (“TCJA”) breathed new life into the potential benefits of QSBS through permanently reducing the top federal tax rate for a C corporation’s income from 35% to 21%, making operating a business through a C corporation much more attractive. Since passage of the TCJA, a number of strategies have excited the planning community only to be shut down by subsequent IRS guidance.1 Now that the smoke has largely cleared after the TCJA, the increased benefits of planning with QSBS continues. I wrote about this subject in the past, summarizing presentations at the 2019 Heckerling Institute of Estate Planning.2

The History of QSBS

Section 1202 was added to the Internal Revenue Code in 1993 providing a 50% gain exclusion3 at a time when long term capital gains rates were 28%. This resulted in an effective rate of 14% on qualifying gains. Starting in 1998, Congress reduced the top long-term capital gains rate to 20% but retained the 28% rate on sales of QSBS.4 The result is that the 14% effective rate was retained for QSBS sales, much closer to the 20% top rate than the previous 28% top rate. Then, in 2003, Congress reduced the top rate on long-term capital gains to 15% retaining the 28% rate for QSBS and 50% exclusion.5 The result was only a 1% savings, while still needing to meet all of the qualification requirements for QSBS.

It became clear that taxpayers saw no utility in a 1% rate savings given the need to comply with the various requirements of §1202. In response, Congress attempted to reinvigorate QSBS by increasing the exclusion to 75% in 2009.6 Then, in 2010, Congress increased the rate exclusion to 100%.7 Although the 100% exclusion was temporary and became subject to regular extension, it was made permanent in 2015.8  The exclusion percentage of 50%, 75%, or 100% is tied to the date QSBS was acquired, not the date of sale. As such, it important to keep records of the acquisition date.

Requirements for QSBS Treatment

In order to qualify for QSBS treatment (i.e. exclusion of capital gains from income) a number of requirements must be satisfied. Generally, these requirements are statutory without significant guidance from the IRS or courts. The likely reason is taxpayers’ relatively minimal use of the QSBS gain exclusion historically. With increased attention, it is likely that clarification of some of these requirements will become more important.

Generally, the requirements for a noncorporate taxpayer to qualify for gain exclusion can be summarized as follows:

  • The stock must be held for more than 5 years.9
  • The corporation must be a “qualified small business”10 which is a domestic corporation organized as a C corporation during substantially all11 of the taxpayer’s holding period if:
    • At all times after August 9, 1993, through the date of issuance of the stock, the aggregate gross assets of the corporation must not exceed $50 million.12
    • Immediately after the date of issuance, the aggregate gross assets of the corporation must not exceed $50 million.
    • The corporation agrees to submit reports required by regulation (no such regulations have been issued).
  • The stock is acquired by the taxpayer at its original issue in exchange for money or other property or as compensation for services provided to the corporation.13
  • During substantially all of the taxpayers holding period for the stock, the corporation meets an “active business requirement” 14 which means that at least 80% (by value) of the assets of the corporation are used by the corporation in the active conduct of one or more “qualified trades or businesses.”15 There are additional requirements beyond the scope of this article.16 A “qualified trade or business” is any business other than:17
    • 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 1 or more of its employees.
    • any banking, insurance, financing, leasing, investing, or similar business.
    • any farming business (including the business of raising or harvesting trees),
    • any business involving the production or extraction of products of a character with respect to which a deduction is allowable under IRC §§ 613or 613A.
    • any business of operating a hotel, motel, restaurant, or similar business.
  • The stock must meet certain redemption rules:18
    • The stock must not have been redeemed at any time during the 4-year period beginning 2 years before issuance from a person related to the taxpayer.
    • The corporation must not have, during the 2-year period beginning on the date one year before issuance of the stock, redeemed stock with an aggregate value exceeding 5% of the aggregate value of all of its stock as of the beginning of the 2-year period.

Calculating the Exclusion

Assuming the requirements of QSBS are met, the amount of the gain subject to exclusion must be calculated upon the subsequent sale of stock.19 In calculating the amount of gain subject to exclusion, certain rules and limitations apply.

  • First, there is a special basis rule.20 Under this rule, for purposes of IRC §1202, stock received in exchange for property other than money or stock will be treated as having been acquired by the taxpayer on the date of the exchange and the basis of such stock will be no less than the fair market value of the property exchanged. This prevents use of QSBS to avoid tax on pre-contribution appreciation of assets.
  • Second, application of two limitation rules must be applied.21 Under these limitations, the aggregate amount of gain in any year, from each issuer of QSBS, shall not exceed the greater of:
    • $10,000,000 reduced by the aggregate amount of eligible gain excluded in prior years from disposition of that issuer’s stock;22 or
    • 10 times the aggregate adjusted bases of QSBS issued by such issuer and disposed of by the taxpayer during the taxable year.23

After these calculations are made, the amount of gain subject to exclusion is known. From there, knowing the acquisition date will allow the taxpayer to know whether 50%, 75%, or 100% of the gain is excluded.24 For stock subject to an exclusion less than 100%, a 28% rate applies to the taxable portion.25 For amounts not eligible for exclusion by application of the limitations described above, the general capital gains rate applies (currently a top rate of 20%).

The Effect of the TCJA on QSBS

The biggest change in the TCJA which renewed interest in QSBS planning was the permanent reduction of the top C corporation income tax rate from 35% to a flat 21%. This change alone has caused a number of businesses, existing and start-up, which otherwise may have chosen to be taxes as a pass-through entity (partnership or S corporation) to look more closely at operating as a C corporation.

This significant rate reduction may appear more valuable than its effect on business owners, however. While there is a 37% top federal income tax rate for individuals, qualifying businesses26can benefit from a 20% deduction under §199A. Further, after paying a 21% tax on corporate income, distributions from a C corporation to shareholders results in tax on those dividend distributions subject to a top rate of 20%. Therefore, while a flat 21% corporate tax rate and exclusion from gain on the sale of stock sounds appealing, those benefits must be weighed against loss of the 20% deduction under §199A and the effects of double taxation. Even where QSBS ultimately benefits the taxpayer, that benefit will only be realized upon a sale of stock. In the interim, more overall tax may be paid which only is mitigated some years in the future.

In an article addressing these issues, one author provided the following example:

A is planning to form a new technology business in which he will invest $100,000. Based on A’s projections, the business will earn $200,000 in net income in each of the next five years, which A will withdraw from the business in full as a distribution. After five years, A believes the business will be worth $3 million. Assume that, as the owner of a passthrough business, A would qualify for a full Sec. 199A deduction and that the stock in the corporation would meet the definition of QSB stock. The federal tax consequences over the full life cycle of each business option would be as shown in the table “Taxation as Passthrough vs. C Corporation.”27

Based anecdotally on calculations I have reviewed for clients, regardless of QSBS status, being taxed as a C corporation appears most beneficial when a substantial amount of profits will be reinvested in the business. By doing this, the effects of double taxation are minimized. This significantly balances a C corporation and a passthrough entity (or sole proprietorship). Benefiting from QSBS can either tip the scales in close call situations or enhance an otherwise beneficial decision for C corporation taxation. In his article, Mr. Nitti concludes that QSBS benefits make sense when:

  • A minimum five-year holding period is realistic.
  • Future investors into the business will be able to take advantage of QSBS (noncorporate investors).
  • The expected appreciation in the value of the corporate stock is enough to overcome double taxation on operating income.
  • Shareholders are willing to retain some earnings in the corporation to minimize the effect of double taxation.
  • Based on the nature of the business, the active business requirement and gross-asset test will not be problematic.28

To this end, it is worth noting that, although the 20% deduction under §199A is scheduled to sunset at the end of 2025, both the 21% flat corporate income tax rate and the 100% exclusion for QSBS sales are permanent. Based on this, in certain cases, it may be that taxpayers take a “wait-and-see” approach by benefiting from the 20% deduction under §199A and converting to a C corporation prior to 2026. Of course, before taking this approach, it will be important that the proper analysis is done to calculate the anticipated the consequences.


Although the rules described above, which certainly are not comprehensive, can be difficult to apply, the benefits of QSBS gain exclusion can be powerful in the right circumstances. Businesses, both existing29 and start-up, should consider whether taxation as a C corporation will be beneficial. Given the substantial potential for tax benefits, taking the time to evaluate the possibility may be a worthwhile effort. In the event QSBS makes sense for income tax planning, there can be important estate planning steps to take both to preserve QSBS benefits as well as to enhance family estate planning through the use various planning techniques including using non-grantor trusts, grantor trusts, GRAT’s, etc. (but note that care must be taken to avoid losing “original issue” qualification for transfers to family partnerships). Although a discussion of estate planning with QSBS is beyond the scope of this writing, others have written on the topic.30

In the end, as with many aspects of tax planning, proactive consideration of the potential benefits of QSBS can serve to provide immense benefits. Also similar to other areas of tax planning, it is important not to rush into this choice. There are a number of variables and careful analysis is needed. Likewise, continued operation of the corporation to avoid inadvertent termination of QSBS treatment requires ongoing review. For the taxpayer willing to take these steps, the current tax landscape may just mean it is it time to give the C corporation a fresh look.

S. Gray Edmondson, J.D., LL.M.

Gray practices in the areas of tax, business, and estate planning. View Full Profile.


  1. See, for example, Keebler, Robert S. and Peter J. Melcher, New IRC Regs Block “Crack and Pack,” But Present New Opportunities, Wealth Management, August 15, 2018, https://www.wealthmanagement.com/estate-planning/new-irc-regs-block-crack-and-pack-present-new-opportunities; and Schreiber, Sally P., SALT Deduction Cap Rules Finalized, Safe Harbor Proposed, The Tax Advisor, June 12, 2019, https://www.thetaxadviser.com/news/2019/jun/charitable-contributions-avoid-salt-deduction-cap-201921453.html.
  2. Edmondson, Gray, 2019 Heckerling Takeaways, Feb. 1, 2019, https://esdlawfirm.com/sge-heckerling-2019/.
  3. 1993 Omnibus Budget Reconciliation Act of 1993, Section 13113(a), P.L. 103-66.
  4. Taxpayer Relief Act of 1997, Section 311(a), P.L. 105-34.
  5. Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27.
  6. The American Recovery and Reinvestment Act of 2009, P.L. 111-5.
  7. The Small Business Jobs Act of 2010, P.L. 111-240.
  8. The Protecting Americans from Tax Hikes Act, P.L. 114-113.
  9. IRC §1202(a)(1). Note that there are complex rules regarding the date of acquisition generally contained within IRC §1202(i). Likewise, there are questions concerning the effect of future capital contributions for which no new stock is issues. As to the later, see Gruidl, Nick, Mike Ribble, and Joseph A. Wiener, Sec. 1202: Consequences of Capital Contributions to Closely Held Corporations, April 1, 2019, The Tax Advisor, https://www.thetaxadviser.com/issues/2019/apr/consequences-capital-contributions-closely-held-corporations.html. Note also that, although beyond the scope of this article, IRC §1045 will allow a shareholder with QSBS held more than 6 months to rollover gain into replacement QSBS within 60 days from sale.
  10. IRC §1202(c)(1)(A) and (d).
  11. The term “substantially all” is not defined for this purpose.
  12. For purposes of both gross asset tests referenced in IRC §1202(d), “’aggregate gross assets’ means the amount of cash and the adjusted bases of other property held by the corporation.” IRC §1202(d)(2). Therefore, the corporation can have assets valued at substantially more than $50 million such as depreciated assets or self-created intangibles.
  13. IRC §1202(c)(1)(B). The original issue test is satisfied with respect to a transferee shareholder if the original shareholder transfers shares by gift, at death, or from a partnership to a partner (subject to certain requirements). See IRC §1202(h). There are similar rules applying to conversions. See IRC §1202(f).
  14. IRC §1202(c)(2) and (e). “Substantially all” is not defined for this purpose.
  15. The meaning of a “trade or business” is a difficult term in tax law, largely undefined. I have described this issue previously. See Edmondson, Gray, The Importance of Being a “Trade or Business,” September 12, 2018, https://esdlawfirm.com/the-importance-of-being-a-trade-or-business/.
  16. There are additional special rules relating to this requirement contained within IRC §1202(e) including provisions for reasonable working capital, stock in other corporations, start-up activities, and a maximum value of real estate not used in the corporation’s trade or business. Likewise, stock in a DISC, former disc, REIT, REMIC, or a cooperative will not qualify to satisfy the active business requirements. IRC §1202(e)(4).
  17. IRC §1202(e)(3).
  18. IRC §1202(c)(3).
  19. Once this gain is calculated, it is reported on IRS Form 8949, Part II. See instructions for Schedule D of IRS Form 1040, https://www.irs.gov/instructions/i1040sd.
  20. IRC §1202(i).
  21. IRC §1202(b)(1).
  22. This limitation may be easy to work around by gifts, including to non-grantor trusts, since the transferee will be treated as having received shares at “original issue” but the limitation rule will be calculated separately.
  23. Note that then $10 million per issuer exclusion can be exceeded as long as the aggregate adjusted basis calculation results in a greater amount. The result is that careful planning may be needed in order to time the sale of stock across tax years to minimize the effect of these caps. Likewise, timing formation of the corporation issuing QSBS may be important to maximize basis (i.e. formation by conversion from a partnership after significant basis is acquired by the partnership).
  24. 50% applies from 8/11/1993-2/017/2009; 75% applies from 2/18/2009-9/27/2010; and 100% applies from 9/28/2010-present.
  25. IRC §1(h)(4)(A)(ii) and (h)(7).
  26. Although not identical, and beyond the scope of this article, businesses qualifying for QSBS benefits and those qualifying for the 20% deduction are generally the same.
  27. Nitti, Tony, Qualified Small Business Stock Gets More Attractive, Nov. 1, 2018, The Tax Advisor, https://www.thetaxadviser.com/issues/2018/nov/qualified-small-business-stock-more-attractive.html#fnref_10.
  28. Id.
  29. Since the issuing stock must be a C corporation, revocation of an S election will not allow an existing S corporation to qualify for QSBS treatment. However, if other planning concerns can be addressed, an S corporation may be able to contribute its assets to a newly formed C corporation and qualify. Existing entitles taxed as a partnership should be able to convert pursuant to Rev. Rul. 84-111.
  30. Jenson, Benetta and Sean Largy, Qualified Small Business Stock Exclusion, ACTEC Fall Meeting – Business Planning Committee, Oct. 28, 2018.