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Qualified Stock for the Closely Held Business


Federal Tax Benefits for C Corporations

It would be amazing to have hindsight when initiating a business. Imagine being able to foresee the result of the business enterprise before it was started. Think of how that would influence your decision-making! We do not have a crystal ball; however, we can – and should – anticipate the risks and issues intrinsic in starting and operating a business. Imagine if you can exclude up to $10 million dollars on the sale of your business!

1. Starting a Business

When starting a business, there are many questions to consider and address. 

  • Is this a sound business plan?
  • Who are the founders, are they experienced?
  • How do we hire, maintain and incentivize key employees?
  • How will the entity be financed?
  • Which professionals should be retained to assist?
  • Will the business be retained for the family or investor backed?

The legal structure of the business will impact many areas including, but not limited to:

  • The type of venture being organized
  • The necessary liability protections
  • Ease of access to outside financing
  • Taxes
  • Regulation and administrative work

Defining the optimal business structure depends on the individual situation; several factors should be analyzed and prioritized to determine which entity type is best suited for a particular business.

Today most family and closely held businesses form a limited liability company (LLC). If outside capital is required, the business may convert to a C corporation once the company becomes profitable. This can help with capital raising, since early-stage investors typically prefer investing in a C corporation vs. an LLC.  In some cases, founders will form an LLC and use the initial tax losses to offset taxes on income derived from other sources.

2. Establish a Qualified Small Business

C corporations offer a special opportunity to take advantage of the Qualified Small Business Stock (“QSB”) exclusion under Section 1202 of the Internal Revenue Code. 

Section 1202 was enacted in 1993 as an incentive for taxpayers to start and invest in certain small businesses.  At that time, the statute provided a 50% percent exclusion from income for any gain from the sale or exchange of “qualified small business stock”.  In 2010 this exclusion was increased to 100%.

Qualified Stock Benefits
3. QSB special exclusion

Section 1202 allows taxpayers to exclude from federal tax some or all of the gain on the sale or exchange of QSB stock depending on when the QSB was acquired and held. Any remaining gain is taxed at a 28% rate. As a further benefit, the gain is excluded from both the 3.8% net investment income tax and the alternative minimum tax. The chart below shows the gain exclusion and AMT preference percentages.

Acquisition Period QSB Stock Gain exclusion AMT Preference Section 57 (a)(7)
Before February 18, 2009 50% 7%
February 18, 2009 through September 27, 2010 75% 7%
September 28, 2010 through December 18, 2018 100% 0%

There are gain exclusion limits for any one taxpayer.  In general:

  • $10,000,000 reduced by the aggregate amount of eligible gain taken under Section 1202 in prior years with respect to stock of the same issuer; or
  • 10 times the aggregate QSB of that issuer disposed of by the taxpayer during the taxable year 

The gain exclusion only applies to individuals and pass through entities such as S corporations, partnerships and limited liability companies.

4. Requirements

There are several criteria necessary to qualify for the QSB gain exclusion: 

C Corporation 

Issuers of QSB stock must be a domestic C corporation and maintained as such during substantially the entire time the taxpayer holds the stock.  Several types of C corporations do not qualify for this special exclusion: domestic international sales corporations; possessions corporations; regulated investment companies, real estate investment trusts and cooperatives entities. Also, the holder of the QSB stock cannot be a C corporation.

5-year holding period

The QSB stock must be held for more than five years, subject to specific rules and circumstances, including situations involving gifts, inheritance, stock conversion and partner transfers.


An LLC that is converted to a C corporation may qualify as a QSB stock, in which case the five year holding period starts at the time of the conversion. The stockholder’s basis at conversion is generally the fair market value of the LLC’s assets at that time, thus any appreciation would not qualify for the 1202 exclusion.

Original issue

The QSB stock must be acquired as part of an original issuance directly from either the company or an underwriter in exchange for money or property, or as compensation for services provided to the corporation. Stock purchased through a third party cannot be considered as QSB unless and until the third party sells the stock back to the corporation.

Gross Assets must be under $50 Million

The aggregate gross assets of the corporation (cash plus aggregated tax basis of property) must not have exceeded $50 million before and immediately after issuance of QSB stock.

80% of assets must be used in a qualifying active business 

A corporation must meet the active business requirement during the holding period, which means at least 80% of the corporation’s assets must be used by the corporation in the active conduct of a trade or business. The corporation cannot be an investment vehicle or inactive business.

Section 1202 (e)(2) treats assets as used in the active conduct of a qualified trade or business –  even if the corporation does not have any gross income from the activity – if the corporation is engaged startup activities in connection with:

  • investigating the creation or acquisition of an active trade or business;
  • creating an active trade or business;
  • activities engaged for income and profit in anticipation that an active trade or business will begin;
  • activities resulting in research and experimental expenditures.

Specific Businesses NOT considered Active Business 

Corporations primarily focused in the fields of health, law, accounting, engineering, architecture, actual science, consulting, performing arts, athletics, financial, hotels, restaurants, oil, gas, banking, investment, or farming will NOT qualify as an active business under Section 1202.

5. Investor Planning when Purchasing and Holding QSB Stock

Investor’s initial thoughts

Those considering an initial investment in QSB should do some careful planning.

Before you invest, determine if the stock will qualify for QSB stock. Speak to the company and its officers as well as your tax professionals to provide guidance. 

Determine the tax consequences of investing in a C corporation versus the benefits of investing in a pass through entity. Remember that the QSB stock would be subject to double taxation when dividends are distributed to the taxpayer. Try to assess whether the anticipated growth in the company, coupled with the QSB stock benefits upon a sale, can produce favorable after tax yields. 

Also consider the original purpose of the investment. Is it primarily for capital appreciation or to receive annual income from the investment? Keep in mind that typically, QSB stock is issued for startup companies that require a substantial amount of startup capital to launch the venture and to be a successful operating company.

Once you elect to purchase an interest in a C corporation, maintain complete and accurate records, including date purchased; consideration paid; evidence of payment; and copy of the stock certificate. It may be prudent to obtain a statement from company officers confirming that the entity: is a C corporation; has less than $50 million in assets immediately after the purchase and that at least 80% of the company assets are used in the active conduct of a qualifying business.

Monitor the QSB stock 

Once QSB investments have been made it is important to monitor the investment to ensure ongoing compliance with the IRS Code. Speak with management to determine that the requirements continue to satisfy the IRS Code. The two main pitfalls that can lead to the QSB disqualifications are receiving certain stock redemptions during the holding period and failing the active business requirement.

Liquidity Event Planning 

When you are getting ready to sell the QSB stock, it is critical to properly plan, so that you can preserve the gain exclusion. The main consideration is whether the five-year holding period has been fulfilled. This can be easily evidenced by the date of the stock certificates or tax and brokerage records confirming the stock sale date.

Once it is clear that the stock qualifies for the five-year holding period, focus on maximizing the potential gain exclusions (the greater of $10 million or 10 times the tax basis). Applying the rules is fairly simple when you intend to sell one issuance of QSB stock with a single cost basis.  However, planning the sale of multiple issuances of QSB stock in the same company with separate cost basis is often complex and challenging to calculate.

Often a taxpayer is required to sell the QSB before the five-year holding period has been satisfied. In the case of a rollover, you can defer the gain on the QSB stock sale if certain requirements are met:

  • The initial investment in QSB stock must be held for a minimum of six months 
  • The stock is sold
  • You purchase replacement QSB stock within 60 days of the sale of the initial QSB stock
  • You make an election on or before the due date of the tax return (including extensions) for filing your income tax return for the taxable year in which the QSB stock is sold. 

Replacement Stock

Once the above conditions are satisfied, a gain will be recognized only to the extent that the proceeds received from the sale of the QSB stock exceed the cost of the replacement QSB stock. Moreover, the replacement QSB stock will now be subject to a new gain exclusion limitation. If this technique is properly executed, you may be able to exclude more gain than was permitted on the sale of the initial QSB stock.

6. Other Planning Considerations

State Taxes

Because the Section 1202 exclusion only applies to the federal tax, capital gains may be taxed at the state level. You should determine whether the relevant state allows a portion or all of the Section 1202 exclusion. 

For Massachusetts residents, gains from a sale of QSB stock are taxed at approximate yearly 3% rate instead of the normal tax rate. However, to qualify for the lower capital gain, the taxpayer needs to comply with the following requirements:   

  • investment must be made within 5 years of the date of incorporation and must qualify as QSB stock under Section 1202;
  • the stock must be held for at least 3 years;
  • the corporation must
    1. be domiciled in Massachusetts and incorporated (in Massachusetts or elsewhere) on or after January 1, 2011;
    2. have less than $50 million in assets at the date of the investment; and
    3. must comply with the same active business criteria pursuant to Section 1202. 

Divorce Settlements 

When negotiating divorce agreements, determine if some of the investment interests are QSB stock. This is important because the Sec. 1202 enables parties to shift some of the benefits and burdens to the other party.

Estate Planning 

If you have QSB stock with substantial unrealized appreciation, an analysis should determine whether it would be more advantageous to

  • keep the interests, receive the step-up in basis and transfer at death; or 
  • gift the interests during your lifetime. 

Successful Business 

If you own a successful business and are considering starting either another enterprise or one that relates to the existing business already operating, it may be worthwhile to establish the new venture as a C Corp eligible for the Qualified Small Business stock exclusion. 

Employee Compensation

QSB stock can be used to compensate employees. This is an excellent strategy for early-stage companies limited in cash with a need to attract employees. 

Many startup companies with limited cash during the operational phase will issue debt and equity compensation for services rendered. The conversion of non-cash compensation in a qualified small business, creates QSB stock and triggers the five-year holding period. If you have been issued stock options, warrants, convertible debt, or restricted stock in a QSB, you should compare the traditional tax implications of converting the stock with the QSB benefits.

Potential Changes

Congress has proposed reducing the benefits completely. The Build Back Better Tax Act proposed late 2021 reduced the benefits on a sale. At this time, it does not appear the legislation will be passed in 2022.


QSB stock provisions appear to work as Congress intended, which is to stimulate small business formation. Companies that require sufficient capital to bring the product to the market and rapidly scale their business often can take advantage of Section 1202 and be better positioned to attract investors – particularly high-net-worth individuals, family offices and venture capitalists.

For additional insight on strategies related to business formations including QSB and Section 1202, please contact Stephen Wilchins, Founding Partner at Wilchins Cosentino & Novins at swilchins@wcn.com or call  781-247-8010

For more information on our Private Client Services practice serving business owners and high-net worth individuals, click here. For additional information on our Business Law practice, click here

This Article is not legal advice and should not be taken as such or relied upon as legal advice.

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