United States: Recent Changes Allow Tax-Free Receipt Of Up To $10 Million In Gain From The Sale Of Small Business Stock

Last Updated: January 24 2013
Article by Bernie J. Pistillo, Maureen E. Linch and David B. Strong

One silver lining to the American Taxpayer Relief Act of 2012 ("ATRA") is that it extended the 100% exclusion for capital gain on qualified small business stock ("QSBS") acquired between 2010 and 2011 to include stock purchased in 2012 and 2013. It also eliminated the alternative minimum tax ("AMT") that might otherwise apply to gain on QSBS acquired between 2010 and 2013 and mitigated the AMT effect for shares purchased in other years. These changes can allow certain taxpayers to recognize up to $10 million in tax-free gain. In the face of the many increases in tax rates enacted under ATRA, the extension of the 100% QSBS exclusion and the permanent mitigation of the applicable AMT rules provides significant relief to noncorporate taxpayers who invest in businesses with assets of $50 million or less.

Taxpayers who purchased QSBS in September 2010 or later will not be eligible to realize the benefit of the 100% gain exclusion until September 2015 at the earliest. Nonetheless, the changes made by Congress under ATRA are relevant now both for taxpayers who are making decisions about whether to invest in small businesses as well as entrepreneurs who are making decisions about what type of entity to form in starting a new business. Additionally, taxpayers who acquired QSBS in 2012, before ATRA retroactively extended the 100% exclusion to stock acquired in 2012, may be entitled to QSBS benefits when they sell their shares in 2017 or later, and should not overlook the potential benefits available.


Under Section 1202,1 an individual shareholder who has held QSBS for more than five years is eligible for a full or partial exclusion of gain on the sale of his or her QSBS.2 In order to qualify as QSBS, stock must be:

  • issued by a "qualified small business" after August 10, 1993;3 and
  • acquired by the taxpayer at original issuance in exchange for money, property (other than stock), or services; or acquired in a nonrecognition transaction from a transferor meeting these requirements.4


A qualified small business ("QSB") is a corporation that meets the following requirements:

  • It is a domestic corporation that has been a C corporation for substantially all of the taxpayer's holding period for his or her stock.5
  • The aggregate gross assets of the corporation at all times from August 10, 1993 until immediately after the issuance of the taxpayer's stock do not exceed $50 million.6 For this purpose, a corporation's aggregate gross assets are its cash (including any cash contributed in connection with the current issuance) plus the aggregate adjusted bases of other property held by the corporation.
  • During substantially all of the taxpayer's holding period for the stock, at least 80% of the corporation's assets have been used in the active conduct of a trade or business that is in a category other than any of the following: o professional services (such as health, law, engineering, architecture, and brokerage services);
  • banking, insurance, financing, leasing, or similar businesses;
  • farming;
  • mining or natural resource production or extraction; and
  • operating a hotel, motel, restaurant, or similar business.7


The portion of a taxpayer's gain that is excluded under Section 1202 generally depends on when the taxpayer acquired the stock. For QSBS acquired between September 28, 2010 and December 31, 2013, 100% of the gain is excludable.8 For QSBS acquired between February 18, 2009 and September 27, 2010, 75% of the gain is excludable.9 For stock acquired at any other time, 50% of the gain is excludable.10 The date on which the taxpayer sells his or her stock is not relevant to the amount of gain that is excludable, provided that the five-year holding period is met.

The amount of gain from the QSBS of any particular issuer that any particular taxpayer may exclude under Section 1202 is limited to the greater of:

  • $10 million, reduced by the aggregate gain attributable to QSBS of that issuer excluded by that taxpayer in prior years,11 or
  • 10 times the taxpayer's basis in his or her QSBS of that issuer disposed of in that year.12

Any portion of QSBS gain that remains subject to tax (because it exceeds the per-issuer limits or is in excess of the exclusion percentage for the applicable year) is taxed at a 28% rate.13 Additionally, in any year in which the AMT impact is not entirely eliminated (e.g., for shares acquired before September 28, 2010 or after December 31, 2013), the AMT may apply to claw back some of the gain excluded by Section 1202, resulting in slightly higher effective rates on gain from QSBS. Gain on QSBS purchased between September 28, 2010 and December 31, 2013 is exempt from the AMT and therefore entirely exempt from tax (up to the $10 million or 10-times-basis limit described above).14 The table at the conclusion of this alert shows the effective tax rates for gain on QSBS purchased in different years.

Gain that is exempt from tax under Section 1202 should also be exempt from the 3.8% Medicare tax applicable to capital gain on stock, which took effect January 1, 2013. The Medicare tax is imposed on individuals at a rate of 3.8% on the lesser of net investment income or modified adjusted gross income in excess of $200,000 (in the case of an unmarried taxpayer) or $250,000 (for couples filing jointly).15 "Net investment income" includes only gain that is taken into account in computing taxable income.16 Accordingly, income that is excluded under Section 1202 should also be excluded from the 3.8% Medicare tax.


In certain circumstances, a taxpayer's share of QSBS gain attributable to an interest in a pass-through entity - such as a partnership, an S corporation, a regulated investment company, or a common trust fund - can be eligible for exclusion under Section 1202.17 In order for gain allocated to an individual by a pass-through entity to qualify for this treatment, the gain must be:

  • attributable to the sale or exchange of stock that has been held for more than five years and that is QSBS in the hands of the pass-through entity (treating the pass-through entity as an individual for purposes of the rules described above),18 and
  • includable in the taxpayer's income as a result of his or her holding the interest in the pass-through entity on the date on which the pass-through entity acquired the QSBS and at all times until the disposition of the QSBS by the pass-through entity.19

The $10 million or 10-times-basis per-issuer limitation described above applies at the taxpayer level. For these purposes, the taxpayer must treat any gain on QSBS held through a pass-through entity as gain from a direct disposition of the stock of the issuer and must take into account his or her proportionate share of the basis of the pass-through entity in the QSBS in calculating the gain on the stock.20 Increases in the taxpayer's percentage interest in the pass-through entity after the date on which the entity acquired the QSBS are ignored in determining the amount of gain eligible for exclusion in the hands of the taxpayer.21


In limited cases, if a taxpayer exchanges QSBS for the stock of another corporation, the stock received by the taxpayer may be treated as QSBS.22 This rule applies in the case of:

  • reorganizations described in Section 368 (where the QSB is acquired by another corporation and shareholders exchange QSBS for stock of the acquiring corporation); and
  • corporate formation transactions described in Section 351 (where shareholders of a QSB transfer their QSBS to a new corporation and the transferring shareholders "control" the new corporation after the transfer, along with others transferring cash or property to the new corporation at the same time).23

In both of these cases, stock of the acquiring corporation or of the new corporation is treated as QSBS even though it would not otherwise so qualify. If the acquiring corporation or the new corporation is itself a QSB, then the stock of the corporation received in exchange for the QSBS is treated in full as QSBS. If the acquiring corporation or the new corporation is not itself a QSB, then the shares in the corporation received in the exchange will be treated as QSBS only to the extent of the gain that would have been recognized at the time of the Section 368 or Section 351 transaction had the original QSBS been sold in a taxable transaction at that time.24 In other words, the gain exclusion under Section 1202 will be preserved to the extent of the value of the QSBS at the time of the Section 368 or Section 351 transfer. Special rules apply if there are successive transfers of QSBS in multiple reorganizations or corporate formations.25


In order to prevent taxpayers from circumventing the requirement that QSBS be newly issued, the QSB issuer may not redeem its stock within specified time periods. Under Section 1202(c)(3), stock acquired by the taxpayer is not treated as QSBS if the issuer purchased stock from the taxpayer, or a from person "related" to the taxpayer, at any time during the four-year period beginning two years before the issuance of the stock in question. In general, a shareholder would be related to the corporation for this purpose if he or she directly or indirectly owned more than 50% of the corporation's stock.26 In addition, stock issued by a corporation will not be QSBS if, during the two-year period beginning on the date one year before the issuance of the stock, the issuer made one or more purchases of its stock with a total value exceeding 5% of the aggregate value of all of its stock as of the beginning of the two-year period.27 These restrictions are subject to de minimis exceptions described in the applicable Treasury regulations.28


Section 1202 may affect an entrepreneur's decision to form a start-up business as a limited liability company ("LLC"), an S corporation, or a partnership. Start-ups often choose to form a pass-through entity such as an LLC or an S corporation in order to sidestep the entity-level tax payable by C corporations on their operating income. Although section 1202 requires the use of a C corporation in order to obtain its benefits, many start-ups have no taxable income in their early years (despite the success of their business model) due to favorable tax allowances and deductible items. This means that the use of a C corporation by such a business may well not represent a significant cost, while section 1202 would afford the opportunity to eliminate a substantial amount of tax when the QSB shares are subsequently sold.

Furthermore, both start-ups and existing QSBs can issue QSBS to employees and founders in exchange for services rendered to the company (other than services as an underwriter)29 as well as property. The extremely broad definition applicable to "property" under Section 1202 by reason of Section 351 may allow some planning flexibility for employees and founders of QSBs.30 Under Section 351, "property" encompasses virtually anything that can be "identified, valued, and transferred," including inchoate intangible property such as a nonbinding letter of intent and other amorphous intangible assets such as goodwill.31

In the case of an entrepreneur deciding whether to form an entity taxable as a C corporation or a partnership, Section 1202 might provide sufficient incentive through 2013 to organize business operations as a C corporation (or an LLC taxable as a C corporation), given the temporary exemption from shareholder-level tax on QSBS and the fact that virtually all of the features of a partnership investment can be replicated using a corporate (or LLC taxable as a C corporation) structure. The exemption from federal income tax, AMT, and the Medicare tax make the sale of QSBS acquired from 2010 through 2013 significantly more advantageous from a tax perspective than the sale of an interest in or the assets of a partnership.


ATRA's extension of the 100% gain exclusion on QSBS acquired from 2010 through 2013 as well as its permanent reduction of the AMT clawback to 7% of excluded gain for stock acquired in other years have made Section 1202 extremely attractive to noncorporate investors in small businesses. These provisions are welcome relief in light of the significant tax increases to capital gain after 2012 (including the 3.8% Medicare tax). Investors who have recently acquired stock of small businesses, investors who are considering investing in small businesses, and entrepreneurs who are making entity formation choices all should be aware of the noteworthy benefits associated with an investment in QSBS.

Investors who acquired QSBS in January 2008 or earlier will begin to realize the benefit of the reduction in the AMT clawback as early as this year if they sell their QSBS. Taxpayers who purchased QSBS after September 27, 2010 will be able to sell their QSBS without incurring any tax liability as early as the end of September 2015.


1 All Section references herein are to the Internal Revenue Code of 1986, as amended, and the Treasury regulations promulgated thereunder.

2 Section 1202(a)(1).

3 Section 1202(c)(1).

4 Id. Qualified nonrecognition transfers include gift, death, and transfers from a partnership to a partner. In these cases, the transferee will be treated as having the same method of acquisition and holding period as the transferor. See Section 1202(h).

5 Sections 1202(d)(1) and 1202(c)(2)(A).

6 Section 1202(d)(1)(A).

7 Section 1202(e)(3).

8 Section 1202(a)(4).

9 Section 1202(a)(3).

10 Section 1202(a)(1). Additionally, QSBS of certain corporations operating in an enterprise zone is eligible for a 60% exclusion. Section 1202(a)(2).

11 Section 1202(b)(1)(A).

12 Section 1202(b)(1)(B).

13 Section 1(h)(4)(A)(ii).

14 Section 1202(a)(4).

15 Section 1411(a)(1).

16 Section 1411(c)(1)(A)(iii).

17 Section 1202(g).

18 Section 1202(g)(2)(A).

19 Section 1202(g)(2)(B).

20 Section 1202(g)(1)(B).

21 Section 1202(g)(3).

22 Section 1202(h)(4).

23 Id. "Control" for this purpose means ownership of 80% or more of the voting stock and 80% or more of each class of nonvoting stock. See Section 368(c).

24 Section 1202(h)(4)(B).

25 Section 1202(h)(4)(D).

26 See Sections 1202(c)(3), 267(b), and 707(b).

27 Section 1202(c)(3)(B).

28 See Treasury regulations section 1.1202-2.

29 Section 1202(c)(1)(B)(ii).

30 Section 1202 contains several general references to Section 351 but no specific statutory definition of "property" for purposes of Section 1202. However, given that a transfer of an appreciated asset to a corporation in exchange for stock would need to satisfy the "property" requirement of Section 351 in order to be nontaxable, it would strain credibility to suggest that Congress intended for a taxpayer to be subject to an altogether different requirement for purposes of Section 1202. For further discussion, see David Strong, Section 1202 Qualified Small Business Stock, Aug. 11, 2011, available at http://www.mofo.com/files/Uploads/Images/110811-Section-1202-Qualified-Small-Business-Stock.pdf .

31 U.S. v. Stafford, 727 F.2d 1043, 1052 (11th Cir. 1984).

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Up-coming Events Search
Font Size:
Mondaq on Twitter
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions