Exclusion of Capital Gain with QSBS Section 1202 for S‑Corp Owners

Section 1202 provides a powerful exclusion of gain for “qualified small business stock” (QSBS) issued by C corporations that meet strict eligibility rules; S corporations cannot issue QSBS, but an S‑corporation owner can still benefit in two ways: (1) by having the S corporation invest in QSBS of another C corporation and pass the exclusion through, or (2) by converting to (or forming) a C corporation and issuing new QSBS that satisfies Section 1202’s requirements, including holding period and issuer/stock eligibility; recent One Big Beautiful Bill Act (OBBBA) changes adjusted holding‑period tiers and per‑issuer limits for post‑enactment stock, so careful timing and tracking are essential. IRC § 1202; OBBBA Merged Changes; IRS Newsroom – One Big Beautiful Bill Provisions

What QSBS is and the core benefits

• QSBS is stock in a domestic C corporation, originally issued to the taxpayer (not as an underwriter) for money, property (not stock), or services, where the corporation meets the “qualified small business” and “active business” requirements; if the stock is held for the required period, a statutory portion of the gain is excluded from gross income on sale. IRC § 1202(a), (c)(1)

• For stock acquired after the “applicable date” added by OBBBA, exclusion percentages phase in by holding period: 50% after 3 years, 75% after 4 years, and 100% after 5 years; special windows for earlier acquisition periods continue to apply as modified by OBBBA. IRC § 1202(a)(5); OBBBA Merged Changes; IRS Newsroom – One Big Beautiful Bill Provisions

• The excludable gain is limited per issuer to the greater of an “applicable dollar limit” ($10,000,000 for stock acquired on or before the applicable date; $15,000,000 for stock acquired after the applicable date, with inflation adjustments after 2026) reduced by prior exclusions for that issuer, or 10 times the aggregate adjusted bases of QSBS disposed of during the year; basis for this limit is determined without post‑issuance additions. IRC § 1202(b)(1), (4)–(5); OBBBA Merged Changes

Exact eligibility rules for C corporations (issuer requirements)

• Qualified small business: The issuer must be a domestic C corporation; at all times before and immediately after the QSBS issuance, its aggregate gross assets must not exceed $75,000,000 (as amended), and the issuer must agree to required shareholder/IRS reporting. IRC § 1202(d)(1)–(2); OBBBA Merged Changes

• Active business test: During substantially all of the shareholder’s holding period, at least 80% (by value) of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses, and the corporation must remain a C corporation through that period. IRC § 1202(c)(2)(A), (e)(1)

• Excluded trades/businesses: Service businesses in specified fields, financial/banking/insurance/leasing/investing businesses, farming, extraction/production eligible for §§ 613/613A, and hotel/motel/restaurant or similar businesses are excluded. IRC § 1202(e)(3)

• Working capital/look‑through: Reasonable working capital and qualified R&D financing may count as active business assets (subject to limits); assets and activities of majority‑owned subsidiaries are tested on a look‑through basis; limits apply to portfolio stock/securities and non‑business real estate. IRC § 1202(e)(5)–(8)

• Ineligible issuers: RICs, REITs, REMICs, DISCs/former DISCs, and cooperatives cannot be QSBS issuers. IRC § 1202(e)(4)

Exact eligibility rules for the stock (shareholder requirements)

• Original issuance: The taxpayer must acquire the stock at its original issue (directly or through an underwriter) in exchange for money, property (not stock), or as compensation for services (other than underwriting). IRC § 1202(c)(1)(B)

• Holding period: Post‑applicable‑date stock qualifies for tiered exclusions at 3/4/5 years; for QSBS received solely through conversion of other QSBS in the same corporation, the holding period tacks. IRC § 1202(a), (f)

• Redemptions: Certain redemptions near the time of issuance can disqualify stock; disqualifying purchases from the taxpayer/related persons in a 4‑year window beginning 2 years before issuance, and “significant redemptions” in the 2‑year window centered on issuance, are tested with de minimis exceptions and safe harbors (termination of services, death, disability, or divorce). IRC § 1202(c)(3); Treas. Reg. § 1.1202‑2(a)–(d)

• Transfers/reorganizations: Gifts and transfers at death preserve QSBS status/holding period; certain § 351 and § 368 reorganizations carry over QSBS status and holding period to new stock, but the exclusion is limited to the gain that would have been recognized if nonrecognition hadn’t applied (successive application permitted). IRC § 1202(h)(1)–(4)

Limits and special rules

• Per‑issuer limitation and 10× basis rule: The shareholder’s annual per‑issuer exclusion is limited to the applicable dollar limit or 10× basis; separate rules apply to married filing separately vs. joint returns, with special allocation for joint filers in subsequent years. IRC § 1202(b)(1)–(5)

• Pass‑through entities: Partners, S‑corporation shareholders, RIC shareholders, and common trust fund participants can claim the § 1202 exclusion on amounts attributable to QSBS sold by the entity if they held their entity interest when the entity acquired the QSBS and continuously until disposition; gain/basis allocations are proportionate and limited by the interest originally held. IRC § 1202(g)(1)–(4)

• Short positions: An offsetting short position can deny the exclusion unless specific timing and elections are met. IRC § 1202(j)

How an S‑corp owner can take advantage today

1. Use your S corporation to invest in QSBS of another C corporation
   An S corporation is a pass‑through entity for § 1202; if the S corporation acquires QSBS at original issue in a qualifying C corporation and holds it for the required period, the gain on sale can be passed through and each shareholder may claim their proportionate exclusion—provided they held their S‑corp interest at acquisition and continuously until disposition. IRC § 1202(g)(1)–(4)
   Planning points: ensure the issuer meets the gross‑assets and active‑business tests, acquire at original issue, avoid disqualifying redemptions (observe de minimis and exceptions), track per‑issuer limits and exclusion percentages based on the acquisition date (including OBBBA’s applicable date). IRC § 1202(d), (e), (c)(3), (b); Treas. Reg. § 1.1202‑2; OBBBA Merged Changes

2. Convert your own S corporation to a QSBS‑eligible C corporation and issue new QSBS
   QSBS must be stock of a C corporation; stock issued while the corporation is an S corporation does not qualify; to create QSBS, terminate the S election (prospectively) or form a new C corporation, then issue stock at original issue while meeting the “qualified small business” and “active business” tests, and hold the stock through the required period. IRC § 1202(c)(1), (c)(2)(A), (d), (e)
   Practical steps: ensure the corporation is a C corporation during substantially all of the QSBS holding period; at issuance, aggregate gross assets must not exceed $75,000,000 (including fair market value of contributed property); issue stock for money, property (not stock), or services (other than underwriting); avoid disqualifying redemptions around issuance; operate in a qualifying trade/business and satisfy the 80% asset use test; hold for 3/4/5 years (for 50%/75%/100% exclusion for post‑applicable‑date stock). IRC § 1202(a)(5), (c)(1)(B), (c)(2)(A), (d), (e), (c)(3); OBBBA Merged Changes
   Restructurings/exchanges: certain § 351 or § 368 transactions after QSBS issuance can preserve status and holding period in successor stock, subject to the nonrecognition limitation; retrofitting old S‑corp shares into QSBS isn’t permitted—new C‑corp QSBS must be issued after conversion. IRC § 1202(h)(4), (c)(1)(B)

3. Shareholder‑level strategies and special rules
   Transfers by gift or at death preserve QSBS status/holding period for the transferee, enabling estate or lifetime gifting strategies; if a partnership or S corporation holds QSBS, a partner/shareholder must have held their interest at the entity’s acquisition and continuously thereafter to claim § 1202 on their share at disposition. IRC § 1202(h)(1)–(2), (g)(2)

Pitfalls to avoid
Issuer redemptions surrounding issuance (including from related persons) above de minimis thresholds can disqualify the stock; ineligible trades or businesses (e.g., specified services, finance, hotels/restaurants) defeat the active business test; and the corporation must remain a C corporation during substantially all of the QSBS holding period. IRC § 1202(c)(3), (e)(3), (c)(2)(A); Treas. Reg. § 1.1202‑2

Summary
Depending on acquisition date and holding period, 50%/75%/100% of gain from QSBS can be excluded, subject to per‑issuer limits and the 10× basis rule, with generous pass‑through and transfer provisions; S‑corp owners can either invest via their S corporation in QSBS of other qualifying C corporations (satisfying the timing and continuity rules) or convert to a C corporation and issue new QSBS, then hold for the requisite period while avoiding disqualifying redemptions and non‑qualifying trades/businesses—carefully tracking OBBBA’s applicable‑date changes and updated dollar limits. IRC § 1202(a), (b), (g), (h); Treas. Reg. § 1.1202‑2; OBBBA Merged Changes; IRS Newsroom – One Big Beautiful Bill Provisions

This essay is not tax advice. Always consult a qualified tax professional for your specific situation.