Section 1202 allows shareholders of eligible small businesses to realize capital gains without paying tax. More commonly known as the Qualified Small Business Stock Exclusion (QSBS), this law aims to increase and encourage investment in small businesses. 

To qualify under Section 1202, both the shareholder and the business must meet eligibility criteria. For those who qualify, they may be able to skip paying taxes on up to 50 percent of any eligible gain. 

What is a Small Business? 

Not every small business qualifies for the exclusion. The IRS uses a restrictive definition of small business for Section 1202. Some of these conditions include: 

A business must also use at least 80 percent of its assets in one of its qualified trades or businesses.  

What is a Shareholder? 

To be eligible for the exclusion, the stockholder must be an individual. They must acquire the stock by buying it, in exchange for money or property, or as payment for services provided. Stockholders who receive their shares from another person generally cannot take advantage of Section 1202. 

What is an Eligible Gain? 

An eligible gain is one that qualifies for the exclusion. It involves any sale or exchange of eligible stock that the stockholder has held for more than five years.  

If a stockholder has not had the stock for at least five years, they may be able to defer gains by investing their gain in the stock of another qualified small business. This must be done within 60 days of the sale. 

Are There Limitations on the Exclusion? 

Yes. For each share that qualifies for the QSBS, the exclusionary gain must be the greater of: 

or