Selling stock in a growing business should be a milestone—not a trigger for a massive tax bill. If you own shares in a qualified small business, Section 1202 of the Internal Revenue Code offers a powerful tax break: the chance to exclude up to 100% of your capital gains when you sell.
This exemption, commonly referred to as the Qualified Small Business Stock (QSBS) exclusion—was created to encourage investment in small, innovative companies. But it only applies under very specific conditions, and it’s easy to miss out if you don’t plan ahead.
This article provides a high-level overview to help you understand how the exemption works, who qualifies, and when this strategy makes sense. It’s a complex area of the tax code, so be sure to consult a CPA before making any moves.
When does it make sense to use this strategy?
For founders, early employees, or investors in high-growth businesses, the Section 1202 exemption can offer one of the most generous tax advantages available—excluding up to $10 million or 10 times your investment in capital gains. If you’re aiming for a strategic exit and already meet the structural criteria, it’s worth exploring.
This strategy tends to be most effective when:
- You own stock in a startup or growth-stage company with a likely acquisition or exit on the horizon
- The company operates in technology, research, or product development—sectors more likely to meet eligibility requirements
- You expect to hold your stock for at least five years and want to minimize taxes when the time comes to sell
It’s not a fit for every business. Here are a few limitations to keep in mind:
- The exemption only applies to C corporations—LLCs, S corps, and partnerships don’t qualify
- Eligibility rules are strict, especially around industry type and how the stock is acquired
- Timing matters—the five-year holding requirement means this needs to be part of your long-term planning, not a last-minute decision
How do I qualify for the Small Business Stock Exemption?
To claim the Section 1202 exemption, your stock—and the company behind it—need to meet a few key requirements.
You must hold the stock for at least five years
The clock starts when the stock is originally issued to you—not when you join the company or exercise options. Sell too soon, and you lose the exemption entirely.
The stock must come directly from the company
You need to acquire the stock at original issuance, either by investing, working for the company, or participating in an early fundraising round. Buying shares from someone else on a secondary market doesn’t count.
The company must have had $50 million or less in assets when the stock was issued
This is a hard cutoff. If the company crossed $50 million in total assets before your shares were issued, they’re not eligible. Growth after issuance is fine—as long as you got in early.
The business has to be in a qualifying industry
Not every type of business qualifies. The IRS excludes certain service-heavy industries, including:
- Law, accounting, and consulting
- Banking and financial services
- Restaurants, hotels, and hospitality
- Farming and agriculture
- Mining or oil and gas extraction
This exemption is aimed at product-driven businesses—especially those focused on tech, research, and innovation. If you’re unsure whether your company qualifies, it’s worth talking with a tax advisor before moving forward.
For a full breakdown of eligibility requirements and legal definitions, you can access Section 1202 of the Internal Revenue Code.
What are the rules surrounding the Small Business Stock Exemption?
- Capital gains limit
The QSBS exemption allows you to exclude up to $10 million in capital gains—or 10 times your investment basis, whichever is greater. That limit applies per company, so if you hold qualified stock in more than one business, the exemption could apply to each one separately. - C corporation requirement
Only stock in a C corporation qualifies. If your business is an LLC, S corporation, or partnership, the exemption doesn’t apply. However, there may be other tax strategies worth exploring if you're not structured as a C corp. - Active business requirement
To qualify, the company must use at least 80% of its assets to actively run the business. That means it can’t just be holding investments or passive assets—it needs to be engaged in a real, operational trade or business that meets IRS criteria.
Can my LLC convert to a C corporation to take advantage of this exemption?
Technically, yes—but it’s not as simple as flipping a switch, and we don’t recommend using it as a one-off strategy.
An LLC can convert to a C corporation and issue qualified small business stock, but the five-year holding period only starts after the conversion. Any growth or gains from before the switch won’t qualify for the exemption.
More importantly, restructuring just to chase a tax benefit can create long-term issues—especially if you don’t actually plan to operate as a C corporation going forward. You could run into complications with ownership, tax filings, or your future exit strategy.
A better approach?
If Section 1202 is part of your broader growth plan, consider:
- Forming a new C corporation from the outset
- Contributing your existing business into that entity
- Starting the five-year QSBS clock right away
This structure may help you qualify—but only if done correctly. Work closely with a tax advisor and attorney to make sure everything is set up properly from the start.
What type of business can take advantage of this exemption?
This exemption works best for businesses with high growth potential—especially those planning for a future sale or public offering. If you're structured as a C corporation and meet the industry and asset requirements, Section 1202 can offer significant long-term tax savings.
You’re more likely to benefit from this strategy if:
- You operate in a qualifying industry, such as technology, biotech, or product-based manufacturing
- You’re structured as a C corporation (not an LLC, S corp, or partnership)
- Your total assets were $50 million or less when the stock was issued
- You’re planning for an eventual sale, acquisition, or IPO
If your business doesn’t check these boxes—or you're not planning to exit—it may not be the right fit. But if you're raising outside capital or building with growth in mind, it’s worth exploring early to see if this strategy aligns with your long-term goals.
Are there alternatives if I don’t qualify for the Small Business Stock Exemption?
Not every business—or shareholder—will meet the strict criteria for Section 1202. But that doesn’t mean you’re out of tax planning options. Depending on your timeline and structure, there may be other ways to reduce or defer capital gains.
Section 1045 rollover
If you sell QSBS before meeting the five-year holding period, Section 1045 may allow you to defer taxes—if you reinvest the proceeds into new QSBS within 60 days. This only applies to stock that originally qualified under Section 1202, so it’s a limited but valuable tool for eligible sellers.
Entity structure planning
Your business might benefit more from an S corporation or LLC, depending on how you generate income and what your long-term goals look like. While those structures don’t qualify for QSBS, they may offer other tax advantages—especially for businesses not planning to raise outside capital or go public.
Broader planning strategies
A good CPA can help you explore other options that fit your business, including deductions, credits, or exclusions that don’t require changing your legal structure. The key is making these decisions early—before a major sale or funding event puts you on the clock.
How can I start implementing this strategy?
Section 1202 isn’t something to figure out right before a sale. If you want to take full advantage of the small business stock exemption, it has to be part of your long-term strategy from the start.
Here’s what that looks like:
- Talk to your CPA and attorney early—before issuing stock, raising capital, or restructuring
- Confirm that your business qualifies as a C corporation and meets the $50 million asset limit
- Make sure stock is issued at original purchase—not acquired secondhand
- Track key dates, document valuations, and retain any paperwork that supports your exemption claim
- Align your business operations and exit plans with the five-year holding period
QSBS can be one of the most powerful tax planning tools available to founders, early investors, and fast-growing businesses—but it only works if you meet the requirements and document everything clearly.
If you're thinking about using this strategy or want help mapping out how it fits into your goals, we’re here to help. Schedule a consultation with our team at DiMercurio Advisors—and let’s make sure you’re set up to take full advantage of what the tax code allows.
