Section 1202 QSBS Exclusion Rules: Capital Gains Exclusion Percentages

Section 1202 of the Internal Revenue Code provides one of the most valuable tax benefits available to investors in small businesses: the ability to exclude a significant portion (and in many cases, all) of capital gains from the sale of Qualified Small Business Stock (QSBS) from federal income tax.

This page provides a comprehensive guide to Section 1202 exclusion rules, including exclusion percentages, holding period requirements, per-issuer limitations, and basis considerations.

Exclusion Percentages: The Key Benefit

The percentage of capital gains that can be excluded under Section 1202 depends on when the stock was acquired and how long it has been held.

Stock Acquired on or Before the Applicable Date (July 4, 2025)

For stock acquired on or before July 4, 2025:

• 50% exclusion if held for more than 5 years [IRC §1202(a)(1)(A)]

Historical Exclusion Percentages (still applicable to stock acquired during these periods):

• Stock acquired between February 18, 2009 and September 27, 2010: 75% exclusion if held for more than 5 years [IRC §1202(a)(3)]

• Stock acquired after September 27, 2010 and on or before the applicable date: 100% exclusion if held for more than 5 years [IRC §1202(a)(4)]

Stock Acquired After the Applicable Date (July 4, 2025)

For stock acquired after July 4, 2025, the exclusion percentage is based on holding period (the "applicable percentage"):

• 50% exclusion if held for at least 3 years but less than 4 years
• 75% exclusion if held for at least 4 years but less than 5 years
• 100% exclusion if held for 5 years or more [IRC §1202(a)(1)(B), (a)(5)]

Table: Exclusion Percentages by Acquisition Date and Holding Period

| Acquisition Date | Holding Period | Exclusion Percentage | |-----------------|---------------|---------------------| | On or before Feb 17, 2009 | More than 5 years | 50% | | Feb 18, 2009 - Sept 27, 2010 | More than 5 years | 75% | | Sept 28, 2010 - July 4, 2025 | More than 5 years | 100% | | After July 4, 2025 | 3-4 years | 50% | | After July 4, 2025 | 4-5 years | 75% | | After July 4, 2025 | 5+ years | 100% |

Holding Period Requirements

Stock Acquired on or Before the Applicable Date

Must be held for more than 5 years to qualify for exclusion. [IRC §1202(a)(1)(A)]

Stock Acquired After the Applicable Date

Must be held for at least 3 years to qualify for any exclusion, with the exclusion percentage increasing based on holding period:

• 3 years minimum for 50% exclusion
• 4 years minimum for 75% exclusion
• 5 years minimum for 100% exclusion [IRC §1202(a)(1)(B), (a)(5)]

Holding Period Calculation:

• The holding period generally begins on the day after acquisition
• Section 1223 rules apply for determining holding periods in most cases
• Special rules apply for stock received through gifts, inheritances, and certain corporate transactions

Per-Issuer Dollar Limitations

The exclusion is subject to significant dollar limitations that apply on a per-issuer basis.

Stock Acquired on or Before the Applicable Date

Limit: $10 million (or 10 times the taxpayer's adjusted basis in the QSBS, if greater) per issuer [IRC §1202(b)(4)(A)]

Stock Acquired After the Applicable Date

Limit: $15 million (or 10 times the taxpayer's adjusted basis in the QSBS, if greater) per issuer [IRC §1202(b)(4)(B)]

Inflation Adjustment: Beginning in 2027, the $15 million amount is adjusted for inflation. [IRC §1202(b)(5)]

How the Limit Applies

The limitation applies to "eligible gain" which is gain from the sale or exchange of QSBS held for at least 3 years (more than 5 years for stock acquired on or before the applicable date). [IRC §1202(b)(2)]

Key Points:

• The limit is per issuer, meaning taxpayers can exclude gains from multiple different QSBS issuers, subject to each issuer's separate limit
• The limit applies to the aggregate of eligible gain from dispositions of stock issued by the same corporation
• The limit is reduced by any eligible gain taken into account in prior taxable years from the same issuer

Married Individuals

For married individuals filing separate returns:

• The $10 million limit becomes $5 million per issuer [IRC §1202(b)(3)(A)(i)]
• For post-applicable date stock, the $15 million limit is cut in half [IRC §1202(b)(3)(A)(ii)]

For joint returns, the exclusion amount is allocated equally between spouses for purposes of applying the limitation to subsequent taxable years. [IRC §1202(b)(3)(B)]

Basis Considerations

Exclusion Applies to Gain, Not Gross Proceeds

The exclusion applies to gain, which is the amount realized minus the adjusted basis. [IRC §1202(a)]

Example:

• Stock purchased for $100,000 (basis)
• Stock sold for $1,000,000
• Gain: $900,000
• 100% exclusion applies to $900,000 gain
• Taxable income: $0 (assuming within per-issuer limit)

Adjusted Basis Determinations

For purposes of the per-issuer limitation, adjusted basis is determined without regard to any addition to basis after the date on which such stock was originally issued. [IRC §1202(b)(1)]

This means that subsequent contributions to capital that increase basis are not counted toward the "10 times basis" alternative limit calculation.

Basis Rules for Property Exchanges

If stock is received in exchange for property (other than money or stock), the basis of the stock shall in no event be less than the fair market value of the property exchanged. [IRC §1202(i)(1)]

Capital Contributions

If the adjusted basis of QSBS is adjusted by reason of any contribution to capital after original issuance, the basis of the contributed property shall in no event be treated as less than its fair market value on the date of the contribution. [IRC §1202(i)(2)]

Active Business Requirement

Stock will not qualify as QSBS unless, during substantially all of the taxpayer's holding period, the issuing corporation:

• Meets the active business requirements of Section 1202(e), and
• Is a C corporation [IRC §1202(c)(2)(A)]

This means the corporation must:

• Use at least 80% (by value) of its assets in the active conduct of one or more qualified trades or businesses
• Be an eligible corporation (domestic C corporation, excluding DISCs, RICs, REITs, REMICs, and cooperatives)

If the corporation fails to meet these requirements at any point during the holding period, the stock may lose QSBS status retroactively.

Eligible Gain

"Eligible gain" means gain from the sale or exchange of QSBS:

• Held for at least 3 years (for stock acquired after the applicable date), or
• Held for more than 5 years (for stock acquired on or before the applicable date) [IRC §1202(b)(2)]

Only eligible gain qualifies for the exclusion and counts toward the per-issuer limitation.

Ordinary Income Portion

If any portion of the gain from the sale of QSBS is treated as ordinary income (rather than capital gain), that portion is not eligible for the Section 1202 exclusion.

The exclusion applies only to capital gain, not ordinary income.

Short Positions

Section 1202(j) provides special rules for taxpayers with offsetting short positions. Generally, the exclusion does not apply if the taxpayer has an offsetting short position unless:

• The stock was held for the required period as of the first day there was a short position, and
• The taxpayer elects to recognize gain as if the stock were sold on that first day for its fair market value [IRC §1202(j)(1)]

State Tax Considerations

Important: Section 1202 is a federal tax provision. State tax treatment varies:

• Some states conform to federal QSBS exclusion rules
• Some states (including California and New Jersey) do not conform, meaning state tax is still owed on the excluded gain
• Taxpayers should check their state's tax laws

AMT Considerations (Historical)

For stock acquired before September 28, 2010, excluded gain was an AMT preference item. However, for stock acquired after September 27, 2010, excluded gain is not an AMT preference item, making the benefit more valuable.

The applicable date legislation (Pub. L. 119-21) removed the AMT preference item treatment retroactively for certain periods.

Key Takeaways

1. Exclusion percentages vary: 50%, 75%, or 100% depending on acquisition date and holding period

2. Holding period is critical: Minimum 3-5 years depending on acquisition date

3. Per-issuer limits apply: $10 million (pre-applicable date) or $15 million (post-applicable date) per issuer

4. 10 times basis alternative: The limit is the greater of the dollar amount or 10 times adjusted basis

5. Active business requirement: Must be met throughout the holding period

6. State taxes may still apply: Section 1202 is federal only

7. Ordinary income excluded: Only capital gain qualifies for exclusion

Sources and Citations

• IRC Section 1202: Partial exclusion for gain from certain small business stock
• IRC Section 1202(a): Exclusion provision and percentages
• IRC Section 1202(b): Per-issuer limitations
• IRC Section 1202(i): Basis rules
• IRC Section 1202(j): Short positions
• Pub. L. 119-21: Legislation establishing applicable date (July 4, 2025) and related changes

Verification Date: January 2025

Note: This page reflects the law as of January 2025. Tax law changes frequently, and this information should not be construed as legal or tax advice. Consult with a qualified tax professional regarding your specific situation. Exclusion percentages and limits are subject to change based on acquisition dates and holding periods.