March 7, 2025

IRC 1202: The most important tax code section for founders to understand

IRC 1202 offers a powerful provision in the Internal Revenue Code (IRC) that allows you to exclude capital gains on the sale of qualified small business stock (QSBS). By holding QSBS for a minimum holding period of five years, shareholders can potentially exclude their capital gains from federal income tax.

This provision offers significant tax savings for startups and C corporations, encouraging long-term investments in eligible corporations.

What is IRC 1202?

IRC 1202 enables taxpayers to exclude capital gains from the sale of qualified small business stock (QSBS), provided the stock meets certain criteria. To qualify for the gain exclusion, the stock must be held for five years, and the issuer must be a domestic C corporation engaged in a qualified trade that meets the active business requirement.

Key points:

  • IRC 1202 provides a tax-free benefit on capital gains for qualified small business stock
  • The holding period requirement is five years for taxpayers to qualify for this benefit
  • Small business stock must be issued by a domestic C corporation engaged in an active business

Historical context of IRC 1202

The Qualified Small Business Stock (QSBS) provision under IRC 1202 was introduced as part of the Taxpayer Relief Act of 1997. Initially, this provision provided a 50% exclusion of capital gains on QSBS. In 2010, the Small Business Jobs Act expanded this benefit to 100% for certain investors, effectively removing the tax liability on capital gains from the sale of QSBS held for five years or more.

How to qualify for IRC 1202

To take advantage of the tax-free exclusion on capital gains and maximize your business expense tax deductions, both the stock and the issuer must meet specific criteria. Here’s how to qualify:

Issuer requirements

  1. The issuer must be a domestic C corporation engaged in a qualified trade
  2. The corporation must meet the active business requirement, which states that it has to use at least 80% of its assets in its active business operations, excluding real estate or investment income
  3. The corporation’s aggregate gross assets must be under $50 million at the time of stock issuance

Stock issuance

  1. The stock must be originally issued by the corporation—purchased from the corporation itself
  2. The stock cannot have been subject to significant redemptions that would disqualify the taxpayer from claiming the gain exclusion

Holding period requirement

To qualify for the tax-free exclusion, you must hold the stock for at least five years. This is the holding period requirement necessary for taxpayers to benefit from the capital gains exclusion under IRC 1202.

Explain more IRS requirements and regulations

For IRC 1202 to apply, there are several specific IRS requirements and regulations to understand from a legal perspective. These include definitions and conditions surrounding original issuance, the active business requirement, and redemptions. Each of these terms plays a crucial role in determining whether a business qualifies for the capital gains exclusion available under IRC 1202.

Original issuance

The term “original issuance” is key in determining whether a shareholder qualifies for the capital gains exclusion under IRC 1202.

  • Definition: “Original issuance” refers to the direct purchase of stock from the issuing corporation. This is critical because secondary market transactions, where stock is bought or sold between shareholders rather than from the corporation, do not qualify under IRC 1202.
  • Legal perspective: From a legal standpoint, only newly issued stock qualifies for the capital gains exclusion, not stock purchased from another shareholder. This ensures that the corporation directly benefits from the sale and that the investor is investing in the growth of the business from the ground up rather than simply trading existing shares.
  • IRS regulation: The IRS specifies that shares acquired from a corporation via an offering or direct issuance from the company to the investor will qualify as original issuance, while those acquired through secondary market transactions—such as buying from another shareholder—won’t. This ensures the tax benefit goes to the investor who is directly contributing to the company’s growth.

Active business requirement

The active business requirement under IRC 1202 is designed to ensure that the corporation’s operating as a business and not just holding investments or real estate. For the capital gains exclusion to apply, the corporation must be engaged in an active trade or business that satisfies specific operational criteria.

  • Definition: The corporation must have at least 80% of its assets used in the active conduct of a qualified trade or business. This excludes businesses primarily involved in real estate investments or those that deal with investment income, such as holding stocks, bonds, or other assets not directly related to a business’s primary operations.
  • Legal perspective: From a legal perspective, the active business requirement ensures that the tax benefit is applied to companies that are truly conducting business activities—such as manufacturing, selling goods, or providing services—rather than those that primarily hold investments or assets
  • IRS regulation: The IRS defines a qualified trade or business as one that involves the active conduct of operations, such as producing goods or services sold to customers. A company that primarily deals with investment income or real estate wouldn’t meet the active business requirement—and thus, would not qualify for the capital gains exclusion under IRC 1202.

Redemptions

The issue of redemptions refers to a situation in which a corporation repurchases its own stock, usually from shareholders. Redemptions can have a significant impact on a shareholder’s ability to claim the capital gains exclusion.

  • Definition: Redemptions occur when a corporation buys back stock from a shareholder, reducing the total number of shares outstanding. The stock is then retired or held by the company.
  • Legal perspective: From a legal perspective, redemptions are significant because they can disqualify the stock from meeting the active business requirement. If a C corporation redeems a large portion of its stock, it may reduce the percentage of its assets used in active business operations, which could lead to the business no longer meeting the 80% threshold.
  • IRS regulation: The IRS states that if a corporation has significant redemptions of stock, it may fail to meet the active business requirement under IRC 1202. This means that if a corporation repurchases more than a minor amount of stock from its shareholders, it could disqualify that stock from being considered qualified small business stock.

Maximizing tax savings with IRC 1202

By following IRC 1202's guidelines and maintaining effective cash flow management, you can exclude a significant portion of your capital gains from taxable income. Here's how to maximize your tax savings:

Strategy

Description

Hold your stock for 5 years

The key to benefiting from IRC 1202 is meeting the holding period requirement of 5 years. If you sell the stock before that, you forfeit the gain exclusion, and the capital gains will become taxable at the tax rate.

Track your adjusted basis

The adjusted basis of your qualified small business stock determines the amount of capital gains eligible for tax-free treatment. Be sure to track your tax basis accurately to maximize your gain exclusion.

Consider tax-free rollovers

If you're selling your QSBS and reinvesting the proceeds into another qualified small business stock, you may be eligible for a tax-free rollover under certain conditions.

Be aware of redemptions

If the corporation undergoes significant redemptions of its stock, it may disqualify the stock from meeting the active business requirement, causing you to lose the tax-free treatment on the capital gains.

Common pitfalls and mistakes to avoid

Common mistakes can disqualify you from taking full advantage of IRC 1202. Here’s what to watch out for:

1. Failing to meet the holding period requirement

Selling qualified small business stock before the five-year holding period results in forfeiting the gain exclusion. Keep track of your holding period carefully to ensure eligibility.

2. Ignoring the active business requirement

If a corporation shifts its focus from an active business to holding assets such as real estate or investment income, it may fail to meet the active business requirement under IRC 1202. Ensure the company’s operations remain consistent with IRC 1202’s requirements.

3. Mismanaging adjusted basis

Not tracking your adjusted basis correctly can result in missing out on the gain exclusion. Always ensure that your tax basis reflects accurate investments and stock transactions.

4. Overlooking the IRS letter ruling

In some cases, you might need an IRS letter ruling to confirm whether your stock qualifies under IRC 1202. If you're unsure about your situation, it's always worth seeking official guidance.

How to qualify for IRC 1202

Here are the key qualifications for QSBS, what each requirement means, and why these criteria are crucial for taking advantage of the capital gains exclusion available under IRC 1202:

Requirement

What It Means

Why It Matters

Issuer

Must be a domestic C corporation engaged in a qualified trade

Ensures only eligible businesses benefit from IRC 1202

Holding Period

Stock must be held for five years

To qualify for the capital gains exclusion

Gross Assets

Aggregate gross assets must be under $50 million

Stock Issuance

Must be purchased directly from the corporation

Ensures the stock qualifies from original issuance

Tax planning strategies

When leveraging IRC 1202 for capital gains exclusion, there are several strategies that taxpayers and shareholders can use to maximize tax savings and enhance the benefits of this provision. Here are key tax planning strategies to consider:

1. Combine IRC 1202 with other tax benefits

Many businesses eligible for IRC 1202 can also benefit from other tax incentives, such as research and development (R&D) credits or section 179 deductions for capital expenditures. By combining these tax benefits, you can significantly reduce your overall taxable income.

  • R&D credits: If your business is involved in research and development activities, you can take advantage of R&D tax credits alongside IRC 1202. This can provide immediate tax savings while still qualifying for the capital gains exclusion when you sell qualified small business stock. This strategy works particularly well for startups in tech, biotech, and other innovative industries.
  • Section 179 deductions: Section 179 allows businesses to expense certain capital assets in the year you purchase them rather than depreciating them over time. Using this deduction in the same year as you qualify for IRC 1202 can reduce your business’s overall taxable income, enhancing your overall tax savings.

By leveraging these tax benefits together, you can maximize both immediate deductions and long-term exclusions, effectively reducing your overall federal income tax liability.

2. Invest in multiple QSBS

Diversifying your investments across QSBS increases the chances of benefiting from IRC 1202. If you hold QSBS in different qualified trades, you're spreading your investment risk while also expanding your opportunity to exclude capital gains from taxable income.

  • Mitigating risk: By investing in multiple qualified small businesses, particularly in different industries, you diversify your risk. This is especially helpful in the case of startups, where the potential for failure is higher. While one investment may not meet the requirements for IRC 1202, others might, allowing you to maximize your overall tax-free returns.
  • Building a portfolio: If you plan to invest in startups or early-stage companies, consider creating a diversified portfolio of QSBS holdings. The five-year holding period requirement ensures that long-term investors, particularly those who start early in a business’s lifecycle, benefit the most from the capital gains exclusion.

This strategy works particularly well for angel investors or those in venture capital, where investing in multiple small businesses is common practice. The goal is to increase the likelihood that one or more of your investments qualify for IRC 1202, potentially saving you substantial amounts on capital gains taxes.

3. Plan for a tax-free rollover

A tax-free rollover is an option available under IRC 1202 if you sell your qualified small business stock and reinvest the proceeds in another qualified small business within a specified time frame. This allows you to defer the taxes on your capital gains while maintaining the potential for capital gains exclusion.

  • Requirements for rollover: To qualify for a tax-free rollover, you must reinvest the proceeds into QSBS within 60 days of the sale. This strategy allows you to defer taxable income on the capital gains until you eventually sell the new investment.
  • Deferring taxes: The tax-free rollover strategy is ideal for investors looking to grow their wealth in small businesses while postponing the tax burden. By reinvesting in qualified small businesses, you continue to benefit from IRC 1202’s capital gains exclusion while deferring any taxable income from the sale of your initial stock.

If executed properly, this strategy allows for long-term tax deferral, enabling the shareholder to keep more capital working in new investments, thereby compounding the wealth over time.

4. Use IRC 1202 as part of broader estate planning

For high-net-worth individuals, IRC 1202 can be an excellent tool in estate planning. If your business qualifies for IRC 1202, you can exclude capital gains when you pass your QSBS to heirs, under certain conditions, which can significantly reduce the estate tax burden.

  • Transfer of QSBS to heirs: If you’ve held your QSBS for the required five years, and the capital gains exclusion applies, you can pass it down to heirs. This allows them to continue benefiting from the tax-free treatment of the stock.
  • Estate tax savings: For shareholders looking to pass down their holdings in a qualified small business, IRC 1202 can help reduce estate taxes by allowing heirs to inherit QSBS with the same capital gains exclusion benefits. This is an important consideration for founders or angel investors who want to maximize the value passed down to their families while minimizing the tax burden.

This strategy works well in conjunction with other estate planning tools, such as trusts or family limited partnerships, to protect wealth and avoid unnecessary tax penalties.

5. Strategic use of redemptions in business restructuring

If your company is considering a reorganization or redemption strategy, it’s important to understand how these transactions impact eligibility for IRC 1202. In some cases, planning the timing and structure of redemptions can help maintain eligibility for capital gains exclusions while restructuring the business.

  • Redemption planning: If your corporation is planning to buy back shares from shareholders, it’s important to consider how redemptions will affect the active business requirement. If significant redemptions occur, it may disqualify the stock from IRC 1202 eligibility. As a result, it may be beneficial to structure redemptions in a way that avoids violating this requirement.
  • Business restructuring: Reorganization and restructuring efforts, such as converting to an S corporation or merging with another company, can have tax consequences on your QSBS. Structuring these transactions carefully ensures that you retain eligibility for capital gains exclusions under IRC 1202.

Maximize your tax savings with Ramp’s accounting automation

Effectively managing your business’s finances and staying on top of tax planning can be complex, but it’s crucial for ensuring you get the most value from tax-saving opportunities like IRC 1202. By using the right accounting tools, you can streamline your accounting processes, track your adjusted basis, and ensure your business qualifies for capital gains exclusions.

Ramp’s accounting automation software simplifies financial management, helping you maintain accurate records, stay compliant with IRS regulations, and maximize your tax savings. With features that automate key financial tasks and provide real-time insights, Ramp empowers your team to make smarter financial decisions and reduce manual work.

Explore how Ramp’s accounting automation tools can help your business manage finances more efficiently and unlock tax savings opportunities.

Try Ramp for free

The information provided in this article does not constitute accounting, legal or financial advice and is for general informational purposes only. Please contact an accountant, attorney, or financial advisor to obtain advice with respect to your business.

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Ken BoydAccounting and finance expert
Ken Boyd is a former CPA, accounting professor, writer, and editor. He has written four books on accounting topics, including The CPA Exam for Dummies. Ken has filmed video content on accounting topics for LinkedIn Learning, O’Reilly Media, Dummies.com, and creativeLIVE. He has written for Investopedia, QuickBooks, and a number of other publications. Boyd has written test questions for the Auditing test of the CPA exam, and spent three years on the Audit staff of KPMG.
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