Section 1202 stock

The Internal Revenue Code Section 1202 provides the legal basis for the gain exclusion on qualified small business stock. “Section 1202 stock” is informal shorthand for stock that qualifies for this exclusion. The statute allows individual investors to exclude gains from the sale of qualifying small business stock held for at least five years, with exclusion percentages ranging from 50% to 100% depending on acquisition date. For stock acquired after 2014 and before 2027, the exclusion is 100%.

The statute and its evolution

Section 1202 was first enacted in 1993 and has been amended several times. The exclusion percentage has changed multiple times to encourage different policy goals at different times.

Original (1993-2000): 50% exclusion Jobs and Growth Tax Relief Reconciliation Act (2003): Increased to 60% for certain stock Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (2010): Increased to 100% for stock acquired in 2010-2011 American Taxpayer Relief Act (2012): Extended benefit and set current schedule

The current schedule (100% exclusion for 2014-2027 stock, sunsetting thereafter) reflects the most recent congressional action.

Acquisition date as the key trigger

The exclusion percentage depends entirely on the acquisition date (the date you purchase or receive the stock), not the sale date. This is critical:

Buy stock on January 15, 2020 (qualifies for 100% exclusion). Sell on January 15, 2024 (for a $1 million gain). You are entitled to the 100% exclusion, even though tax law will change on January 1, 2027.

Conversely, buy on January 15, 2027 (no exclusion under current law). Even if you hold to 2035, the stock does not qualify for the exclusion.

Sunset and future changes

The 100% exclusion for stock acquired between 2014 and 2027 is currently the law. However, it sunsets on December 31, 2026, reverting to 0% exclusion for stock acquired in 2027 and later.

This sunset has prompted speculation that Congress may extend the benefit before it expires. However, no extension is guaranteed. Investors should be aware of the December 2026 deadline.

The five-year holding requirement

You must hold the stock for at least five years from the date of acquisition (issuance). The five-year period is measured from the date you purchased or received the stock, not from some later event.

Example: Buy on January 1, 2022. The five-year period expires on January 1, 2027. You can sell on January 1, 2027, or anytime thereafter, and receive the exclusion.

Sell on December 31, 2026 (one day early), and you do not qualify for the exclusion.

The C-corporation requirement

Section 1202 applies only to stock in C-corporations. If you invest in a partnership, S-corporation, or LLC taxed as a partnership, you do not get the Section 1202 exclusion, even if the company otherwise qualifies.

This is important for startup investing: the legal structure of the company affects your tax treatment.

The $50 million asset test

The corporation’s total assets cannot exceed $50 million at the time you acquire the stock. If the corporation had $45 million in assets when you invested, it qualifies. If the corporation later grows to $100 million, it does not disqualify your stock—the test is at acquisition time only.

The $10 million per-company limit

You can exclude gains up to $10 million per company, or 10× your original cost basis, whichever is greater. This prevents the exclusion from applying to outsized gains on mega-successful startups.

Example: You invest $100,000 in a startup. The company sells for $500 million. Your gain is $499,900,000. You can exclude only $10 million of that gain. (Though you can invest more to raise the limit.)

Active business requirement

The corporation must use at least 80% of its assets in active business (not passive investments like real estate or marketable securities held for investment). This prevents the exclusion from applying to investment companies or holding companies.

Non-recognition and basis

If you have a non-recognition event (e.g., stock for stock exchange in an acquisition), the holding period and basis from your original stock can carry forward to the new stock. This is complex; consult a tax professional if you exchange stock.

No state-level exclusion

The federal Section 1202 exclusion does not apply to state income tax (in most states). You owe federal tax on 0% of the excluded gain, but state tax on 100% of the gain. Some states (California, Massachusetts) have enacted parallel state-level QSBS exclusions, but they are not automatic.

Reporting

You report Section 1202 gains on Form 8949 and Schedule D, calculating the excluded portion separately. Your tax software should handle this, but you must affirmatively designate the stock as qualifying under Section 1202.

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