In an attempt to further encourage investment in new ventures, small businesses, and specialized small business investment companies, gains from investments by noncorporate taxpayers in qualified small business stock (“QSBS”) acquired through the end of 2011, and held for more than five years have been exempted from capital gains tax.


Section 1202 of the Internal Revenue Code (the “Code”) excludes 50% of the capital gains from the sale of QSBS held for more than five years. The purpose of this tax provision was to stimulate new cash flow into start-up companies by reducing the effective tax rate on future stock gains. In 2009, as part of a legislative effort to stimulate the economy, the percentage exclusion in Code Section 1202 was raised from 50% to 75% for QSBS acquired after February 17, 2009 and before September 28, 2010. The percentage was raised again from 75% to 100% for gain on stock acquired after September 27, 2010 and before January 1, 2012.

What is QSBS?

In general, QSBS is defined as any stock in a corporation that is acquired at its original issue. The issuing corporation, however, (i) must meet the “active business test” and “gross asset test” described below; (ii) not violate the prohibition on “significant redemptions” described below or related party redemptions; and (iii) be a C corporation during substantially all of the taxpayer’s holding period. Stock that is purchased from an existing shareholder cannot qualify as QSBS. Thus, this tax exemption applies to growth equity investments, but does not generally apply to buyout transactions.

Active Business Test

The “active business test” requires that during substantially all of the taxpayer’s holding period, the issuer uses at least 80% of its assets (measured by value) in the active conduct of one or more “qualified trades or businesses.” A “qualified trade or business” specifically includes start-up activities and certain research and experimentation activities conducted in connection with a future qualified business. The term is otherwise defined as any trade or business, other than specifically excluded businesses. Exceptions include certain service businesses and professional activities (such as law or medicine), financial services, banking, farming, the extraction of natural resources and the operation of hotels, motels, restaurants or other similar businesses.

Gross Asset Test

The “gross asset test” requires that the enterprise value of the issuer does not exceed $50 million at any time before the issuance of the QSBS or immediately after the purchase of the QSBS.

Prohibition on Significant Redemptions

Stock will not be treated as QSBS if, at any time during the two-year period beginning on the date that is one year before the issuance of the stock, the issuer redeemed (or redeems), in the aggregate, stock with a value exceeding five percent of the value of all of its stock as of the beginning of such two-year period. For example, if one year prior to the investment, the issuer had an equity value of $10,000,000, then for the two-year period starting one year prior to the purchase of QSBS from the issuer, and continuing one year after the investment, no more than $500,000 of the issuer’s stock may be redeemed.

How Much Gain Can Be Excluded?

The amount of gain that can be excluded from gross income under Code Section 1202 is limited to the greater of: (i) $10 million ($5 million for married taxpayers filing separately) or (ii) 10 times the taxpayer’s basis in the stock. This limitation applies on a per-issuer basis, allowing an investor to utilize the exclusion for multiple qualified small business stockholdings in different companies.