How To Qualify For QSBS Exemption

By: Steven Masur, Tim Fisher, and Danielle Cerniello

We recently analyzed whether entrepreneurs should close their LLC and open a corporation (more specifically, C-Corp) to reduce or avoid capital gains tax on the sale of their company under Section 1202 QSBS (qualified small business stock). In response, this article will take a deeper dive into QTB (qualified trade or business); discussing the relative merits of states in which to incorporate; and describing the limitations to exclusion rates anticipated under the Biden Administration.

What is Section 1202 QSBS and How Do I Qualify?

In the event your business qualifies under Section 1202, then upon the sale of your business, instead of owing your capital gains tax to the IRS, some or all of the capital gains will be excluded from federal tax. This exclusion applies to non-corporate taxpayers, meaning individuals, partnerships, limited liabilities taxed as partnerships, and trusts. Moreover, based on a change in the law in 2010, if you acquired the small business stock after September 27, 2010, then you can exclude 100% of the capital gains. Lastly, you can exclude up to the greater of $10 million or 10 times the adjusted basis of the gain. However, if all of the capital gains are not excluded, the taxable portion has an assessment at a maximum tax rate of 28%.

In order to qualify, there is a minimum holding period of five years. This means that if today, you changed your business form from an LLC to a corporation for tax purposes (either by conversion, by merger, by electing to be taxed as a corporation, or by dissolving the LLC and forming a corporation) and sold stock or sold the entire company a year from today, you would not qualify for Section 1202 QSBS tax benefits. However, if the sale instead occurred five or more years after becoming a corporation, then you may qualify for Section 1202 QSBS tax benefits. The key is that Section 1202 should be used as a strategic planning mechanism if you are likely to sell your business in five or more years. It is not as simple as switching from an LLC to a corporation and then realizing benefits the following tax year.

Further, to be considered QSBS, the stock must be that of a domestic (US) C-Corp.. As a practical matter, once a corporation is an S-Corp it cannot qualify for Section 1202 QSBS tax benefits by changing to a C-Corp.  Moreover, the gross-asset tests must be met, meaning the company’s gross assets cannot exceed $50 million.

You Must Be A QTB To Qualify

The company must be a qualified trade or business (QTB) for substantially the entire five-year holding period. Essentially, Section 1202 does not consider a business to be a QTB if it offers value to customers primarily in the form of services. This is likely the case if the business’ principal asset is the reputation or skill of one or more of its employees.

For example, a QTB does not include performing services in fields such as: health, law, engineering, architecture, accounting, performing arts, consulting, athletics, financial services, brokerage services, etc. The law’s QTB definition also excludes businesses in banking, insurance, financing, leasing, investing, farming, and any motel, hotel, or restaurant. However, it does include industries such as manufacturing, technology, research and development, and software.

Importantly, just because your business may offer value in the form of services does not mean you will automatically not qualify as a QTB. For example, if you are in the business of architecture and primarily provide customers with tangible goods tools and equipment rather than services, then it remains possible to qualify as a QTB for the purpose of realizing benefits under Section 1202. Moreover, at least 80% of the company’s assets must be used for the QTB activities. Lastly, even if your business predominately provides services, because QTB requirement is based on the holding period and not on the entire history of the company, you may still qualify by restructuring to a business model that would qualify for the QSBS as you consider changing from an LLC to a C-Corp.

Consider the State of Incorporation

Generally, the State of Delaware is the most popular state to incorporate due to the bi-partisan political consensus to keep the corporation statute modern, and the quality of Delaware courts and judges. However, each state brings its own set of corporate laws and tax breaks which may be favorable to you and worth looking into. For example, other states that have enacted favorable laws for corporations are: Nevada, Wyoming, South Dakota, Alaska, Florida, Montana, to name a few. With your lawyer and tax advisor you should assess the laws of various states and your business objectives.

Importantly, if you decide to switch to a corporation, it is not an overnight process. Depending on the company’s complexity, the amount of equity holders, and other considerations, the process can take approximately a month or more.

Plot Twist: The Biden Administration Seeks to Limit QSBS’ Exclusion Rate

The 2010 amendment to Section 1202 allows for a 100% exclusion. In the proposed Build Back Better Act the current Administration sought to reinstate Section 1202 to its original 1993 version. If this proposed change goes through, then for taxpayers with an adjusted gross income (AGI) equal to or greater than $400,000, the capital gain exclusion would be limited to 50% (instead of 100%). Also, under the proposed changes, the gain that would not be excluded would then be subject to half the applicable capital gain tax rate of 28% and 7% of the excluded gain would constitute alternate minimum taxable income; therefore, any gain not excluded would be taxed at an effective rate of 14%, plus a possible alternate minimum tax on 3.5% of the gain.


Taxes as it relates to the law can become murky and complicated, and changes happen relatively quickly, so a decision made one day, may not serve you quite as well years later. This QSBS exclusion is the perfect example as to why we must thoroughly consider all information available to us, and hire excellent tax professionals who stay up on changes in the law. Changing from an LLC to a corporation takes time, effort, and money, especially if you have a lot of investors. Most often, it is necessary to replace all of your corporate documents, and reissue equity to your equity holders, and change the nature of the equity rights (e.g., a profits interest in an LLC does not translate well in a corporate environment.)  Regarding the uncertainty of proposed changes to Section 1202, you should consider the complexity of your current business structure and whether the efforts necessary to change to a corporation would be worth the limited exclusion rate. Alternatively, you should consider whether you would be happy to qualify for only a 50% exclusion if the proposed changes go through, remembering that it only applies to capital gains, not regular income, and your corporation would be subject to corporate taxation on its income earned during the holding period.   If you are unlikely to sell your stock, making the change is unlikely to benefit you.

Regardless of the potential changes, it’s important to remember that this QSBS exclusion is for those planning for the future. If you would qualify for QSBS, waiting at least five years to realize these benefits might be a perfect exit strategy.