Many taxpayers who sell their businesses are taking advantage of the capital gains exclusion offered by Internal Revenue Code Section 1202 (I.R.C. § 1202), also known as Qualified Small Business Stock (QSBS). However, as the need for this powerful and popular tax incentive has increased, so has scrutiny. The IRS is now actively auditing and challenging Section 1202 claims, making it critical for investors, founders, and tax professionals to understand both the benefits and the enforcement risks.
What Is Qualified Small Business Stock (QSBS)?
QSBS refers to stock issued by a domestic C corporation that meets specific eligibility criteria under Section 1202. If the requirements are met, a taxpayer may exclude a portion—or all—of the gain from income when the stock is sold. This provision is designed to encourage long-term investment in small businesses through favorable tax treatment.
Key Requirements for Section 1202 Qualification
To qualify for the QSBS exclusion under Section 1202, all of the following must be true:
- Eligible Corporation: The issuing entity must be a C corporation with total gross assets not exceeding $50 million.
- Original Issuance: The taxpayer must acquire the stock at its original issuance.
- Qualified Trade or Business: The company must operate in a qualified industry.
- Five-Year Holding Period: The stock must be held for at least five years.
- Post-1993 Issuance: The stock must be issued after August 10, 1993.
Capital Gains Exclusion Amount
Depending on when the QSBS was acquired, the percentage of the gain that is not taxed (that is, the exclusion percentage) differs:
- 100% exclusion for stock acquired after September 27, 2010
- 75% exclusion for stock acquired between February 18, 2009 and September 27, 2010
- 50% exclusion for stock acquired before February 18, 2009
The maximum exclusion is the greater of $10 million or 10 times the adjusted basis of the stock.
Not all states follow the federal rules in Section 1202. For example, California does not “conform” (or follow) Section 1202. Thus, in states like California, the entire gain from the sale of QSBS will be subject to state income taxes.
IRS Enforcement and Audit Trends for Section 1202
As Section 1202 has become more popular, it has also attracted increased scrutiny from the IRS. The IRS has begun targeting Section 1202 claims during audits, particularly in high-income returns. Issues flagged include:
- Failure to meet the qualified trade or business standard
- Improper documentation
- Stock held in pass-through entities without tracking
- Misunderstandings of conversion rules
IRS scrutiny will continue to increase as more and more business owners use Section 1202.
Practical Planning Considerations
Given the IRS’s heightened focus, taxpayers should:
- Confirm eligibility of the corporation;
- Document acquisition and capitalization clearly;
- Evaluate industry classification; and
- Review holding periods and ownership structures.
Planning in advance is essential to mitigate the risk of an IRS audit.
How the Former IRS Attorneys at Our Firm Can Help
Section 1202 provides a powerful incentive to invest in early-stage companies and startups, but taxpayers must be cautious and methodical in applying it. As IRS scrutiny increases, proper planning, structuring, and documentation are critical to realizing the benefit.
The former IRS attorneys at Holtz, Slavett & Drabkin can help taxpayers both during the sale process and after. During the sale process, our tax attorneys can evaluate whether a taxpayer qualifies for Section 1202 QSBS and can advise taxpayers on additional documents and information to keep as part of the sale process. Our attorneys also regularly represent clients who are under audit by the IRS or in court (Tax Court or District Court) regarding Section 1202 QSBS and other matters related to the sale of a business.
David J. Warner practices in all aspects of tax controversy including tax audits, tax litigation, and collection defense. David regularly advises clients and accounts on sales of businesses, including Section 1202 QSBS. Before joining Holtz, Slavett & Drabkin, David was a Senior Trial Attorney with the IRS Office of Chief Counsel in Laguna Niguel for 9 years. As an IRS attorney, he handled over 500 cases before the U.S. Tax Court, including the most complex international cases and partnership and corporate matters. David also advised the local IRS Special Enforcement Program (SEP) and Large Business & International (LB&I) International Individual Compliance (IIC) revenue agents on complex domestic and international audits. David was an Adjunct Professor of Law at University of California Irvine School of Law, Chapman University Fowler School of Law, and Loyola Law School, where he taught courses on tax practice and procedure, partnership tax, bankruptcy tax, and corporate tax.
Holtz, Slavett & Drabkin, APLC is a tax controversy and tax litigation law firm consisting of nine (9) former IRS trial attorneys. We represent taxpayers in all aspects of tax disputes with the IRS and state tax authorities. To schedule a consultation, please contact David at (949) 999-6606.