1. Eligible Shareholder - The stock must be held, directly or indirectly, by an eligible shareholder. Eligible shareholders are non-corporate shareholders including individuals, trusts, and estates. Suppose the shareholder is a partnership or S corporation. In that case, the gain may still qualify, but there are additional requirements that must be met for non-corporate owners of the pass-through entity to claim the benefits of Section 1202. Only U.S. taxpayers qualify for the Sec 1202 benefits.

2. Holding Period - The stock must be held for more than five years before it’s disposed. Generally, the holding period of the stock begins on the date the stock was issued. Suppose stock was issued in exchange for non-cash property. In that case, the Section 1202 holding period still begins on the exchange date even if the holding period for general tax purposes carries over.

If the stock is issued from the conversion of debt or the exercise of stock options or warrants, the holding period doesn’t begin until the conversion or exercise. Additionally, some hedging transactions can disqualify stock from Section 1202 treatment.

In determining whether a shareholder has met the five-year requirement, a shareholder can “tack on” previous holding periods if the stock was inherited, received as a gift, in a distribution from a partnership, or in certain stock conversions or exchange.

3. Original issuance of stock - The taxpayer must have acquired the stock on original issuance after Aug. 10, 1993. Consequently, the stock must be purchased from the company, rather than another shareholder. However, the stock doesn’t have to be issued as a part of the initial incorporation. Stock received as compensation for services provided to the corporation meets this requirement (see more on this later). However, stock that’s received in exchange for other stock can sometimes qualify, although it’s subject to additional requirements.

In certain situations, stock can be treated as having been received at original issuance even when the shareholder is not the original owner of the shares. When stock is received via a gift, at death, or as a distribution from a partnership, the stock is treated as having been received by the transferee in the same manner as the transferor. Thus, if the stock was acquired by the transferor at original issuance, the transferee will be treated as having done the same. In other words, theholding period of the original owner is tacked on to the subsequent owner.

For stock distributed from a partnership to a partner, to meet the definition of QSB stock in the hands of the partner:

(1) the stock must have been QSB stock in the partnership's hands (ignoring the five-year holding period requirement),

(2) the partner must have been a partner from the date the partnership acquired the stock through the date of the distribution, and

(3) the partner cannot treat stock the partnership distributed as QSB stock to the extent the partner's share of the distributed stock exceeds the partner's interest in the partnership at the time the partnership acquired the stock.

Committee reports clarified that the issuance date is determined in accordance with the rules of Sec. 83.

Example: In 2015, Jack receives 2,000 shares of QSBS stock in exchange for services provided. The stock is restricted and nontransferable until 2020. Jack does not make a Sec. 83(b) election. In 2020, Jack fully vests in the stock, and at that time, in accordance with Sec. 83, Jack includes the FMV of the stock in income. For purposes of Sec. 1202, the stock's issuance date is 2020, when the stock vested.

When convertible QSB stock is converted into other stock of the same corporation, the stock received in the conversion is treated as QSB stock, and the date of issuance is the date the convertible stock was originally acquired by the shareholder (Sec. 1202(f)).

Example: Jack is issued 2,000 shares of convertible preferred stock in Widget Inc., in 2018. The convertible preferred stock meets the definition of QSBS. In 2021, Jack converts the stock into 4,000 shares of Widget Inc. common stock. The common stock received by Jack is treated as QSBS, and Jack is treated as having originally acquired the common stock in 2018.

When stock is received via gift, inheritance, or as a distribution from a partnership, the acquisition date is the date on which the transferor acquired the stock (Sec. 1202(h)(1)(B)).

Example: On June 1, 2016, Jack contributes $1,000 to X Co. in exchange for stock. The stock meets all the requirements of QSB stock. On July 15, 2020, Jack gifts the shares to Sally, his sister. In July 2021, Sally sells the stock. Because Sally is treated as having acquired the stock on June 1, 2016, the five-year holding period is met. 

4. Eligible Corporation (Sec 1202(e)(4)) – Generally the corporation must be a domestic C corporation. The corporation must be an eligible corporation when the stock is issued and during substantially all the taxpayer’s holding period. An eligible corporation is any domestic C corporation other than certain limited exceptions (such as IC-DISC, former DISC, RIC, REIT, REMIC, or cooperative). An S corporation is not an eligible corporation, but an LLC that has elected to be taxed as a C corporation is eligible. Furthermore, while the corporation must be domiciled in the U.S., the activity of that corporation or its subsidiaries can be domestic or international.

5. $50 Million Gross Assets Limitation - The corporation must not have had more than $50 million of tax basis in its assets at any time between Aug. 11, 1993, through the moment immediately after the issuance of the stock. This test is evaluated at the time of each stock issuance. Once the asset test is met, this test is not reevaluated at a later date for that stock. Therefore, stock issued when the corporation has less than $50 million in tax basis in its assets continues to qualify, even if the corporation’s assets later exceed $50 million.

CAUTION: Acquisitions, fundraising rounds, licensing agreements, and inventory can cause a company to exceed this threshold and lead to QSBS disqualification.

6. Redemption Transactions - Because Congress intended to encourage investment in small business corporations, it wanted to prevent situations where capital invested for Section 1202 was used to fund redemptions of other shareholders. To prevent this type of undesirable activity, Congress cast a wide net in disqualifying stock that is issued shortly before or after a redemption of stock. This is one of the most common traps for taxpayers and results in inadvertently disqualifying stock that met all the other requirements.

7. Qualified trade or business requirement - The corporation must be engaged in (or performing activities to start up) a “qualified” trade or business. This includes any business other than those in the businesses listed below. Unfortunately, there’s very limited guidance on exactly what most of these terms mean and how broadly they should be construed, leaving room for interpretation by both taxpayers and the IRS. Prohibited businesses include:

• Professional service businesses including in the fields of health, law, engineering, accounting, consulting, brokerage, and like businesses. 
  
  
• Performing arts, athletics or any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees.
  
  
• Banking, financing, leasing, investing, and like businesses.
  
  
• Farming and gardening 
  
  
• Oil, gas, & mining 
  
  
• Hospitality including hotel, motel, restaurant, and like businesses.  
  
  
• Real estate & other passive businesses 

8. Active business requirement - The corporation must use at least 80% of the fair market value of its assets in the active conduct of a qualified trade or business. This requirement must be satisfied during substantially all the taxpayer’s holding period of the stock. Further, only up to 50% of the corporation’s assets can be made up of working capital held to support reasonable needs of the business or to support research.

For purposes of this requirement, a corporation automatically fails to meet this test if:

• 10% or more of the corporation’s net assets consist of stock or securities in other corporations in which the corporation does not own over 50%; or
  
  
• 10% or more of the corporation’s gross assets consist of real property not being used in the active conduct of a qualified business.

1.    The company’s current QSB status (or lack thereof).

2.   Whether the company has merged or has been acquired by another corporation. (Except if the company was acquired before the five-year period ended, in which case the QSBS holder would no longer be eligible for this benefit.) Note: In a merger or acquisition scenario, one of the following, or a combination, can occur, depending on the transaction:

• QSBS holders may be able to conduct a share-for-share transfer in which shares are exchanged for shares in the acquiring company; in this case, QSBS status is maintained, but the capital-gains exclusion is capped at the transaction value rather than the full $10 million investment cap;
  
  
• QSBS holders, for example high-net-worth individuals, may cash out and defer capital gains by investing into another QSBS company.

3.   Whether the stock has been transferred, gifted, or inherited. (Except if the stock was transferred to a partnership, in which case it would lose its QSBS status.) 

1.   If the company performs a disqualifying repurchase. 

2.   If the company changes its business model and begins to operate as an excluded business type. 

1.   Alabama

2.   California

3.   Mississippi

4.   New Jersey

5.   Pennsylvania

6.   Puerto Rico