Public equities are an excellent investment choice—they’re straightforward to manage, offer immense potential for growth, and boast a strong track record of generating returns in the long run. Unfortunately, one of the biggest drawbacks to investing in run-of-the-mill equities is the federal tax on capital gains, which can be as hefty as 23.8%.

Fortunately, Uncle Sam has a few exceptions squirreled away in his tax code. One section of the Internal Revenue Code (IRC), Section 1202, actually allows stock from certain businesses that fit particular qualifications to be exempt from capital gains tax. But how exactly do you take advantage of this provision—and is it too good to be true?

What’s Section 1202—and what’s QSBS?

Section 1202, also known as the Small Business Stock Gains Exclusion, is a section of the IRC that excludes certain small business stock from federal capital gains tax.

While some earlier stock acquisitions are only eligible for a 50% or 75% exclusion from federal tax, qualified small business stock (QSBS) acquired after September 27, 2010 are eligible for a 100% exclusion.

Needless to say, this is a rather generous tax break—so what separates QSBS from other kinds of stock, such as the exchange-listed kind you can buy through an online broker? In other words, what’s the catch?

To be QSBS-eligible, corporate stock must have first and foremost been issued by a domestic C corporation, a type of business structure where the owners or shareholders of the business are taxed separately from the business itself. On top of this, it must be a business that does not operate in the health, law, architecture, engineering, performing arts, athletic, financial, farming, restaurant, or hotel/motel industries.

In other words, ownership interest in limited liability companies (LLCs), S Corporations, partnerships, and sole proprietorships don’t qualify for QSBS. Additionally, there are restrictions on how large the stock-issuing company can be—it’s qualified small business stock, after all. 

Crucially, a qualifying C corporation must have had $50 million or fewer in assets and have used at least 80% of those assets in the active conduct of business at the moment of issuance for its stock to qualify as QSBS under Section 1202.

More specific qualifications demand that the corporation not have purchased any of its stock from the taxpayer or anyone related within a four-year period, starting two years prior to the issuance of the stock, and that the corporation not “significantly redeem” its stock within a two-year period, starting one year prior to the issuance of the stock. (Note here that “significantly redeem” is defined as purchases with an aggregate value exceeding 5% of the aggregate value of all of its stock.)

As you can see, there’s a good deal that goes into defining QSBS. While these regulations may sound strict and somewhat convoluted, keep in mind the tax-related upsides to acquiring QSBS—especially the qualified stock of high-growth companies that have the potential to appreciate dramatically in value—can be enormous.

So, how can you get your hands on some QSBS? Well, it’s not too dissimilar from buying any other kinds of corporate stock. You can acquire QSBS in exchange for money as you would other stock purchases, or receive it in exchange for property or services rendered. What you cannot exchange for QSBS is other stock—if you do this, your entire QSBS exclusion will be disallowed, even if all other requirements are met.

So suppose you managed to find and acquire a stock that fits the definition of a QSBS—congrats! Now you just need to wait for the stock to appreciate in value, and make sure you wait at least five years’ time. If you sell prior to the five year mark—you guessed it—it won’t be exempt from capital gains tax.

So fast forward half a decade, and now you’re ready to take advantage of Section 1202 and rake in some major tax savings—but how much money can you really save this way?

Can you truly save millions of dollars?

Getting a massive tax break sounds great, but you’re probably left wondering if it’s too good to be true. Luckily, you can genuinely save millions by taking advantage of Section 1202.

However, like every tax break, there’s a limit—sort of. An investor can exclude from capital gains taxation the greater of either $10 million or 10 times the adjusted basis of the stock, with the ceiling of the latter being up to $500 million.

For most people, these numbers—especially the latter figure—sound functionally limitless. In practice, however, individual investors who purchase QSBS typically write small checks into early-stage companies—and unless you run a VC or growth equity fund that can afford to make multi-million-dollar investments in small businesses, 10 times the adjusted basis will usually fall below the $10 million figure, effectively making that number the limit for a taxpayer.

This means that every dollar of capital gain in excess of the $10 million mark will typically be exposed to taxation, even if it is QSBS. That said, remember how we noted earlier that there’s only “sort of” a limit? That’s where stacking and packing QSBS comes into play.

“Stacking” the QSBS exclusion

Stacking and packing QSBS are both ways of increasing the amount of realized capital gains that can be excluded from taxation. Stacking QSBS takes advantage of the fact that Section 1202 applies separately to each taxpayer. For this reason, you can shield more gains from taxation by increasing the number of taxpayers that can take advantage of the exclusion. Especially worth noting is that a “taxpayer” doesn’t have to be an individual, but can also mean a trust, partnership, estate, or S corporation. Thus, by transferring some of your stock to other taxpayers/taxpaying entities that you trust, you can “stack” exclusion after exclusion and circumvent the $10 million cap.

The “packing” strategy for QSBS

Packing QSBS is a different method that tries to take advantage of the adjusted basis rather than the $10 million maximum, and there are a couple of ways to go about it. One way to pack QSBS is to contribute cash or property other than stock to the company, which increases the adjusted basis.

In doing so, you’re effectively ratcheting up the figure that will be multiplied by 10 so that you can unlock a much higher exclusion cap. For instance, if you contribute $2 million worth of cash and $1 million in real estate to a newly-formed C corporation, your adjusted basis is $3 million. You can potentially exclude up to 10 times your basis, or $30 million, from taxation.

Requirements, restrictions, and more

Now that you understand the basics of Section 1202 and how to use it to exclude some of your capital gains from taxation, you’re likely eager to start taking advantage of this lucrative tax break—but let’s hold on for just another minute. There are a number of particular requirements, vague rules, and general restrictions that you must be aware of before diving in.

Stacking QSBS often entails gifting or transferring stock from one taxpayer to another. While simple in theory, it’s far more convoluted in practice. For example, contributing QSBS to a single-member LLC is fine, and the stock remains QSBS. However, if another person were to join the company, creating a multi-member LLC, the stock would lose its status as QSBS.

In general, the Internal Revenue Code (IRC) has tricky rules relating to pass-through entities such as LLCs, partnerships, and entities taxed as S corporations, and the IRS has been reluctant to provide further clarity on these restrictions. This can lead to problems when trying to stack QSBS as it may cause the stock to lose its status and fall subject to taxation.

Packing has its own difficulties and pitfalls. While a taxpayer may want to purchase as much stock as possible in order to inflate their adjusted basis—and consequently, their 10x exclusion cap—there must be a legitimate business purpose for the acquisition, tax avoidance notwithstanding. If the IRS finds that the measure is purely a tax avoidance ploy with no bona fide business purpose, it may disallow the taxpayer’s QSBS exclusion.

The takeaway

Section 1202 of the IRC is a major boon to investors and entrepreneurs, allowing an exclusion of at least $10 million from the federal tax when taking advantage of QSBS. Taxpayers looking to employ more advanced strategies can “stack” or “pack” their QSBS to unlock further tax savings.

While properly taking advantage of Section 1202 may yield millions of dollars in savings, the section comes with a litany of qualifications, restrictions, and pitfalls—so it’s critically important that taxpayers follow these rules to a T. That said, properly taking advantage of Section 1202 may yield millions of dollars in savings, and you should carefully consider if investing in QSBS is right for you.

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