Take It From a Tax Attorney: This Is a Magic Multimillion-Dollar Tax-Saving Strategy

Magic numbers do exist: 1202 is a magic number for those involved in start-ups and similar business activities that involve the sale of highly appreciated stock. It can magically erase millions in taxes for certain people.

Internal Revenue Code (IRC) Section 1202 provides an income tax exemption in an amount equal to the greater of $10 million or 10 times the adjusted basis of qualifying stock. The exempt amount is determined per taxpayer holding the stock sold.

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The 1202 stock exemption is referred to as the qualified small business stock exemption (QSBS). While described as the small business tax exemption, the business can be very large and still qualify.

Note: While this article references a $10 million exemption, the One Big Beautiful Bill tax legislation signed into law on July 4 will increase this exemption to $15 million for stock acquired after July 4, 2025.

To qualify, the stock must meet the following criteria:

1. Original issue

You must have acquired the stock in an original issue from the company itself (not through a secondary transaction) on or after August 10, 1993.

Stock received as compensation for services performed may qualify. Stock received as an inheritance also qualifies if that stock was original issue.

2. $50 million gross asset limitation

The corporation must not have had more than $50 million of income tax basis in its assets at any time from August 11, 1993, until immediately after the issuance of the stock.

Note that the corporation still qualifies if its assets later grow to have a value higher than $50 million in income tax basis.

3. Eligible shareholder

The stock must be held directly or indirectly by an eligible shareholder. Eligible shareholders are all non-corporate shareholders, including individuals, trusts and estates. A partnership or S corporation may qualify, but additional requests are imposed.

Care must be taken with partnerships acting as shareholders that create additional challenges and may even reduce the ultimate benefit to the partners unless the partnership appropriately preserves the 1202 stock qualification.

4. Eligible corporation

An eligible corporation is any domestic corporation taxed pursuant to subchapter C of the IRC IC-DISC and former DISC. An S corporation is not an eligible corporation, but an LLC that elects to be taxed as a C corporation is eligible.

Substantially all of the costs must be used in a "qualified trade or business." A qualified trade or business means a business other than:

• Performances of service in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset is the reputation or the skill of one or more of its employees
• Banking, financing, insurance, leasing, investing or similar businesses
• Farming, gardening, growing or other agricultural business
• Mining, drilling or other extraction-type business
• Operation of a hotel, motel, restaurant or other hospitality services 1202 (e)(3)

5. Holding period

The stock must be held for five years before being sold or otherwise transferred for the exclusion from tax to apply.

The 1202 holding period begins on the date that the stock was issued, even if your general tax holding period is longer. To determine the five-year holding period, you can tack on or add previous holding periods for stock received as a gift, inheritance, distribution from a partnership or certain stock conversions or exchanges.

Shareholders seeking to sell prior to the expiration of the five-year holding period may defer by reinvesting in another QSBS if the stock was held at least six months. (Businesses involving an owner's personal reputation or goodwill are less likely to qualify.)

6. Corporation must not engage in prohibited industries

Prohibited industries or activities include personal services, financing, insurance, investigating, farming, mining or running a hotel, motel or investments.

Examples of qualifying businesses include manufacturing companies with 500 employees or fewer and non-manufacturing businesses with gross receipts below $7.5 million.

How it works: One $3.7 million scenario

You create a business start-up, invest $2 million and receive shares in 2019 in a qualifying corporation. The business is widely successful, and you sell your shares in 2025 for $12 million.

That sale is tax-free because you have a $2 million basis and a $10 million exclusion of gain from taxation for the 1202 stock. For a California resident, the combined tax rate is 20% + 3.89% (NIIT) and 13.3% (CA tax) for a total marginal rate of 37.1%.

The tax savings if you qualified for a 1202 exclusion would be $3,710,000, a substantial savings and a great start for your next business investment.

How to maximize 1202 exclusions

Because this exemption is determined on a per-taxpayer basis, planning opportunities are available.

The 1202 exclusion is a per-taxpayer exclusion, meaning each qualified shareholder in a married couple is entitled to the full $10 million or full 10 times basis exclusion. That said, there is no clear authority for a husband and a wife to each qualify for the full exclusion $10 million exclusion.

Section 1202(b)(1) provides an exclusion for a taxpayer with an eligible gain. Spouses filing a joint return are treated as separate taxpayers for many purposes.

However, Section 1202(b)(1)(A) requires the $10 million exclusion be divided into two separate $5 million exclusions if a married couple file separate returns.

In Marvin v Levy (1942) 46 BTA 1145, that court determined for purposes of net capital loss reporting limit, a married couple filing separate returns was not treated as two separate taxpayers with two limits, but rather as an integrated taxpayer.

This may indicate that a spouse has an uphill battle seeking to qualify for an additional, separate $10 million exclusion.

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That said, there is ample authority for treating spouses as two separate taxpayers that support such a position. The plain language of Section 1202 in the reference to the gain exclusion is the "amount of a taxpayer," and the IRC generally treats each spouse as a separate taxpayer.

While the reference to a $5 million exclusion applies to a married taxpayer filing separately, Congress did not put any limitation that both spouses could not have Section 1202 investments and exclusions.

So, if you seek to qualify as husband and wife for two separate 1202 exclusions, structure your plan to reinforce that you and your spouse should be characterized as two separate taxpayers and two separate investors. Each of you may wish to hold your shares in separate trusts for that purpose.

'Stacking' the exemption

The cumulative $10 million limit applies on a per-taxpayer basis, so a QSBS shareholder can create additional taxpayers to benefit from additional $10 million exclusions under subparagraph (A) of 1202(b)(1).

This process of creating (or involving) additional taxpayers is often described as "stacking the exemption."

The original QSBS shareholder generally must sell his or her shares to qualify for a Section 1202 gain exclusion. However, some transfers, specifically gifts and bequests at death, are exceptions to this general rule.

The recipient of the gift or inheritance is considered to have the same cost basis and holding period as the transferor. The transfer must be to a separate taxpayer for federal income tax purposes.

Note that the gift does not need to be a transfer and need not to be recognized as a completed gift for gift tax purposes.

Whether the QSBS shareholder should make transfer(s) as a completed gift or not will depend on his/her estate planning goals, including whether you have a taxable estate for estate tax purposes and any remaining federal gift and any remaining federal gift or generation-skipping transfer tax exemptions.

The following gifts or transfers that would qualify:

• Individuals (but perhaps not your spouse as discussed above)
• Non-grantor trust
• Incomplete non-grantor trust (ING)
• Trust distribution to beneficiary other than creator, grantor or settlor

Consider establishing a trust situs, or jurisdiction, in a state that does not have income tax to minimize the state income tax.

For example, I hold qualifying 1202 stock with a cost basis that allows me to exclude gain of up to $10 million. I create a complex trust for the benefit of my son and another trust for my daughter. I can now exclude separately up to $30 million of otherwise taxable gains. A tremendous result.

'Packing' the 1202 exemption

"Packing the exemption" describes taking actions to increase the basis of the QSBS shares for a greater exemption. Note that the 1202 exemption is an amount equal to the greater of $10 million or 10 times the cost basis.

As we've outlined, trusts can clearly be established to qualify for an additional $10 million exclusions for children or other family members. Gifting QSBS shares to asset protection trusts, such as a Nevada DAPT or a Delaware DAPT, can be used to create additional 1202 exclusions.

Another way to maximize your exemption would be to reduce your taxable gain by raising the cost basis of your stock. Steps to increase the basis that underlies the exemption include:

• Contribute cash or property for QSBS shares.
• Sell both ineligible high-basis QSBS shares in the same calendar year as eligible lower-basis QSBS shares.
• Contribute property after some appreciation. Property that will appreciate can be contributed when that basis value is increased. The tax basis of property contributed is equal to the fair market value at the time of the contribution.
• Operate as a partnership initially (multi-member limited liability company (LLC)) and then incorporate when the value of the assets exceeds $1 million.
• QSBC can be issued for services actually performed. The shareholders' basis in that stock is equal to the amount of compensation or wages triggered by the issuance of shares (if unrestricted shares). If restricted shares, then you vest when the restriction is lifted. If an IRC Section 83 S election is filed, the restricted shares are considered issued when the certificate is filed.

Reinvesting 1202 sale proceeds in new stock tax-free

IRC section 1045 provides that shareholders may sell qualified 1202 stock and reinvest the sale proceeds on a tax-free basis in another 1202 stock corporation.

Factoring in state income tax

When considering steps to stack the exemption, always consider state tax treatment. First, most states conform with 1202 stock treatment or have no state income tax. States that do not conform are Alabama, California, Mississippi, New Jersey and Pennsylvania.

As a general rule, you should consider establishing a trust situs in one of the nine states that do not have income tax: Nevada, Florida, Alaska, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming. (Note that while Washington does not have a state income tax, it does have a long-term capital gains tax for high earners.)

Conclusions

A $10 million or 10 times basis exclusion from income tax at sale seems almost too good to be true. But it's not, so 1202 stock should be considered when you are forming your company or venture.

To qualify, the corporation must be taxed as a C corporation. This means no losses can be deducted by the shareholders individually.

Forming as a limited liability company (LLC) taxed as a partnership may permit deducting early year losses on personal tax returns of the shareholders to offset tax on other income.

The LLC could later be converted or reorganized into a C corporation for income tax purposes when the company is profitable.

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