I am always surprised at how many IT business owners still don’t know about this special tax loophole that not only works for federal purposes, but for some states as well. I personally took advantage of this loophole for federal tax purposes when I sold my last company, but was not in a state (i.e. California) where I could use it for state tax purposes. That loophole is the Internal Revenue Code Section 1202 Qualified Small Business Stock (QSBS) Gains Exclusion.
Of course there is always a catch, and the first one is that you need to have been a C corporation for the last five years to take advantage of it. Now, for those of you who are S corps, it won’t apply to you. But you have always had an advantage over C corps anyway, as most of your gain will always be capital gain, regardless. And while an S corporation is not an eligible corporation, an LLC that has elected to be taxed as a C corporation is eligible. For those who are still with me because you are a C corp, here is a handy table that shows what percentage of capital gains exclusion you can receive. And yes, it goes all the way up to 100% for those of you who incorporated after 9/20/2010. If you need a refresher on the current capital gains rates and how the percentages vary, be sure to read this blog.

While this code section was enacted in 1993 to encourage investment in small business, it has been the best loophole (as a business owner) to avoid paying taxes on up to 100% of your taxable gains from the sale of your stock…but the stock must have been issued after August 10, 1993, and it applies to the greater of $10 million or 10 times the aggregate adjusted basis of the stock at the time of issuance. Don’t remember what you paid for your stock? Look at the capital stock value section of your balance sheet and take your percentage share. For example, if you issued 10,000 shares at $1 per share (and you are 100% shareholder), you will likely see $10,000 in capital stock. Taking that $10,000 times 10 allows for up to $100,000 or $10M, whichever is greater in capital gains exclusion. Since most of the sellers I see purchased their stock for $1 a share, you most likely will fall under the $10 million limitation.
Let’s look at a real example. Bob incorporated his business as an S corporation in 1995, but based on the advice of his CPA, he changed to a C corporation in January of 2019. He paid $10,000 for his shares in the company. First, he has to wait until January of 2024 (5 years) to take advantage of the exclusion. Now, say he sells in June of 2024 for $12M. He can apply the capital gains exclusion against the first $10 million only, as it is greater than $100,000 ($10,000 times 10).
8 Requirements to Qualify for Section 1202 Benefits
Now, if we really get into the weeds (which you have to with tax rules), there are eight requirements to qualify for Section 1202 benefits. Some of these are determined by the shareholder, and others are determined based on the activities of the corporation. Most of these benefits are usually met by the typical VAR or MSP selling today, but let’s review them in summary below:
1. Eligible shareholder: The stock must be held directly or indirectly by an eligible shareholder (individuals, trusts, and estates). So, yes, you are safe if you decide to put your company into a family trust. Partnerships and other S corporations can be eligible, but it gets trickier.
2. Holding period: The stock must be held for more than five years before it is sold. Generally, the holding period starts on the day the stock was issued, but a shareholder can add on a previous holding period in certain stock conversions or exchanges.
3. Original issuance of stock: The shareholder must have received the stock on original issuance after August 10, 1993. But it doesn’t have to be issued as part of the original incorporation. So, let’s say Bob issues himself 5,000 shares when he incorporated, but then gave his sister 5,000 shares a few years later when she began working in the company. His sister would be eligible as well, in this case, because stock received as compensation for services provided to the corporation meets this requirement.
4. Eligible corporation: This is any domestic C corporation outside of certain exceptions (IC-DISC, REIT, REMIC, or cooperative). Remember, an LLC taxed as a C corporation does qualify. The corporation must be in the US but can serve customers internationally.
5. Gross assets limitation: The corporation must not have had more than $50 million in assets during its entire holding period. Usually not an issue for most IT service providers.
6. Redemption transactions: Any redemptions in the year preceding or following a stock issuance can disqualify the stock from Section 1202. This can be as little as 5% of the total stock. A stock redemption is a transaction in which a corporation acquires its own stock from a shareholder in exchange for cash or other property.
7. Qualified trade or business requirement: Again, as IT service professionals, I think most of you will qualify, but the corporation must not be engaged in any of the activities listed below. Unfortunately, there is very little guidance on exactly what most of these terms mean and how they should be interpreted, but you should be safe here.

And finally
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. Also, only up to 50% of the corporation’s assets can be made up of working capital held to support the reasonable needs of the business (i.e., don’t stockpile too much cash in the company, or you may violate the rule). You can also fail this test if 10% or more of the assets of the corporation consist of real property not being used in the active conduct of the business, meaning you have real estate on your books that is unrelated to you occupying the space. So, be careful there.
States that Follow the QSBS Rule
Some of you will be fortunate enough to live in a state that conforms with Section 1202, allowing you to exclude the gain for state tax purposes as well. Below is a visual of each state and how they are treated.

Many times, I do get asked the question, “Can a seller move to a different state (i.e., Texas) to avoid the state capital gains tax?” I personally looked into this as well, being a California resident where the maximum tax rate is 13.3% for revenue over $2M for married filing jointly or $1M for single filers. And through my research and review of case studies, California would find a way to claw back my revenue, even though I might have moved to a different state before the sale. So, it’s wise to check with your tax advisor if that is something you are contemplating.
If you want to learn more about QSBS, here is a great website that also has a calculator: https://www.qsbsexpert.com/qsbs-basics/
Finally, remember that I am not giving tax advice, so be sure to engage a CPA in your state who can give you tax advice on your particular situation.