QSBS Section 1202: The Tax-Free Exit for Qualifying Business Owners

You built a $6M contracting company from nothing. Now a PE firm offers $4M for your equity. At the 20% federal capital gains rate plus 3.8% NIIT plus state tax, you're looking at roughly $1 million in taxes on the sale.

Or zero. If you structured correctly under §1202, the entire $4M gain could be federally tax-free.

How Section 1202 Works

Section 1202 of the Internal Revenue Code allows shareholders of Qualified Small Business Stock (QSBS) to exclude up to the greater of $10 million or 10x their basis in capital gains. The exclusion is 100% for stock acquired after September 27, 2010.

Requirements: the business must be a C-corporation (not S-Corp, not LLC), gross assets must be under $50 million at the time stock is issued, the stock must be held for at least 5 years, and at least 80% of the corporation's assets must be used in an active trade or business.

The Catch: You're Probably an S-Corp

Most trade contractors are S-Corps — which don't qualify. But if an exit is 5+ years away, converting to C-Corp and issuing new stock starts the QSBS clock. You'd pay C-Corp-level taxes during the holding period (currently 21%), but the exit is tax-free.

The math: 5 years of 21% corporate tax + zero exit tax vs. S-Corp pass-through rates + 25%+ exit tax. For contractors expecting $3M+ in sale proceeds, the C-Corp + QSBS path often wins by a wide margin.

Who This Fits

Ideal candidate: Contractor 5+ years from exit, expecting $2M+ in capital gains, willing to operate as C-Corp, meets the $50M gross asset test.

Not a fit: Selling within 3 years (can't meet holding period), already above $50M in assets, or income level where C-Corp double taxation during the holding period outweighs exit savings.

This is advanced exit planning that requires modeling years in advance. It pairs with exit tax planning, installment sales, and the broader tax strategy.