Unlock Potential Small Business Tax Benefits with Section 1202

A little-known portion of the Internal Revenue Code, Section 1202, allows owners and shareholders of certain small businesses to exclude gains from federal capital gains tax up to $15 million or 10 times the shareholder’s basis or initial investment, whichever is greater. Although Section 1202 (the small business stock gains exclusion) does not apply to all companies, when it does apply, it can result in significant tax savings—especially after recent updates under the 2025 tax law.

What is Section 1202?

Qualified small business stock exemptions were established to encourage the founding of and individual investment in small businesses in the U.S. The exemption was enacted in 1993, and recent legislation has expanded its availability and impact. In fact, since 1993, lawmakers have updated the parameters of Section 1202 several times—including the major expansion under the One Big Beautiful Bill Act of 2025.

In general, if you hold stock in a qualifying small business for a certain period and then sell it, a portion—or potentially all—of the proceeds could be exempt from federal taxation. Depending on state law, the exemption may also apply to state income tax as well.

How Section 1202 changed in 2025 (OBBBA effective July 4)

Some key qualifications for QSBS issued on or before July 4, 2025:

• The stock was issued by a domestic C-Corp other than a hotel, restaurant, financial institution, real estate company, farm, mining company or business relating to law, engineering or architecture.
• The stock was originally issued after Aug. 10, 1993, in exchange for cash, or as compensation for a service rendered.

○ 50% exclusion:  stock acquired between 8/10/1993 and 2/17/2009.

○ 75% exclusion: stock acquired between 2/18/2009 and 9/27/2010.

○ 100% exclusion: stock acquired after 9/27/2010.

• When the stock was issued, the corporation had $50 million or less in assets.
• The taxpayer has held the stock for a minimum of five years before selling it.
• The corporation satisfies the active business requirements during the taxpayer’s holding period

New rules (for QSBS issued after July 4, 2025):

• For QSBS issued after July 4, 2025, the issuing company must have had $75 million or less in gross assets at the time of issuance (indexed for inflation starting in 2026).
• The taxpayer must meet a minimum holding period:

○ 3 years → 50% exclusion.

○ 4 years → 75% exclusion.

○ 5 years or more → 100% exclusion.

How to incorporate advance planning strategies with Section 1202

Stacking the exclusion
Because the exclusion applies per taxpayer, families and business owners can “stack” the benefit by spreading ownership across multiple shareholders, trusts, or family members. This can multiply the $10M/$15M exclusion limit many times over.

Section 1045 rollover (“Resetting” opportunity)
Even if you sell QSBS before meeting the five-year holding period, you may be able to roll over proceeds into new QSBS under Section 1045. This strategy can effectively “reset the clock” and preserve the ability to capture a future exclusion.

Entity structure matters
The way you structure your business from the outset is critical. Only C corporations qualify and meeting the active business requirement requires careful attention. Forward planning is essential — QSBS benefits cannot be retroactively created once the business is already operating under a different structure.

Planning sales to use both exclusions
By staggering QSBS stock sales across different years, an owner can use both the $10M/$15M lifetime exclusion and the 10x basis exclusion, significantly reducing taxable gain.

How might Section 1202 help your business

Section 1202 offers tax savings ideas for small business owners and start-up companies, especially those considering a future sale or succession plan. If you are considering a sale at some point, you and your investors might be able to pay less income tax from that sale by applying Section 1202.

The following are examples of how Section 1202 could apply to small business stock sales and gifts. These examples serve only as jumping-off points; real-life situations will vary and require the input of your tax advisor.

Stock Sale Example (Pre-2025 Issuance) Allen was issued stock in ABC Inc. on Jan. 1, 2011, in exchange for $3 million. On Feb. 1, 2021, Allen sold his shares for $30 million, which resulted in a capital gain of $27 million. Allen would have paid $6,426,000 in capital gains tax as a result of the sale. However, assuming the stock qualifies under Section 1202, Allen can exclude up to $30 million of gain from federal taxation (10 times his initial investment). The entire $27 million gain would be excluded, and Allen would pay no federal capital gains tax.

Although this is a simplified example, it illustrates the power of the Section 1202 tax exclusion, which we have found that many qualified business owners and investors have never considered or even heard about.

Gifting example:
On Jan. 1, 2011, Ellen was issued 5,000 shares of DEF Inc. stock in exchange for $1 million. By 2021, the value of those shares grew to $40 million. If she sold the shares, it would result in a $39 million gain. Assuming Ellen owns all the shares at the time of sale, she could exclude up to $10 million of the gain from taxation (the greater of $10 million or 10 times her initial investment). That means $29 million of the gain would be subject to capital gains federal taxation.

However, what would happen if, in 2016, Ellen had gifted 1,000 shares to each of her four children? Then, at the time of sale, Ellen and each child would own 1,000 shares. With a total gain of $39 million, each of them would yield a $7,800,000 gain. Assuming the stock qualifies under Section 1202, each of the five shareholders could exclude up to $10 million of gain and eliminate federal capital gains tax on their $7,800,000 gain. In other words, the entire $39 million gain would be excluded from federal taxation and result in no federal capital gains tax. That would be a savings of $9,282,000 ($39 million x 23.8 percent).

Using both exclusions example:
Allen was issued stock in ABC Inc. on Jan. 1, 2011, in exchange for $1 million.

In Feb. 1,2024 he sold half of his shares for $15M, which resulted in capital gain of $14.5M. Assuming the stock qualifies under Section 1202. Allen can exclude up to $10 million of gain from federal taxation (greater of $10M or 10 times basis of sold shares). 

On January 15, 2025, Allen sells the other half of his shares for $15M, which resulted in a capital gain of $14.5 million. Allen can exclude $5 million of gain from federal taxation (10 times his remaining basis).

This example highlights how the basis exclusion can be used annually regardless of the year acquired.

Again, this is another simplified example, but it shows how Section 1202 could benefit business owners and through forward-thinking and proper planning can create generational wealth.

What are the planning implications for Section 1202?

Given that, at this time, Section 1202 applies only to C-Corp issued stock, significant planning should ideally begin more than five years ahead of any stock transaction. You want to ensure that changes to your business structure and any gifts of shares can qualify for a Section 1202 exemption.

If your business is not currently structured as a C-Corp, you may still qualify for future benefits by converting to a C-Corp before issuing stock, provided you meet the eligibility criteria at the time of issuance.

Next steps

Applying Section 1202 to your business transition planning could result in significant tax savings. However, this law applies to very specific small businesses and to certain stock transactions involving them. Working with a CPA is your best bet for determining whether your situation falls in line with the rules and any possible changes.

Have questions about 1202? Ask an Advisor.

Consult with your Comerica relationship manager or connect with us here to discuss how taking advantage of Section 1202 might help optimize your tax strategies.

To receive additional insights on tax mitigation, business ownership or business transition, subscribe now.