26 U.S. Code Section 1202—“Partial Exclusion for Gain from Certain Small Business Stock,” better known as QSBS—offers plenty of upside for small businesses and investors. However, the legislation also contains a great deal of ambiguity, resulting in confusion among qualified small businesses and their investors.
This uncertainty is why the American Institute of Certified Public Accountants (AICPA) has stepped in to express concerns about the lack of administrative guidance or commentary since Section 1202’s enactment in 1993. In a December 3, 2024 letter to the U.S. Department of the Treasury and Internal Revenue Service (IRS), AICPA offered suggestions to “provide taxpayers with needed clarity on how this benefit applies and whether they are eligible to take advantage of it,” said Ning Yim, senior manager, AICPA Tax Policy & Advocacy, in a recent AICPA-CIMA website posting.
QSBS Clarifications, as Recommended by AICPA
The AICPA has identified the following areas of ambiguity within QSBS:
Timing of the $50M Gross Asset Limitation Is Confusing
Currently, to qualify as a “small business” for QSBS purposes, a company must have had aggregate gross assets of no more than $50 million at the time the stock is issued. The AICPA points out that confusion arises around the timing and interpretation of this threshold—especially when businesses receive multiple rounds of funding or go through reorganizations.
The AICPA recommends using existing definitions in the tax code to simplify compliance, defining a “predecessor corporation” as one that transfers most of its assets under the following IRC sections:
- Section 118—“Contributions to the Capital of a Corporation”
- Section 351—“Transfer to Corporation Controlled by Transferor”
- Section 381—“Carryovers in Certain Corporate Acquisitions”
By creating explicit safe harbors for scenarios like stock conversions, reorganizations, and funding rounds, the IRS could alleviate much of the guesswork. Investors and companies would know exactly where they stand and wouldn’t have to worry about inadvertently disqualifying their QSBS.
“Active Business” Requirements Are Subjective
For Section 1202 benefits to apply, a company must be actively engaged in a qualified trade or business. Yet, terms like “active” and “qualified trade or business” remain somewhat subjective. To remove ambiguity, the organization recommended the following changes:
- Use Section 1.199A-5—“Specified Service Trades or Businesses”—as a framework for defining a qualified business.
- Implement a safe harbor provision to help taxpayers determine whether their business qualifies.
- Allow corporate partners to include business activities of their partnerships, rather than treating partnership interests as passive assets.
Corporate Transactions Lack Clear Rules
Mergers, acquisitions, and restructurings often muddy the waters of QSBS eligibility. Transferring stock, converting organizational structures (e.g., from LLC to C-corp), or merging with another entity can all trigger questions about whether the stock still qualifies. The AICPA’s letter urges the IRS and Treasury to establish uniform guidelines, reducing the need for investors to seek private letter rulings or engage in lengthy tax disputes.
When a qualifying small business goes through a merger or a substantial acquisition, the fear is that investors could lose their QSBS benefits. The AICPA recommends creating pathways that allow these transactions to proceed without jeopardizing Section 1202 exclusions, provided the business still meets foundational requirements.
Noting that Section 1203(h)(3) preserves QSBS’s qualified status after corporate recapitalizations or reorganizations (allowing investors to claim tax benefits), the AICPA recommended these transactions not be subject to Section 1202(h)(4)(B), which limits the tax exclusion to the gain amount at the time of exchange if the reorganization fails to meet eligibility requirements.
Finally, the AICPA urged Treasury and the IRS to ensure that stock received in a Section 355 tax-free corporate spinoff remains QSBS, allowing investors to retain its tax benefits.
The Potential Benefits of the AICPA Recommendations
Stronger administrative guidance on QSBS could help in several ways:
- Boosting Investor Confidence: Clarity in tax regulations, especially around something as advantageous as QSBS, can be a powerful motivator for venture capitalists, angel investors, and other early-stage backers. With fewer unknowns, investors can confidently allocate capital, knowing they’re positioned to benefit from potential QSBS tax exclusions in the future.
- Unlocking Funding for Startups: When businesses can demonstrate they fall squarely under QSBS eligibility—and can remain there—raising money gets easier. If investors know their gains are likely to be tax-exempt, they’re often more willing to fund ventures, even those at higher risk.
- Streamlining Legal and Accounting Processes: Ambiguities often lead to extra paperwork, time-consuming legal opinions, and potential pitfalls. Clear guidance from the IRS and Treasury would reduce the burden on CFOs, tax directors, and founders who must navigate complex rules or risk penalties and disputes.
The IRS has been working on new regulatory guidance around QSBS, and we will continue to track new guidance as it develops. If you have questions about QSBS in your portfolio or need assistance on understanding its tax benefits, our expert team at CapGains is here to assist. Contact us today for more information and a free portfolio analysis.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.
