Section 1202 QSBS: The $10 Million Exclusion
Section 1202 Qualified Small Business Stock: gains on qualifying stock are 100% excluded from federal capital gains tax (for stock acquired after September 27, 2010). Requirements: (1) C-corporation (S-corps, LLCs, partnerships do NOT qualify); (2) Domestic company; (3) Active business in a qualifying industry — excludes professional services (law, medicine, finance, consulting), hotels, restaurants, banking, insurance; (4) Company had gross assets of $50 million or less at the time of stock issuance (not when you sell); (5) Original issuance to the investor (not secondary market purchase); (6) Held for more than 5 years. Exclusion limit: greater of $10 million or 10x the taxpayer's adjusted basis in the stock. California does NOT conform to the federal QSBS exclusion — state taxes apply.
QSBS Stacking and Multiplication Strategies
The $10M QSBS exclusion applies per taxpayer per issuing corporation. Stacking strategies: (1) Spousal stacking — each spouse can separately hold QSBS for $20M combined exclusion from the same company; (2) Trust stacking — gifting QSBS to irrevocable trusts (each trust is a separate taxpayer); (3) Partnership pass-through — if a partnership holds QSBS for 5+ years, each partner gets their own $10M exclusion on their share (proportional). Important: QSBS transfers are complex — gifts and bequests of QSBS generally preserve eligibility, but sales of QSBS to a new investor do not transfer the original issuance date. The 5-year clock runs from the date of original issuance to the original holder. Conversions from other entity types to C-corp: new issuance date resets the 5-year clock.
Section 1244: Ordinary Loss Treatment for Failed Investments
Section 1244 allows shareholders of small domestic corporations to treat losses on qualifying stock as ordinary losses rather than capital losses. Ordinary loss limit: $100,000/year for married filing jointly; $50,000 for single filers. Ordinary losses offset ordinary income without the $3,000 capital loss limitation. Requirements: (1) Stock must be in a domestic corporation; (2) At the time the stock was issued, the corporation's equity capital did not exceed $1 million; (3) The corporation must have derived more than 50% of its gross receipts from active business (not passive investment) during the 5 tax years preceding the loss. Investment amounts over the Section 1244 limit generate capital losses (limited to $3,000/year against ordinary income). Strategy: when investing in a startup, ensure the investment qualifies for Section 1244 — if the company fails, you want ordinary loss treatment, not capital loss.
83(b) Election: The 30-Day Window You Cannot Miss
The 83(b) election allows a recipient of restricted property (commonly startup founders' stock or early employee equity subject to vesting) to elect to be taxed on the property at grant date (when value may be near zero) rather than at vesting date (when value may be much higher). Without 83(b): you pay ordinary income tax on the FMV at each vesting date — potentially at high ordinary income rates when the company has grown. With 83(b): you pay tax on grant-date FMV (potentially near $0.001/share for founders); subsequent appreciation is capital gain; 5-year QSBS clock starts at grant, not vesting. Critical: 83(b) must be filed with the IRS within 30 calendar days of the grant/transfer date — no extensions, no exceptions. File by certified mail, keep the return receipt. A copy should also go to the company. Missing this deadline is not fixable and can result in substantial ordinary income at each vesting event.
Carried Interest, SAFEs, and Convertible Notes
SAFEs (Simple Agreements for Future Equity): a SAFE is not stock — it's a right to receive stock in a future financing. Tax treatment: no taxable event at SAFE execution; the clock for QSBS 5-year hold starts when the SAFE converts to equity, not when the SAFE was issued. This can delay QSBS eligibility. Convertible notes: similar — the 5-year QSBS hold begins at note conversion. For angels: investing via SAFEs/convertible notes in seed rounds may push QSBS eligibility later than expected. Carried interest (fund managers): carried interest — the general partner's profits interest in a fund — is taxed at capital gains rates when the underlying investments are sold (subject to the 3-year holding period under the 2017 TCJA changes; gains on assets held less than 3 years by the fund are recharacterized as short-term capital gains or ordinary income for carried interest holders).