The proposed Senate version of H.R. 1, the House-passed One Big, Beautiful Bill Act (OBBBA) would expand the Qualified Small Business Stock (QSBS) exclusion provided by IRC Section 1202. Notably, the House-passed version of H.R. 1 did not include an IRC Section 1202 provision.

Current law

IRC Section 1202 excludes gain from the sale of QSBS that is held for more than five years. The exclusion is 100% for stock acquired after September 27, 2010, and either 50% or 75% for stock acquired in earlier periods.

The gain excluded under IRC Section 1202 is not treated as a preference item for purposes of the alternative minimum tax (AMT) under IRC Section 57(a)(7) for post-2010 acquisitions. The exclusion is subject to a per-issuer cap, which is generally the greater of $10 million or 10 times a taxpayer's basis in the subject stock. The exclusion does not apply if a corporation's aggregate gross assets exceed $50 million at any time from the corporation's date of formation through the moment immediately after the stock is originally issued to the taxpayer.

Proposal

The Senate proposal would provide for a tiered gain exclusion for QSBS; 50% for QSBS held for at least three years, 75% for QSBS held for at least four years, and 100% for QSBS held for at least five years. This change would only apply to stock originally issued after the date of the OBBBA's enactment. The gain excluded under the three- and four-year rules would not be treated as a preference item for purposes of the alternative minimum tax (AMT) under IRC Section 57(a)(7) if the stock were to be acquired after September 27, 2010.

The per-issuer cumulative exclusion limitation would increase from $10 million to $15 million, subject to an annual inflation-adjustment increase. Taxpayers fully utilizing the inflation-adjusted per-issuer limitation in any tax year would no longer be eligible for additional inflation adjustments. The Senate proposal would also make conforming amendments to ensure married-filing-separately taxpayers could benefit from the inflation-adjusted per-issuer limitation.

Finally, the Senate proposal would increase the "aggregate gross asset" calculation under IRC Section 1202(d) to $75 million from $50 million, which would also be subject to an annual inflation adjustment.

Effective dates

Amendments made by the proposed legislation would generally be effective for stock issued or acquired, and to tax years beginning on or after, the date of enactment unless otherwise stated above.

Implications

The proposed legislation affecting IRC Section 1202 would represent a significant expansion of the QSBS incentive and make much needed changes as it relates to the incentives' original purpose of encouraging Americans to make high-risk, long-term, growth-oriented investments.¹

On this point, high-risk but successful investments would benefit greatly from the proposed Senate changes. First, increasing the per-issuer limitation to $15 million from $10 million would increase the cash-tax benefit of the 100% exclusion to $3.57 million (compared to the current law benefit of $2.38 million).² For investments made after the date of enactment, where the AMT preference does not apply, the 50% exclusion under the new three-year holding period and the 75% exclusion under the four-year holding period would result in cash-tax benefits of as much as $1.19 million and $2.38 million, respectively.³ Note, however, that these figures represent just the floor of the cash-tax benefit, given that the per-issuer limitation will be inflation-adjusted over time. As proposed, investments made in otherwise eligible QSBS before the OBBBA's enactment would still only benefit from the current per-issuer limitation of $10 million under IRC Section 1202(b)(1)(A) (even if sold after the OBBBA's enactment).

Second, increasing the computation of "aggregate gross assets" to $75 million (subject to future inflation-adjustments) provides a much needed update to the $50 million threshold, which has remained the same since the statutes' original enactment in 1993.⁴ The increased dollar figure coupled with (1) proposed full expensing for business property⁵ and (2) proposed full expensing of domestic research and experimental expenditures⁶ would likely interact favorably for many start-ups. Those start-ups would likely satisfy the "qualified small business" requirement for a longer period compared to current law because the accelerated deductions described previously will act to lower their "aggregate gross asset" computation.⁷

The proposed changes to IRC Section 1202 under the Senate version of the OBBBA represent a welcome set of changes that would foster the sort of intentioned tax policy towards American innovation originally envisioned upon the statutes' original enactment.