Legal & Compliance
Last updated
Quick Answer
The IRS code section that provides the legal basis for excluding capital gains on qualified small business stock, enabling tax-free returns for eligible venture investors.
Section 1202 of the Internal Revenue Code is the statutory foundation for the Qualified Small Business Stock (QSBS) exclusion. It specifies the requirements a company and its shareholders must meet to qualify for capital gains exclusion upon sale of stock. Key requirements include: the issuing company must be a domestic C-corporation, its aggregate gross assets must not exceed $50 million at the time of stock issuance, the stock must be acquired at original issuance, and at least 80% of the company's assets must be used in an active trade or business. The section has been amended multiple times, with the most favorable 100% exclusion applying to stock acquired after September 27, 2010.
In Practice
A VC fund invests $2 million in a Series A round of a SaaS startup organized as a C-corp with $15 million in gross assets. The fund's tax counsel confirms the investment qualifies under Section 1202. When the startup exits five years later at a 20x return, the fund's $40 million gain is eligible for the full 100% exclusion, dramatically improving the fund's net returns to LPs.
Why It Matters
Section 1202 is the reason most venture-backed startups are structured as C-corporations rather than LLCs. Understanding this section helps founders make the right entity choice from day one, and helps investors structure their holdings to maximize after-tax returns.
VC Beast Take
Section 1202 is venture capital's best-kept secret that's hiding in plain sight. Most founders obsess over valuation negotiations while completely ignoring QSBS qualification, which can be worth millions more than squeezing out an extra percentage point of equity. The irony is that many high-growth startups inadvertently disqualify themselves by raising too much capital or pivoting business models. Smart investors now audit QSBS compliance as part of due diligence—it's that material to returns.
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Section 1202 of the Internal Revenue Code is the statutory foundation for the Qualified Small Business Stock (QSBS) exclusion. It specifies the requirements a company and its shareholders must meet to qualify for capital gains exclusion upon sale of stock.
Understanding Section 1202 is critical for founders navigating the fundraising process. It directly impacts deal terms, valuation, and the relationship between founders and investors.
Section 1202 falls under the legal category in venture capital. This area covers concepts related to the legal frameworks and compliance requirements in venture capital.
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