Section 1202 allows certain shareholders of C corporations to exclude up to 100% of the taxable gain recognized on the sale of their qualified small business stock (QSBS). Because this can play an important role in reducing the impact of taxes on the sale of a contracting business, contractors should plan in advance to ensure that they can qualify. Any contractor considering an exit from their business in the next five to 10 years should begin planning today. This is particularly true for contractors structured as flow-through entities (such as partnerships and subchapter S corporations) because time is needed both to restructure into a C corporation as well as to hold the stock long enough to qualify as QSBS.
Why is Section 1202 so powerful?
When a shareholder sells QSBS, they are permitted to exclude up to 100% of the gain on the sale of that stock. The maximum exclusion is the greater of (1) $15 million ($10 million for stock issued before July 5, 2026) and (2) 10 times the investment in the stock. In the right circumstances, this can result in a completely tax-free exit from a qualifying business.
While QSBS has often been associated just with technology companies or other extremely high-growth businesses, that’s no longer the case and the opportunity is quickly gaining steam across other industries. Given the current market conditions with the sale of contracting businesses, QSBS is quickly catching on in that industry, and qualifying as QSBS can be one of the most lucrative ways to increase the after-tax cashflow from the sale of a contracting business.
What contractors are a good fit for a Section 1202 qualified small business stock exclusion?
Really any contractor has the potential to be a good fit. However, one whose owners are looking to exit the business in the next five to 10 years or who otherwise don’t have a clear succession plan in place can be particularly good candidates to look at QSBS much more closely. For a business already structured as a C corporation, the necessary planning can happen much more quickly, although these businesses still have a number of items to focus on, as discussed below. Nevertheless, even a contractor structured as a flow-through entity can still take advantage of this tax-saving exit strategy, but some additional considerations come into play.
What can prevent a contractor from qualifying for the Section 1202 QSBS exclusion?
Given the massive tax savings at play, there are a number of considerations that contractors must keep in mind to ensure they qualify for the exclusion and maximize their opportunity.
- Stock must be originally issued after Aug. 11, 1993. Stock issued at different times qualify for differing levels of exclusion, but it must be issued by the corporation to the shareholder after Aug. 11, 1993, to qualify for any exclusion at all. If stock was issued prior to this date or acquired from another shareholder, it will never qualify as QSBS. However, it’s possible for a shareholder to have received their stock as an inheritance or gift and still qualify as QSBS, as long as it was QSBS in the hands of the transferor (i.e., it was originally issued to the transferor after Aug. 11, 1993). Therefore, even a second-generation family-owned contractor may still have QSBS. Even a very old contracting business could have some QSBS if some stock was directly issued by the company to the shareholder after Aug. 11, 1993, even though earlier generations received their stock prior to that date.
- Restrictions on nonqualified activities. Section 1202 imposes restrictions and limitations on the types of businesses that can qualify. In effect, a business qualifies as long as it’s not specifically enumerated as disqualified. While “construction” is not listed among the disqualified businesses, some contractors might perform activities in some of the disqualified businesses, including engineering, architecture, consulting, and ownership, dealing in, and rental of real estate property. In other areas of tax law, it has been concluded that performing these types of activities aren’t disqualified as long as they’re merely a component of a broader service and aren’t offered as a separate service. For example, a manufacturing company engineers the products that it sells but is often viewed as a phase of the manufacturing process and not the provision of engineering services to customers.
- In the context of a contractor, the line may not always be quite so clear. If a contractor is simply following the architectural and engineering plans developed by others, that likely does not cross into the disqualified service. However, if the contractor is both designing the object of the construction and then performing the construction, those potentially disqualifying services may not be as easy to distinguish as in the manufacturing example. This is a facts-and-circumstances analysis that can differ from contract to contract. Since this test is applied over substantially all of the holding period of a shareholder’s stock, it often requires an extended lookback period to understand not just how the company operates today but also how it operated in the past.
- Skill or reputation of the owner. Another disqualifying activity is a business where the principal asset is the skill or reputation of one or more owner or employee. This can be particularly important to contractors since many business owners are the ones providing services and clients may be paying a premium to have a particular craftsman perform a specialized task. However, case law has distinguished between a business where a talented owner has been able to train its workforce to perform quality work from one where the owner is the only one capable of providing the service. For example, a carpentry contractor that employs dozens of carpenters who can show up on a site and do the basic woodwork necessary to meet job requirements is unlikely to run afoul of the “skill or reputation” restriction. However, a specialized boutique carpentry and woodworking business that is owned by a person recognized as an artisan master carpenter who is closely involved with every custom installation might have a harder time with this restriction.
- 80% asset test. Even if a business has some disqualifying activities in the fields noted above, all is not lost. As long as at least 80% of the fair market value of its assets is used in qualified businesses, then the business may still qualify in its entirety. Many of the potentially disqualifying activities (e.g., engineering and architectural services) often are not asset intensive, while core construction services often have more significant asset requirements, so having some of these disqualifying activities may not be fatal. However, since this is a fair market value test, intangible value associated with these activities must also be considered.
- Investment assets and excess working capital. In evaluating the 80% test, it’s important to distinguish between business and nonbusiness assets. A business that holds investment assets or intercompany/shareholder receivables is likely holding nonbusiness assets that count against the 80% test. Certain short-term investments, such as stocks, securities, or unrelated real estate property, have even more restrictive thresholds.
- Even if excess cash isn’t invested in these ways, QSBS headwinds can exist simply by having excess cash. However, even if excess cash isn’t invested, it can still create headwinds because a business can’t have more than 50% of the value of its assets made up of working capital held to support reasonable needs of the business or to support research. Since contractors often have significant working capital (e.g., accounts receivable, costs in excess of billings, etc.), a contractor can easily exceed the 50% limit if there isn’t enough value in nonworking capital assets. Contractors that have made a practice of keeping significant cash assets at the ready in order to move quickly on certain opportunities, or to protect against market fluctuations, must monitor this requirement closely.
- Asset level test. In order for stock issued by a corporation to start off on a path to a QSBS exclusion, the corporation must not have more than $75 million of tax basis assets at any time between Aug. 11, 1993, and the moment immediately after the issuance of the stock ($50 million for stock issued prior to July 5, 2025). This provision can provide a challenge for contractors with slow paying customers where accounts receivable accumulate over time or where significant amounts of high-value construction equipment are necessary, like asphalt or concrete contractors. However, since this test is measured on a tax basis, the generous bonus depreciation rules that have applied for many years help to keep this number lower, as long as the contractor takes advantage of those provisions.
Restructuring a general contractor passthrough to qualify for Section 1202 QSBS exclusion
Many contractors operate as pass-through entities, and the decision to structure the business in that manner was probably the right answer when it was made. But if the current owners are contemplating an exit at some point in the future, or they just otherwise haven’t thought about what it would mean to be a C corporation in a while, entertaining a conversion to a C corporation can make a lot of sense. This is particularly true if a potential exit is at least three years away and there’s an expected increase in company value between the time of the C corporation conversion and the planned exit. This is often a decision that must balance many tax and nontax factors, but if the potential for QSBS exclusion is also on the table, that can have a significant influence on the decision.
When converting a pass-through entity to a C corporation, any built-in gain inherent in the business at the time of conversion won’t qualify for a QSBS exclusion later on. However, the conversion has a multiplying effect on the total exclusion down the road because the 10 times maximum exclusion is based on the fair market value of the shareholder’s stock at the time of conversion. This has the potential to significantly increase the amount of future gain that the shareholder group can exclude, which also puts a particular emphasis on the valuation performed at this event.
Once the owners agree to convert a flow-through into a C corporation in order to qualify for the QSBS exclusion, they must decide on how and when to execute the conversion. For those focused on a date when they want to leave the business, the calculation may be as simple as executing the conversion as quickly as possible in order to get started on the three-year holding period.
A conversion to a C corporation can be accomplished in a variety of manners that typically have minimal impact on the day-to-day operations of the business. However, the exact process of conversion is critical because some conversion mechanisms — such as the revocation of an S election — will not cause the business to qualify. Also, while the conversion can often be accomplished in a tax-free manner, there may be unique circumstances in some businesses that can cause some amount of tax on conversion. Care should be taken to ensure that the business evaluates all tax and nontax considerations before executing on this type of plan.
Key takeaways
- Section 1202 can enable a fully or largely tax-free business exit. By allowing up to 100% exclusion of qualified gains, it can potentially save owners millions.
- Early planning is critical. Contractors should begin preparing 5–10 years before an exit to meet entity structure and holding period requirements.
- Eligibility is broader than many realize. It extends beyond tech to contractors, though qualification depends on meeting specific operational and asset tests.
- Certain activities and asset levels can disqualify or limit benefits. This makes it essential to evaluate business operations, ownership structure, and balance sheet composition.
- Restructuring to a C corporation can unlock significant benefits. But keep in mind timing, valuation, and execution details materially impact the ultimate exclusion.
