How the OBBBA’s changes to section 1202 represent opportunity for private equity

Executive summary: Changes to section 1202 will enhance the attractiveness of investments in qualified small business stock corporations

The bill commonly known as the One Big Beautiful Bill Act (OBBBA) significantly enhances the attractiveness of qualified small business stock (QSBS) by introducing pivotal changes to section 1202 of the Internal Revenue Code. Key modifications include reduced holding periods for partial tax exclusions and an increased target size threshold for qualifying businesses.

These changes present a substantial opportunity for private equity (PE) firms by making investments in small businesses more appealing and potentially more lucrative. The ability to realize tax benefits sooner and the inclusion of larger startups under the QSBS umbrella are poised to increase interest and capital flow from PE into the small business sector, as well as the need to reassess entity choice decisions (C corporations versus pass-through entities).

Summary of changes to the QSBS exclusion under section 1202

The OBBBA expands the scope and benefits of section 1202, which is designed to incentivize investment in startups and small businesses. The provision allows noncorporate taxpayers to potentially exclude from federal tax up to 100% of capital gains from the sale of qualified small business stock if certain requirements are met.

The OBBBA makes the following three key modifications to section 1202:

Shorter holding periods

The OBBBA reduces the holding periods required to benefit from QSBS exclusions. Now, investors can enjoy a 50% exclusion for stock held for at least three years, 75% exclusion for stock held for at least four years, and 100% exclusion for stock held for at least five years. This makes QSBS more attractive by allowing investors to realize tax benefits sooner.

With the OBBBA’s new 50% or 75% exclusion, the includible gain on sale of QSBS with a three- or four-year (but less than five-year) holding period is subject to a 28% capital gains rate, which is higher than the standard capital gains rate of 15% or 20% on the sale of nonqualifying stock.

For QSBS subject to the 50% exclusion, this would result in a 14% (or 7%) rate on such gain. (Of the gain on the sale of QSBS held for more than three years but less than four, 50% is excluded while 50% will be subject to the 28% capital gains rate, resulting in a blended effective rate of 14%.) In addition, the gain not excluded may also be subject to the net investment tax.

Increased exclusion cap

The OBBBA raises the cap on the amount of gain that a taxpayer may exclude from taxation. Prior to the change, that cap was generally the greater of either $10 million or 10 times the basis of the stock sold. Under the OBBBA, the $10 million component of the cap is increased to $15 million. Calculating the excludable gain is similar under increased cap.

This higher exclusion cap allows investors to shield more of their gains from taxes, making investments in qualified small businesses even more appealing.

Higher asset threshold

The asset threshold for a company to qualify as a small business under section 1202 (in other words, the amount of assets a company may hold and still qualify to issue QSBS) has been increased from $50 million to $75 million. This change allows larger startups to qualify for QSBS benefits, broadening the range of companies that can attract investment under these favorable tax conditions.

Impact on private equity and small business

Changes to section 1202 in the OBBBA are likely to significantly affect PE, particularly in terms of increasing interest in small businesses. Here’s how:

Look-through rule

Retention of the look-through rule to the ultimate investor makes the section 1202 exclusion a powerful tax advantage for the fund and investors. Under this rule, an investor can hold their QSBS through multiple layers of pass-through entities and enjoy the section 1202 capital gain exclusion.

Enhanced investment appeal

With the reduced holding periods and increased exclusion caps, PE firms can realize substantial tax benefits more quickly. This makes investments in small businesses more attractive, as the potential for higher after-tax returns increases. Note, also, that the three-year holding period for the 50% exclusion coincides with the three-year holding period for carried-interest.

Broader investment opportunities

The higher asset threshold means that a larger number of small businesses can qualify for QSBS benefits. This expansion allows PE firms to consider a wider range of investment opportunities, including slightly larger startups that were previously ineligible.

Increased capital flow

More PE capital is likely to flow into small businesses. This influx of investment can drive growth and innovation within the small business sector, benefitting investors, entrepreneurs, and the economy as a whole.

Competitive advantage

Firms that are adept at identifying and investing in QSBS-eligible businesses may gain a competitive edge. By leveraging the tax advantages of QSBS, these firms can offer more attractive terms to potential portfolio companies and differentiate themselves in the market.