Section 1202 Qualified Small Business Stock Considerations for Manufacturing and Distribution Companies

Manufacturing and distribution companies frequently require significant equity capital to support growth, capacity expansion, and supply-chain investment. From a federal income tax perspective, equity structuring decisions made early in a company’s lifecycle can materially affect the after-tax outcome for founders and investors upon a liquidity event. Section 1202 of the Internal Revenue Code provides a statutory capital-gain exclusion for eligible dispositions of Qualified Small Business Stock (“QSBS”), subject to strict issuance, holding period, and operational requirements.

When properly satisfied and documented, Section 1202 may allow noncorporate shareholders to exclude a portion—or, for certain issuances, all—of the eligible gain realized on a sale of QSBS. Recent legislative developments have expanded certain thresholds relevant to manufacturing and distribution businesses, increasing the planning relevance of Section 1202 for companies in these sectors.

Overview of Section 1202 and QSBS Treatment

Section 1202 was enacted to incentivize long-term investment in domestic operating C corporations by providing an exclusion from gross income for gain realized on the sale or exchange of QSBS held for more than five years. To qualify:

• The issuing corporation must be a domestic C corporation at the time of issuance and during substantially all of the shareholder’s holding period.
• Stock must be acquired at original issuance in exchange for money, property (other than stock), or services.
• The issuing corporation must satisfy the aggregate gross assets test (measured immediately before and after issuance).
• The corporation must conduct a qualified active trade or business during substantially all of the holding period.

For QSBS issued after September 27, 2010, up to 100% of the eligible gain may be excluded from federal income tax, subject to the per-issuer limitation equal to the greater of (i) $10 million (as adjusted for certain issuances) or (ii) 10× the taxpayer’s adjusted basis in the disposed shares.

Holding-Period Mechanics and Partial Exclusions

The Section 1202 exclusion is conditioned on a minimum five-year holding period. Earlier dispositions do not qualify for the exclusion absent the application of rollover provisions under Section 1045.

Historically, the exclusion percentage depended on the stock’s issuance date:

• 50% exclusion – QSBS issued before February 18, 2009
• 75% exclusion – QSBS issued between February 18, 2009, and September 27, 2010
• 100% exclusion – QSBS issued after September 27, 2010

For manufacturing and distribution shareholders contemplating liquidity events, precise identification of issuance dates, holding period tacking events, and prior exchanges is critical. While certain tax-deferred reorganizations may preserve QSBS status, these outcomes depend on detailed compliance with Sections 351, 368, and related guidance and should not be assumed without transaction-specific analysis.

Qualified Trade or Business Analysis for Manufacturing and Distribution Companies

Manufacturing and distribution activities are generally treated as qualified active trades or businesses for Section 1202 purposes and are not among the statutorily excluded service-based categories (e.g., health, law, consulting, financial services).

To satisfy the active business requirement:

• At least 80% (by value) of the corporation’s assets must be used in the active conduct of a qualified trade or business.
• Working capital may qualify if it is held for reasonably anticipated business needs or deployed in qualifying research or operational expansion.
• Asset usage must be evaluated on a continuous basis throughout substantially all of the shareholder’s holding period.

Recent legislation increased the aggregate gross assets threshold to $75 million for stock issued after July 4, 2025, expanding the population of manufacturing and distribution companies that may qualify at issuance. This test must be satisfied immediately before and immediately after each stock issuance.

Federal Legislative Developments and State-Tax Considerations

Federal legislative changes — including those enacted under the One Big Beautiful Bill Act — have modified certain parameters relevant to Section 1202, including asset thresholds and exclusion mechanics. These changes increase the importance of contemporaneous documentation and forward-looking tax modeling.

State-level conformity remains inconsistent. While many states follow the federal QSBS exclusion in whole or in part, others disallow it entirely or impose alternative limitations. Manufacturing and distribution companies operating across multiple jurisdictions must analyze state-specific conformity rules when estimating the net tax benefit of a potential QSBS-eligible exit.

Risk Management and Substantiation Considerations

Section 1202 qualification is highly factual and subject to ongoing compliance requirements. In 2025, the IRS placed QSBS issues on its “no-rule” list, preventing taxpayers from obtaining Private Letter Rulings on qualification questions.

As a result, taxpayers must rely on:

• Contemporaneous capitalization and asset-valuation records
• Detailed documentation of original issuance and consideration
• Ongoing monitoring of asset composition and business activities

Failure to satisfy any requirement during the holding period may taint QSBS eligibility, either in whole or in part.

Planning Considerations for Manufacturing and Distribution Leadership

Manufacturing and distribution companies evaluating Section 1202 should:

1. Confirm that current and projected operations constitute a qualified trade or business.
2. Review entity structure to determine whether C corporation status is appropriate.
3. Analyze capitalization history to identify QSBS-eligible shares.
4. Evaluate equity compensation structures to preserve QSBS treatment for founders and key employees.
5. Maintain a centralized QSBS substantiation file to support eligibility upon exit.

Advanced techniques, including trust planning, multiple-issuer strategies, and divisional separations, require careful coordination with tax and legal advisors experienced in Section 1202 planning.

How Citrin Cooperman Can Assist

Section 1202 presents a statutory opportunity for qualifying manufacturing and distribution companies to improve after-tax exit outcomes for founders and investors. Given the complexity of the rules and the absence of ruling relief, early-stage planning, continuous compliance, and transaction-specific analysis are essential.

For further discussion, please contact Nichol Chiarella, Patrick Manning, or a member of Citrin Cooperman’s Mergers and Acquisitions Tax Practice.