The IRC 1202 Capital Gains Exclusion – Almost too Good to be True

By Kenneth H. Bridges, CPA, PFS May 2026

Generally, when something sounds too good to be true, that’s because, in fact, it is not true. An exception to that general rule is the IRC 1202 capital gains exclusion.

IRC 1202 was first enacted in 1993. However, as first enacted, it was of fairly limited benefit, due in large part to an alternative minimum tax adjustment that tended to claw back much of the otherwise tax savings. Over the years since then, legislation has been enacted which has steadily increased the potential benefit.

Legislation enacted in 2010 provides that for C-corp stock in a qualifying business received after September 27, 2010 and held for at least 5 years, the selling shareholders can enjoy a 100% capital gains exclusion on up to the greater of $10,000,000 (per shareholder limit at individual shareholder level with spouses treated as a single shareholder) or 10 times the amount invested in the stock.  Legislation enacted in 2025 increased (for stock acquired after July 4, 2025) the potential gain exclusion to $15,000,000 and provides for a new partial gain exclusion for qualifying shares held for less than 5 years (50% exclusion for stock held at least 3 years and 75% for stock held at least 4 years). 

In order for the C-corp stock to qualify, the corporation must be conducting an active business and cannot be in a disqualified industry (performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services, or in banking, insurance, financing, leasing, investing, farming, natural resources, hotels and restaurants).  Also, the company must not have had (at the time of issuance of the stock and essentially at all times before that) assets in excess of $50,000,000 ($75,000,000 for stock acquired after July 4, 2025), and the company must be a domestic (i.e. U.S., not foreign) corporation.

For C-corp stock acquired between August 10, 1993 and September 26, 2010, a 50% or 75% exclusion may apply, in lieu of the 100% exclusion.

A partnership can convert to C-corp status in order to become eligible for the IRC 1202 exclusion, but the holding period for the required 3, 4 or 5 year period begins on the date of conversion, any pre-conversion appreciation in value is not eligible for the exclusion, and the value of the business on the date of conversion must not exceed $75,000,000 (or $50,000,000 for conversions occurring before July 5, 2025). On the plus side, however, the 10x limit is also based on value as of the date of conversion.

It should be noted that one downside of converting to C-corp status is that any gain not covered by the exclusion is subject not only to income tax, but also the 3.8% Medicare tax on net investment income (which does not apply to gain on the sale of a flowthrough entity by an active participant in the business).  Accordingly, if the gain is high enough, the 3.8% Medicare tax can actually exceed the income tax savings of the IRC 1202 exclusion.

As a general rule, a partnership can convert to C-corp status tax-free. However,  there are important exceptions. Under IRC 357(c), if the company has liabilities in excess of basis, then a taxable gain is recognized to the extent of the excess.  Also, under IRC 465(e), previously deducted losses may have to be recaptured if the partner/shareholder’s “amount at risk” drops as a result of the conversion. Further, pursuant to Treasury Regulation 1.451-8(c)(4), a partnership with a deferred revenue liability may be required to accelerate the recognition of the deferred income upon conversion to C-corp status.

Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP, an Atlanta-based CPA firm.

This article is presented for educational and informational purposes only, and is not intended to constitute legal advice.  The article provides only a very general summary of complex rules.  For advice on how these rules may apply to your specific situation, contact your legal counsel.