Turning a Missed Opportunity into Tax Savings: QSBS to the Rescue!
By Cody Heimerdinger
When an IRS Exam Turns Into an Opportunity
A taxpayer sells stock in a privately held C-corporation in 2021, recognizing a $1,000,000 long-term capital gain. The return is filed showing the gain as fully taxable.
In the same year, the taxpayer makes a non-cash charitable contribution of $1,000,000, claiming a deduction under IRC §170.
Fast Forward
Now, several years later, the IRS is examining that charitable contribution. If the contribution is disallowed, the taxpayer faces a 32% ordinary income adjustment, but their advisor identifies a critical opportunity: the stock sold in 2021 may qualify as Qualified Small Business Stock (QSBS) under IRC §1202, which allows up to 100% exclusion of gain if certain conditions are met.
The Numbers at a Glance
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Applying §1202 would eliminate $238,000 of capital gains tax exposure, and if the charitable deduction is disallowed, the QSBS exclusion could neutralize the IRS adjustment by converting a fully taxable gain into a tax-free event.
Why §1202 Matters
Section 1202 was designed to encourage investment in small businesses by offering a complete exclusion of capital gain on qualified C-corporation stock held for more than five years.
To qualify, the following must be true:
- The company is a domestic C-corporation.
- Its gross assets did not exceed $50 million when the stock was issued.
- At least 80% of its assets were used in an active qualified trade or business (not professional services or finance).
- The taxpayer acquired the stock at original issuance (not by purchase from another shareholder).
- The stock was held for more than five years before sale.
- The corporation did not redeem shares two years before or after issuance.
If those tests are met, up to $10 million of gain per taxpayer, per corporation (or 10× basis whichever is greater) can be excluded from federal tax.
Procedural Timing: When the Year Is Under Audit
When a taxpayer realizes the stock might qualify for QSBS after filing, there’s still a path forward, as long as the statute of limitations remains open (typically three years from the filing date).
If the tax year is under examination:
- Changes are submitted through the Revenue Agent, not directly to the IRS Service Center.
- The taxpayer can request the change asserting the §1202 position while the audit is pending. This preserves the right to claim the exclusion without interfering with the ongoing exam.
This dual-track strategy allows the taxpayer to maintain the original charitable deduction defense and preserve the ability to exclude the gain if the IRS disallows the charitable deduction.
A Win-Win Framework
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The Takeaway
A properly documented §1202 claim can turn a potential tax increase into a tax-free outcome.
Even when a prior return is under examination, careful coordination and timely filing of a protective §1202 claim can secure powerful benefits.
At current rates:
- Capital gain exclusion: 23.8% savings = $238,000.
- Ordinary tax from disallowance: 32% exposure = $320,000.
That’s more than half a million dollars in potential tax difference, all depending on planning, timing, and qualification. When the IRS reopens your past, it may also open a door to better tax treatment. Under §1202, what once seemed like a tax problem can become a tax-free opportunity.