Choice of Entity, employee stock options and the small business stock capital gain exclusion
August 25, 2025
© 2025 by Michael C. Gray
Entrepreneurs creating new businesses have had an important benefit enhanced by the One Big Beautiful Bill Act of 2025 (OBBA, H.R. 1, P.L. 119-21) – the Section 1202 Small Business Stock capital gain exclusion. There are many tax planning considerations, including the choice of form of entity for the business, and employee stock option considerations.
Qualified Small Business Stock gain exclusion.
Before the adoption of OBBBA, noncorporate taxpayers could exclude from taxable income capital gains from the sale or exchange of qualified small business stock held for more than five years.
Before the change, the exclusion was (still applies for qualified stock acquired before July 5, 2025):
- 100% of the gain for qualified stock acquired after September 27, 2010;
- 75% of the gain for qualified stock acquired after February 17, 2009 and before September 28, 2010; and
- 50% of the gain for qualified stock acquired before February 18, 2009 (increased to 60% of the gain attributable to periods before 2019 if the stock was issued by a corporation in an empowerment zone and acquired after December 21, 2000.)
For stock acquired before September 28, 2010, 7% of the excluded gain is a tax preference item for alternative minimum tax reporting.
Excludable gain on dispositions of qualified stock from any single issuer for a tax year is limited to the greater of (1) $10 million, reduced by the aggregate amount excluded for the issuer’s stock in prior years ($5 million for married, filing separately); or (2) 10 times the taxpayer’s adjusted basis in all of the issuer’s stock disposed of during the tax years.
Gains on dispositions of qualified stock held by a pass-through entity for more than five years is passed through to partners, shareholders and participants who held interests in the entity when it acquired the stock and at all times thereafter. The exclusion can’t reflect any increase in the person’s share of the entity after the entity acquired the stock.
In addition to the exclusion, taxable gains from sales of qualified stock may be deferred under Internal Revenue Codes Section 1045 by reinvesting the sale proceeds in stock of another qualified small business within 60 days after the sale.
Qualified small business stock is stock issued after August 10, 1993, and acquired by the taxpayer at the original issue, directly or through an underwriter, in exchange for money or property, or as compensation for services provided to the corporation. The issuing corporation must be a domestic C corporation other than a regulated investment company, cooperative, or other pass-through corporation.
Both before and immediately after the qualified stock is issued, the corporation’s aggregate gross assets must not exceed $50 million, with parent-subsidiary controlled groups treated as one corporation. During substantially all of the taxpayer’s holding period, at least 80% of the value of the corporation’s assets must be used in the active conduct of qualified trades or businesses.
A qualified business does not include the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business if its principal asset is the reputation or skill of employees. Hospitality, farming, insurance, finance and mineral extraction also are not qualified businesses.
Note that retail, manufacturing, and research to develop a product are qualifying businesses.
How OBBA changes the thresholds.
OBBBA changes the gain exclusion by creating tiers, effective for stock issued or acquired and to tax years commencing after July 4, 2025. The exclusion ratios are 50% after three years, 75% after four years, and 100% after five years. The per-issue dollar cap for post-enactment shares is increased from $10 million to $15 million reduced by the aggregate amount excluded for the issuer’s stock in prior years ($7.5 million for married persons filing separately), indexed for inflation after 2026. The post-enactment aggregate-asset ceiling is increased from $50 million to $75 million, indexed for inflation after 2026.
There is no alternative minimum tax preference for the excluded gains for these shares.
The higher asset ceiling means the stock of more corporations will qualify for the exclusion.
Shareholders who have capital gains from sales of qualified small business stock will be eligible to exclude more of their gains from taxable income.
The holding period requirement to qualify for a partial exclusion has been relaxed, so more sales of qualified small business stock will qualify for some exclusion from taxable income.
In the past, the thresholds haven’t been indexed for inflation. Under OBBA, the thresholds will be automatically increased for inflation after 2026.
Family tax planning tip.
Giving family members cash to purchase qualified small business stock can increase the exclusion threshold for the family. (Up to $15 million per family member.)
Choice of entity considerations.
Making a decision about what form a business should be requires having a long-term horizon and a crystal ball.
According to a Bureau of Labor Statistics report in 2024, about 20% of startups that opened for business in 2013 failed during the first year. About 39% of startups failed within the first three years. About 50% of startups failed within the first five years. About 65% failed within the first ten years. It seems the odds are against realizing a gain from the sale of startup stock. Only a handful of shareholders do.
For small business stock to qualify for the exclusion, it must be issued by a corporation that qualifies when the stock is issued. The corporation that issues the stock must be a regular “C” corporation (including an LLC that elects to be taxed as a C corporation – most don’t). Stock issued by an “S” (passthrough entity) corporation doesn’t qualify, but stock issued by a former S corporation after terminating its S election and becoming a C corporation can qualify.
Why is this important?
Business startups typically generate losses during their first few years. Losses of a C corporation are “locked” in the business and aren’t deductible for its owners. Losses of passthrough entities are eligible to be deducted on the income tax returns of their owners, subject to limitations like basis limitations, passive activity loss limitations, and at risk limitations.
Owners of general partnerships and sole proprietorships include their shares of “at risk” debt in their investment for the limitation for deducting business losses. (If the business fails, they are liable for the debt.)
Passthrough entities aren’t subject to double taxation, like C corporations. The owners pay income taxes on the entity’s taxable income and add that income to their tax basis (cost for computing taxable gain) for the sale of their ownership interest.
Partnerships and sole proprietorships have an advantage of being able to possibly liquidate by distributing their assets tax-free.
For businesses whose business plans don’t include having a public offering of their shares or selling the business at a multiple asset value for the foreseeable future, these are good reasons to choose passthrough structures, not C corporations.
For businesses that are adequately capitalized and are developing significant intellectual property or significant net income for a high multiple valuation that is expected to be sold soon after five years, or that plan to make a public offering of their shares, C corporations look more attractive.
Employee Stock Options and the Qualified Small Business Stock Capital Gain Exclusion.
The Ninth Circuit Court of Appeals has confirmed the Tax Court in holding employee stock options don’t qualify as stock for the Small Business Stock Capital Gain Exclusion. The court also ruled the holding period of employee stock options before exercising them isn’t included for the 5-year holding period requirement. The shares must be owned to start the clock.[1]
Any ordinary income for stock acquired by exercising an employee stock option isn’t eligible for the Small Business Stock Capital Gain Exclusion.
As explained below, determining when the holding period begins becomes complicated when employee stock options have a vesting schedule and the employer or other option granter permits an early exercise of employee stock options. For nonqualified stock options, the employee may elect under Section 83(b) to treat the early exercise as taxable for regular tax and alternative minimum tax reporting. When that election is made, the holding period starts on the date of exercise. When that election isn’t made, the holding period starts on the later of the vesting date or the date of exercise.
For incentive stock options, the regular tax holding period starts on the date of exercise, regardless of vesting. The Section 83(b) election to treat the early exercise as taxable only applies for the alternative minimum tax and the option is treated as a nonqualified option for alternative minimum tax reporting. (The holding period might start on different dates for regular tax and AMT reporting. Note there is no AMT adjustment relating to most Small Business Stock Capital Gain Exclusions. For stock acquired before September 28, 2010, 7% of the excluded gain is a tax preference item for alternative minimum tax reporting.)
What are vesting and early exercise, and how does the Section 83(b) election work?
Companies that grant employee stock options are rewarding certain behaviors and trying to accomplish their own objectives. The terms of options are flexible and can vary according to an agreement between the employer and the employee.
Most employers include a vesting schedule for the options they offer to create “golden handcuffs” for keeping employees. Until a share of stock is vested, the employee may not sell or transfer it, except to the employer. If the employee separates from service with the company before the stock is vested, the company typically repurchases the shares from the employee for the option price.
There are no vesting requirements dictated in the Internal Revenue Code. A very common vesting schedule is to be fully vested for 20% of the shares when the option is granted. After one year of service is completed, 1/48 of the remaining shares are vested for each additional month of service completed. The shares are 100% vested when five years of service are completed after the option was granted.
Some options may not be exercised until the related shares are vested.
Many companies, especially those preparing for an initial public offering (IPO), permit their employees to exercise their options before the stock is vested. This is called an early exercise privilege.
In an old private letter ruling, the IRS said that, for the purpose of determining whether the holding period requirements for regular tax reporting have been met for incentive stock options, restrictions on the stock received and the related rules of Section 83 are disregarded. If there is a disqualifying disposition, Section 83 will apply, resulting in ordinary income for the excess of the selling price over the option price. The ruling specifically applies to the six months “insider” holding period under Securities and Exchange Act Section 16.[2]
In regulations issued in 2004, the IRS confirmed that the transfer of unvested shares for an early exercise of an ISO starts the clock for the ISO holding period rules.[3]
Under Section 83, a transfer is not effective until the property is vested.[4]
This is important for two reasons. First, when determining if the holding period requirements are met for regular tax reporting, Section 83 is disregarded and the holding period is measured from the date of exercise. If there is a disqualifying disposition and Section 83 applies, the exercise isn’t complete until the stock is received, which is the vesting date. That is also the date ordinary income will be determined, based on the excess of the fair market value of the stock over the option price. Under the “escape hatch” provision, the ordinary income is generally limited to the excess of the amount realized on the sale or exchange over the adjusted basis of the shares.[5] Second, for alternative minimum tax reporting, an ISO is taxed like an NQO. That means the fair market value of the stock for measuring the AMT adjustment and the date of the adjustment are based on the rules under Section 83. (The amount of the tax preference is the excess of the fair market value over the option price on the vesting date.)[6]
If an employee makes an early exercise of an ISO and the stock is expected to rapidly increase in value (as hoped for after an IPO), the employee could have a big tax preference when the stock vests.
There is a way out, but there is a gamble involved. The employee may elect to have the transfer treated as completed as of the exercise date. This is called a “Section 83(b) election” because it is made under Internal Revenue Code Section 83(b). The election must be made no later than 30 days after the date of the transfer.[7] The requirements for the election are at Treasury Regulations Section 1.83-2. The election may optionally be made using Form 15620. The original election is mailed to the Internal Revenue Service Center where the employee files his or her income tax return. (Include a duplicate copy and a self-addressed return envelope so the IRS can return a date-stamped copy of the election.) Another copy is given to the company for whom the services were provided, and also, if the person who performs the services is different from the person who receives the stock, a copy is provided to the transferee who receives the stock.[8] (Employees are no longer required to attach a copy of the election to their federal income tax returns.[9])
The election may not be revoked without IRS consent.[10]
Anthony Kadillak claimed his Section 83(b) election should be held invalid under a claim of right theory, since he sold shares at a loss and other nonvested shares were forfeited when he lost his job. He made an alternative claim that the capital loss limits shouldn’t apply on the AMT schedule and he should be entitled to an alternative minimum tax net operating loss deduction. The Tax Court and Ninth Circuit Court of Appeals ruled against Mr. Kadillak.[11]
When making a Section 83(b) election, the employee is gambling that the stock will at least maintain the value on the date of exercise. If the stock value is lower on the vesting date than on the exercise date, the employee will pay more tax with an 83(b) election than without the election. For example, an ISO is granted with an option price of $10 per share. On January 1, 20X1, the taxpayer makes an early exercise of the option. The fair market value of the stock on January 1, 20X1 is $30 per share. On January 1, 20X2, the stock becomes vested. The fair market value of the stock on January 1, 20X2 is $20 per share. With an 83(b) election, the AMT income would be $30 – $10 = $20 on January 1, 20X1. Without an 83(b) election, the AMT income would be $20 – $10 = $10 on January 1, 20X2.
The Section 83(b) election for an ISO is effective for the alternative minimum tax, but not for computing the regular tax.
Many employers offer an early exercise privilege to their employees before an IPO of the company stock. The employees are usually informed that the Section 83(b) election is available and given forms to make the election. We saw many employees lose on this gamble in the stock market decline of late 2000 and early 2001.
For example, Supercorp is preparing for an IPO. Jane Employee is an employee of Supercorp. Jane is granted an ISO for 10,000 shares of Supercorp at $1.00 per share. The ISO has an early exercise privilege, and is vested 20% at exercise and 20% at the completion of each year of service after the first year. Jane exercises her option immediately after the grant, so there is no excess of fair market value at exercise over the option price. Jane also timely files a Section 83(b) election.
Supercorp proceeds with a successful IPO. The company is very successful, and the stock appreciates. At vesting for year 2, the value is $26 per share, which would have resulted in an AMT adjustment of $50,000. At vesting for year 3, 4 and 5 the value is $51 per share, which would have resulted in an AMT adjustment of $100,000 for each year.
Jane avoided AMT adjustments totaling $350,000 by making the Section 83(b) election. For AMT reporting but not regular tax reporting, she also “locked in” the original tax basis of $1 per share for computing her capital gains when she sells her Supercorp shares if she makes a disqualifying disposition. Her holding period for all of the stock starts on the date of exercise. Since there was no excess of fair market value over the option price on the exercise date, Jane may sell all of her vested shares held more than one year after the exercise date and report long-term capital gain for the entire gain for AMT.
What if Jane didn’t make the Section 83(b) election and sold 4,000 shares for $26 after the year 2 vesting date, but less than two years after the grant date? For regular tax, Jane would report $50,000 of ordinary income (for 2,000 shares vested year 2) and $50,000 of capital gain (for 2,000 shares vested at the grant date). The holding period would be based on the vesting date, which means the capital gain would probably be long term. For the alternative minimum tax, Jane would have an AMT adjustment of $50,000 as of the year 2 vesting date. A long term capital gain of $50,000 would be reported for the sale. If the vesting date and sale date were in the same year, there would be no AMT adjustment, because the same amount of ordinary income ($50,000) would be reported for the same year for the regular tax and the alternative minimum tax.
As another example, Joe Employee has worked at Techcorp for a year. Techcorp is planning an IPO. Joe has an ISO for 100,000 shares that allows an early exercise and has a five-year vesting schedule like Jane’s above. Joe elects to exercise his ISO. He files a timely Section 83(b) election. The fair market value of the shares at exercise is $22 per share, and the option price is $2 per share, resulting in an AMT tax preference in the year of exercise of $2,000,000.
Techcorp proceeds with its IPO. Joe is “locked out” for six months after the IPO and can’t sell his shares. During that time, Techcorp has an unexpected uninsured products liability lawsuit and a strike by unhappy workers and goes bankrupt.
Joe is unable to pay the tax on $2,000,000 of AMT income. His only tax benefit is an AMT capital loss that he can’t use. Joe files for personal bankruptcy, but finds that federal income taxes are non-dischargeable in bankruptcy. He hires a lawyer to make an offer in compromise to the IRS. The IRS settles the tax for the net equity in Joe’s residence, leaving him with nothing.
When the stakes are high, as illustrated in the example with Joe, it’s probably best to not take the gamble of a Section 83(b) election. Get in the position of being in control, able to sell the stock to pay the taxes, before exercising and generating a big tax bill.
The Section 83(b) election is appropriate in a situation like Jane’s, when there is little risk because there is little or no tax.
If the employee is planning to make a disqualifying disposition of the stock, there is generally no advantage of making an early exercise of an ISO. The employee might receive more tax benefits from an early exercise of a NQO with a Section 83(b) election than from an early exercise of an ISO with a disqualified disposition.
With the mismatch of accounting for regular and AMT reporting, the employee could find he or she is paying taxes twice. For example, for an installment sale (not applicable for publicly-traded stock) involving a disqualified disposition of ISO shares for regular tax purposes, an employee could have ordinary income from the disqualified disposition, resulting in a reduced or zero long-term capital gain from the basis adjustment for the ordinary income. For AMT, the employee could have long-term capital gain reported because of a low tax basis. So the employee pays federal regular tax on the regular tax ordinary income and AMT for the long-term capital gain, with no offsetting minimum tax credits! A taxpayer with this situation should consider electing out of installment sale reporting.
Bear in mind when planning to exercise ISOs that you will need to track the regular tax basis and AMT tax basis separately for each exercise relating to each option grant. When an employee has several ISO grants and exercises each grant on each vesting date, it creates a real accounting nightmare. If a paid tax return preparer has to assemble or plan with this information, it can result in astronomical fees. Balance the benefits of risk management with the additional costs of complexity.
Caution! Regular tax deduction for NQO shares and AMT deduction for ISO shares are limited for forfeitures!
One of the consequences of a Section 83(b) election is no deduction is allowed if the property is subsequently forfeited.[12] According to the Treasury Regulations, “if property for which a Section 83(b) election is in effect is forfeited while substantially nonvested, such forfeiture is treated as a sale or exchange upon which there is realized a loss equal to the excess (if any) of (1) the amount paid (if any) for such property, over, (2) the amount realized (if any) upon such forfeiture.”[13] Notice the ordinary income reported on the exercise of the option isn’t included in the tax basis of the stock.
When an incentive stock option is exercised and the stock is held, no ordinary income is taxable for regular tax reporting, but the income is taxable for alternative minimum tax reporting according to the rules under Section 83, so a Section 83(b) election can be made for AMT reporting when the option isn’t vested.
The same rule disallowing the loss on forfeiture of a non-qualified stock option for regular tax reporting applies to AMT reporting of a forfeiture of stock received from the exercise of a non-qualified stock option.[14]
For example, Jane Employee exercises an incentive stock option on January 10, 20X1 for 1,000 shares of Supercorp stock. The options are not vested. The option price is 10¢ per share and the fair market value on the date of exercise is $10.10 per share. Jane makes a Section 83(b) election for the exercise, so she has additional AMT income of $10,000. On November 10, 20X1, Jane is laid off and is required to sell back the unvested shares to Supercorp for her original investment of 10¢ per share. No AMT tax loss is allowed for the forfeiture. (Note that since a loss would not be allowable for regular tax reporting, the escape hatch probably isn’t available for a disqualifying disposition.)[15]
Do not make a Section 83(b) election when you exercise an ISO and you are planning to leave your employer. You could incur an AMT and receive no tax benefit for your minimum tax credit! The AMT would have been avoided for unvested shares by not making a Section 83(b) election. If you don’t understand this, consult with a tax advisor who does.
Again, it is clear the Section 83(b) election should be used very carefully – usually when a minimal amount of AMT income is reported for the election and it appears that a forfeiture is highly unlikely.
[1]Natkunanathan v. Commissioner, 110 AFTR 2d 2012-5193, July 12, 2012.
[2] Letter Ruling 8307138.
[3] Treasury Regulations §1.422-1(b)(3), example 2.
[4] Internal Revenue Code §83(a). Specifically, the transfer is effective when “the rights of the person having the beneficial rights in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier.” See also Treasury Regulations §§1.83-1(a), 1.83-3(a), 1.83-3(b).
[5] Internal Revenue Code §422(c)(2)
[6] Internal Revenue Code §56(b)(3). Also see Instructions for Form 6251, Incentive Stock Options. Treasury Regulations §1.422-1(b)(3), example 2.
[7] Internal Revenue Code §83(b)(2).
[8] Treasury Regulations §1.83-2(d).
[9] TD 9779, 07/26/2016.
[10] Internal Revenue Code §83(b)(2).
[11] Kadillak, CA-9, 2008-2 USTC ¶ 50,462.
[12] Internal Revenue Code §83(b)(1).
[13] Treasury Regulations §1.83-2(a).
[14] Internal Revenue Code §56(b)(3).
[15] Internal Revenue Code §422(c)(2).