Summary: IRC Section 1202 allows eligible non-corporate taxpayers to exclude a significant portion or all the gain recognized on the sale of qualified small business stock (QSBS), with some limits. But what happens when you own QSBS indirectly through a partnership or other pass-through entities? As this article explains, additional eligibility, allocation, and reporting rules apply, and failing to understand them can lead to disappointing tax results.
What qualifies as QSBS under Section 1202
At a high level, QSBS is stock that a non-corporate taxpayer acquires directly from a domestic C corporation at its original issuance in exchange for money, property (other than stock), or services. To qualify, the issuing corporation must meet several requirements.
- First, it must satisfy the qualified small business gross-assets test.
- Second, during substantially all of the taxpayer’s holding period, at least 80% (by value) of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses, and the corporation cannot operate an excluded business or be an ineligible corporation.
- Finally, the taxpayer must satisfy the applicable holding-period requirement before selling the stock. For QSBS acquired after July 4, 2025, Section 1202 provides a phased-in gain exclusion of 50% after three years, 75% after four years, and 100% after five years. For QSBS acquired before July 5, 2025, the stock generally must be held for more than five years, with the applicable exclusion percentage determined by the date the stock was acquired.
Section 1202 planning when QSBS is held through a pass-through entity
While these qualification requirements are often the primary focus of IRC Section 1202 planning, taxpayers holding QSBS through a pass-through entity (PTE) should also consider the procedural rules governing how those requirements are evaluated and challenged. As discussed below, meeting the substantive requirements may not be enough if eligibility determinations are not properly addressed at the PTE level.
How the Section 1202 benefit flows through pass-through entities
QSBS is often held through partnerships and S corporations. Under IRC Section 1202(g), gain recognized by a PTE from the sale of QSBS may flow through to its owners and qualify for the IRC Section 1202 exclusion if the statutory requirements are satisfied. Specifically:
- The stock must qualify as QSBS in the hands of the PTE (determined by treating the PTE as the taxpayer);
- The applicable holding period must be met (3,4 or 5 years); and
- The owner must have held its interest in the PTE on the date the entity acquired the stock and continuously thereafter until the stock was sold.
Importantly, the determination of whether the stock qualifies as QSBS, including requirements relating to the issuing corporation and the holding period, is made at the PTE level rather than on each owner’s individual return.
That distinction can have significant consequences. Because key QSBS qualification determinations are made at the entity-level, disputes over whether stock qualifies for the exclusion also need to be resolved at the entity-level. As a result, individual owners therefore may have limited ability to independently claim, defend, or correct a Section 1202 position after the entity has reported the underlying transaction.
The recent decision in Seed v. United States illustrates that procedural issue. Although the court did not decide whether the stock qualified as QSBS, it held that an individual owner’s refund claim could not proceed because it depended on partnership-level determinations. The case underscores the importance of evaluating and documenting QSBS eligibility at the PTE level before gain is recognized.
Seed v. United States: a cautionary tale for partners
In Seed v. United States (Fed. Cl. June 9, 2026), the pro se plaintiff sought a tax refund, arguing that the capital gain passed through to him from a partnership, qualified for the IRC Section 1202 exclusion. The plaintiff owned an interest in TradeKing Holdings, LLC, an entity taxed as a partnership, that held stock in TradeKing Group, Inc. In 2016, the partnership sold its stock, recognized capital gain, and allocated the gain to its partners, including the plaintiff.
The Plaintiff’s refund claim
After paying the tax, the plaintiff filed a refund claim, arguing that TradeKing Group qualified as an eligible trade or business because it operated a software-driven, self-directed trading platform rather than a disqualified brokerage business. He also argued that certain pre-sale reorganizations had not restarted the holding period required for QSBS treatment. The IRS denied the claim.
The jurisdiction issue
The Court of Federal Claims dismissed the case for lack of jurisdiction under IRC Section 7422(h), which, for 2016, barred refund suits attributable to partnership items. The parties agreed that the refund claim was attributable to the partnership’s capital gain, leaving the court to determine whether that gain constituted a partnership item under IRC Section 6231(a)(3).
The Court’s analysis
Applying the statutory framework, the court concluded that it did. TradeKing Holdings was a partnership required to file a return under IRC Section 6031(a); the capital gain was an item required to be reported under Subtitle A; and the applicable Treasury regulations provide that both partnership items and the legal and factual determinations underlying the characterization of partnership income and gain must be resolved at the partnership level. Because the plaintiff’s arguments regarding the qualified trade or business requirement and the QSBS holding period involved those partnership-level determinations, the court held that it lacked jurisdiction to consider them in an individual refund action.
Key takeaways for partnerships and partners
Notably, the court never reached the underlying merits of whether the stock qualified for IRC Section 1202 treatment. Instead, the case turned entirely on who had the authority to make and challenge those determinations.
As a result, when QSBS is held through a partnership, key Section 1202 determinations are generally made at the partnership level. If the partnership adopts an unfavorable reporting position, individual partners may be unable to claim a different Section 1202 treatment on their own returns. Accordingly, partnerships should evaluate and document QSBS eligibility before reporting the sale.
TEFRA, the BBA, and why the outcome holds for later years
Why TEFRA applied in Seed
IRC Section 7422(h) was part of the Tax Equity and Fiscal Responsibility Act (TEFRA), which required partnership items to be determined in a single, unified partnership-level proceeding rather than through separate actions by individual partners. The Bipartisan Budget Act (BBA) of 2015 repealed the TEFRA partnership audit rules for partnership tax years beginning on or after January 1, 2018, unless a partnership elected to apply the BBA rules earlier. Because Seed involved the 2016 tax year and no election had been made, TEFRA governed.
Why the Repeal of TEFRA does not change the practical result
The repeal of TEFRA does not open a partner-level door for later years. Under the BBA, any adjustment to a partnership-related item must still be made at the partnership level. If a partnership later determines that it improperly reported a transaction — for example, an unclaimed Section 1202 exclusion — it generally must file an administrative adjustment request through its partnership representative rather than leave the fix to an individual partner.
In other words, although the governing procedural regime changed after TEFRA, the practical result remains the same: taxpayers generally cannot bypass the partnership and pursue entity-level Section 1202 determinations on their own returns. As a result, partners generally have limited ability to adopt a position on their own returns that is inconsistent with the partnership reporting, making it critical for partnerships to analyze and document QSBS eligibility before reporting the sale.
Practical takeaways for partnerships holding QSBS
- The Seed decision was a procedural ruling, not a determination of whether the underlying stock qualified as QSBS.
- When QSBS is held through a partnership, key Section 1202 eligibility requirements, including both the qualified-trade-or-business and holding-period questions, are generally determined at the entity-level.
- As a result, partnerships should analyze, document, and report those determinations consistently on the partnership return rather than leaving them to individual
- If a partnership adopts an unfavorable Section 1202 position, an individual partner generally cannot correct that position by claiming the exclusion on their own return and suing for a refund.
- Any correction typically must be pursued through entity-level procedures, such as a TEFRA partnership proceeding or a BBA administrative adjustment request, depending on the tax year.
Final thoughts: the importance of planning before the sale
The Seed decision is a reminder that Section 1202 planning requires more than satisfying the statutory requirements for QSBS status. Entity-level analysis, documentation, and reporting can be just as important as the underlying qualification requirements when it comes time to claim the exclusion.
Taxpayers holding QSBS through partnerships and other PTEs should consult an experienced tax advisor before a sale or other liquidity event occurs. Early planning allows identifying qualification issues before a liquidity event, supporting entity-level documentation and reporting positions, and assisting with administrative procedures needed to preserve valuable tax benefits.
