This week, David Elkins (Netanya, visiting Cincinnati; Google Scholar) reviews a new work by Jennifer Bell Levine (Quinnipiac; Google Scholar), Financing Innovation: Modernizing the Qualified Small Business Stock Rules, 80 Tax Law. _ (forthcoming 2027).
This week’s feature article concerns IRC § 1202, which allows investors to exclude gains on qualified small business stock (QSBS). As Professor Jennifer Bell Levine explains, the provision was enacted in 1993 as a means to encourage long-term equity investment in small, risky businesses that had difficulty obtaining conventional financing. The original exclusion covered 50 percent of gain on stock held for more than five years. Congress later expanded the benefit, first temporarily and then permanently, to a 100 percent exclusion for stock acquired after September 27, 2010. Section 1045, enacted in 1997, separately permits gain deferral when proceeds from qualifying stock are reinvested in other QSBS.
The most recent expansion came in the One Big Beautiful Bill Act of 2025. For newly issued qualifying stock, Congress replaced the uniform five-year holding period with exclusions of 50 percent after three years, 75 percent after four years, and 100 percent after five years. It also raised the per-issuer dollar limitation on excluded gain from $10 million to $15 million and the issuer’s gross-asset ceiling from $50 million to $75 million, with inflation adjustments. Levine sees these changes as a strong reaffirmation of Congress’s commitment to subsidizing entrepreneurial investment, but not as a reconsideration of which businesses should qualify.
She next describes the current statutory framework. The issuing entity must be a domestic C corporation, satisfy a gross-asset test, and devote at least 80 percent of its assets to the active conduct of a qualified trade or business. Numerous activities are excluded, including professional services, finance, hospitality, and businesses principally dependent on employees’ reputation or skill. At the shareholder level, stock generally must be acquired at original issuance for money, property, or services. The exclusion is available only to noncorporate taxpayers and is subject to holding-period and dollar limitations.
Levine’s central criticism is that rules developed for the economy of the early 1990s do not adequately distinguish the businesses Congress now wishes to encourage. Innovation increasingly takes place through software, data, artificial intelligence, and other intangible assets, often in business structures quite different from conventional C corporations. The existing eligibility criteria can therefore favor some ventures over economically comparable ones and induce founders to choose organizational or financing arrangements for tax reasons.
Her first proposed reform concerns the exclusion of service businesses. A traditional law firm might be ineligible because its value depends on the expertise of its lawyers, while a company supplying similar services through an AI-powered software platform might qualify because its value resides in transferable technology. Levine argues that the relevant distinction should concern how a business creates scalable value, not simply whether it provides a service. She offers two approaches: a safe harbor for technology-based businesses whose primary assets are software and other intellectual property, or elimination of the reputation-or-skill restriction while retaining specified industry exclusions.
Second, Levine would replace the gross-asset test with a three-year average gross-receipts test modeled on § 448(c). Tax basis is a poor proxy for business size: a highly valuable software company may have relatively few tax-basis assets, while a manufacturer or renewable-energy startup may exceed the ceiling before earning significant revenue. Asset testing also invites planning around the timing of financing rounds. A receipts test, she argues, would measure operating scale more consistently and be easier to administer. She also considers, without making them central recommendations, domestic employment requirements and income- or wealth-based limits on the investors who can claim the benefit.
Third, she proposes broadening eligibility beyond C corporations to include qualifying investments in LLCs, partnerships, and S corporations. As a less sweeping alternative, she would permit investors to count periods of ownership before a pass-through entity converts to a C corporation toward the QSBS holding period. She also addresses early-stage financing through convertible notes and SAFEs, for which the investment date and the date qualifying stock is issued may differ. She recognizes that holding-period tacking alone would not extend the exclusion to appreciation accruing before conversion.
The article takes the continued existence of QSBS as its starting point rather than rearguing the case for the subsidy. Levine acknowledges criticism concerning fiscal cost and the concentration of benefits among high-income taxpayers, but her principal concern is targeting. If Congress intends to encourage long-term investment in innovative, growing businesses, she argues, eligibility should reflect the economic characteristics of businesses and investments rather than statutory classifications inherited from an earlier era.
This approach leaves two fundamental policy questions largely unaddressed. The first is whether Congress should be using the tax system to encourage investment in particular types of businesses in the first place. Such intervention may be justified when market failures cause private investors to underinvest in activities that generate substantial social benefits. But the mere fact that a business is innovative, growing rapidly, or experiencing difficulty attracting capital does not necessarily establish a case for government intervention. Levine acknowledges that commentators have questioned the necessity and desirability of the QSBS subsidy but expressly places the broader issue beyond the scope of her article. Instead, she treats Congress’s decision to retain and expand the exclusion as a reason to concentrate on improving its design.
The second question arises even if one accepts the desirability of encouraging investment in certain businesses. Is a capital gains exclusion the most effective way to accomplish that objective? An exclusion rewards investors in successful ventures, potentially providing substantial benefits to investments that would have been undertaken even without the incentive, while providing comparatively little benefit to investors whose ventures fail. Other mechanisms, such as direct grants, investment tax credits, or subsidies tied to research and development expenditures, might target the desired activities more directly and at a lower fiscal cost. Although Levine discusses empirical studies suggesting that QSBS influences investment decisions and entrepreneurial activity, she does not systematically compare the capital gains exclusion with these alternative instruments.
To be sure, an article devoted to improving an existing statutory provision need not resolve every question concerning the justification for that provision. Nevertheless, the omission might be considered significant in light of Levine’s recommendations. She proposes not merely to refine the eligibility rules but to expand the availability of an already costly tax preference, potentially increasing its revenue cost substantially. The case for such an expansion depends not only on whether the proposed rules would treat economically similar businesses more consistently, but also on whether the resulting subsidies would generate sufficient additional socially desirable investment to justify their cost. Levine makes a substantial contribution to the first inquiry. The second more thematic question remains largely unexplored. If she is so inclined, I would suggest it as a potentially valuable subject for further study.
Here is the rest of this week’s SSRN tax roundup:
- Oktra Basanto (U. Warmadewa), Evaluation of the Effectiveness of Tax Reform in Increasing State Revenue (Oct. 18, 2026)
