Qualified Small Business Stock under Internal Revenue Code (IRC) Section 1202 offers entrepreneurs and investors a powerful tax break, potentially eliminating up to 100% of federal capital gains tax when they sell their company. This exclusion is capped per taxpayer and per issuer at the greater of $10 million or 10 times the stock’s adjusted basis. The recent One Big Beautiful Bill Act (OBBBA) significantly expands this benefit for stock acquired after July 4, 2025, by increasing the exclusion cap to $15 million and raising the corporate asset limit from $50 million to $75 million. Business owners must structure the sale of their entity as a stock sale of a domestic C-Corporation and meet active business and asset tests at the time of the initial stock issuance to qualify.
Section 1202 Qualified Small Business Stock: The Ultimate Capital Gains Shield
Congress created the Section 1202 Qualified Small Business Stock (QSBS) exclusion to spur investment in domestic small businesses. This provision rewards entrepreneurs and early investors for taking substantial risks on new ventures. QSBS allows eligible non-corporate taxpayers to exclude a portion or all of the capital gains realized from the sale of qualifying stock. For shares acquired after September 27, 2010, and held for more than 5 years, the law currently provides a 100% exclusion from federal capital gains. This exclusion effectively reduces the federal tax rate on the sale gain to zero, eliminating both the ordinary capital gains rate and the 3.8% Net Investment Income Tax (NIIT). Understanding and actively planning for QSBS qualification provides the single most impactful tax benefit available to selling founders.
Qualified Small Business Stock (QSBS) Requirements
Meeting the strict QSBS criteria requires meticulous planning from your company’s inception or very early stage. You must satisfy several critical tests at both the corporate and shareholder levels.
Test 1: Corporate Eligibility (Domestic C-Corporation Status)
The issuing company must be a domestic C-Corporation at the time of stock issuance and throughout the holding period. S-Corporations and most LLCs cannot issue QSBS directly. Converting a pass-through entity (LLC or S-Corp) to a C-Corp can trigger a new holding period requirement.
Test 2: The Original Issuance Rule
The taxpayer must acquire the stock directly from the corporation upon its original issuance. Stock purchased on the secondary market from another shareholder does not qualify. Stock received for cash, property (excluding other stock), or as compensation for services rendered (like founder or employee stock) generally meets this requirement.
Test 3: The Active Business Requirement and Excluded Industries
The corporation must use at least 80% of its assets (by value) in the active conduct of a qualified trade or business during substantially all of the taxpayer’s holding period. Certain service-based and financial firms are specifically excluded from QSBS eligibility. Excluded industries include law, accounting, financial services, consulting, banking, insurance, and hotel or restaurant operations. Your company’s primary activity must fall outside these excluded categories.
Test 4: The Legacy Gross Asset Test ($50 Million Threshold)
The corporation’s aggregate gross assets must not exceed $50 million at any time on or after August 10, 1993, and immediately after the stock issuance. The aggregate gross assets include cash plus the adjusted tax basis of the corporation’s tangible assets. This measurement is crucial; a single round of funding exceeding this limit can permanently disqualify subsequent stock issuances.
Test 5: The Shareholder Eligibility (Non-Corporate Investors)
The shareholder claiming the exclusion must be a non-corporate taxpayer, such as an individual, a trust, or an estate. C-Corporations cannot claim the Section 1202 exclusion. Gain recognized by pass-through entities (like partnerships) can often flow through to their non-corporate owners, preserving the benefit, subject to additional rules.
The One Big Beautiful Bill Act: Modernizing QSBS Benefits
President Trump signed the One Big Beautiful Bill Act (OBBBA) into law on July 4, 2025, fundamentally enhancing the tax incentives for investing in small businesses. These beneficial changes apply exclusively to QSBS acquired on or after July 5, 2025. Stock acquired before this date remains subject to the pre-OBBBA rules.
The New $75 Million Gross Asset Threshold
The OBBBA raises the critical gross asset test limit from $50 million to $75 million. This expansion immediately widens the pool of companies eligible to issue QSBS and allows qualifying businesses to raise significantly more capital before potentially losing their status. The $75 million threshold is subject to future inflation indexing, ensuring long-term relevance.
The $15 Million Exclusion Cap
For stock acquired after July 4, 2025, the per-taxpayer, per-issuer gain exclusion cap increases from $10 million to $15 million. This change provides high-growth founders and investors with an additional $5 million in potential tax-free proceeds upon exit.
Shorter Holding Periods Under OBBBA
The Act introduces a tiered-exclusion schedule, relaxing the five-year holding requirement for partial benefits on newly issued stock:
- 50% Exclusion: Stock held for at least three years but less than four years.
- 75% Exclusion: Stock held for at least four years but less than five years.
- 100% Exclusion: Stock held for five years or more.
This tiered system significantly improves liquidity options for business owners, enabling lucrative exits as early as 3 years post-issuance without sacrificing the full tax benefit.
Advanced QSBS Strategies and Planning
Business owners seeking an M&A transaction must proactively implement strategies to maximize the Section 1202 exclusion.
Maximizing the Exclusion: The Greater of $10 Million vs. 10x Basis
The exclusion limit equals the greater of $10 million (or $15 million under OBBBA) OR 10 times the taxpayer’s aggregate adjusted basis in the QSBS sold during the taxable year. Founders and early employees often receive stock on a nominal basis, making the dollar cap the effective limit. However, shareholders who pay substantial cash or contribute high-value, low-basis property can significantly increase their tax-free gain beyond the dollar cap using the 10x basis calculation.
Section 1045 Rollover: Deferring Capital Gains Tax-Free
If you sell QSBS you held for more than 6 months, but less than 5 years, you have a deferral option. Section 1045 allows you to roll over the realized capital gain tax-free by reinvesting the proceeds into new QSBS within 60 days. This provision offers crucial flexibility, especially when a buyer demands a quick exit before the five-year holding period matures.
QSBS Planning for Founders and Employees (Compensation and Options)
Founders must obtain their stock at the original issuance to start the holding period. Stock acquired via the exercise of stock options (non-qualified stock options or incentive stock options) generally has a holding period that begins on the date of exercise, not the grant date, which can delay the five-year clock. Strategically exercising options early can ensure that the holding period requirement is met before a potential sale. Gifting QSBS to non-corporate family members or trusts can multiply the per-taxpayer exclusion cap across multiple entities.
Frequently Asked Questions (FAQs) About Section 1202
Does the QSBS exclusion apply to state taxes?
No, the Section 1202 exclusion applies only to the federal capital gains tax. Many states, including California, New York, and Massachusetts, currently do not conform to the federal QSBS rules and still impose state income tax on the excluded gain.
Can my S-Corporation or LLC stock qualify as QSBS?
No, only stock issued by a domestic C-Corporation can qualify as QSBS. S-Corps and standard LLCs are pass-through entities and do not meet the corporate structure requirement.
What is the 5-year holding period starting date?
The holding period generally starts on the date the stock was initially issued to the taxpayer in exchange for cash, property, or services. For stock acquired via option exercise, the holding period begins on the date of exercise.
How does the new $75 million asset limit affect my existing stock?
The $75 million limit applies only to QSBS issued on or after July 5, 2025 (under OBBBA). Stock issued before that date must have met the old $50 million limit at the time of its original issuance.
Which businesses are specifically excluded from QSBS?
Excluded businesses predominantly provide services in which the principal asset is the reputation or skill of their employees, including law, accounting, consulting, health, and financial services. Banking, investing, leasing, and operating hotels/restaurants are also excluded.
Windes M&A Team Can Help
The complexity of Section 1202 Qualified Small Business Stock and the nuanced application of the One Big Beautiful Bill Act demand specialized expertise to realize maximum value during an M&A exit. Windes’ M&A strategy services bring deep experience in sell-side due diligence, tax structuring, and exit planning to optimize your transaction. We proactively review your corporate history and asset composition to confirm QSBS eligibility, structure the sale for the most favorable tax outcome (including utilizing the $10 million/10x basis rule and Section 1045 rollovers), and manage all financial modeling and tax projections. Contact the Windes M&A team to ensure your compliance is air-tight, mitigate risks that could deter a buyer, and position your company to capture the maximum tax-free portion of your sale proceeds.
Chase McClung, CPA, CM&AA
Partner, Audit & Assurance Services
Transaction Advisory Practice Leader
Chase works closely with owners of privately held businesses in their preparation for potential mergers and acquisitions. His technical expertise in this area includes financial due diligence for both buyers and sellers, EBITDA and working capital analyses, quality-of-earnings studies, and review of transaction-related agreements.