QSBS and Section 1202: The Tax Exclusion Every Founder Should Know

Section 1202 excludes from federal income tax some or all of the gain when you sell qualified small business stock. The One Big Beautiful Bill Act (P.L. 119-21, signed July 4, 2025) rewrote the main numbers, so the rules now depend on when your stock was issued.

For older stock acquired after September 27, 2010, the exclusion is 100% once the five-year holding period is met. The $15 million cap and $75 million asset test are indexed for inflation for tax years beginning after 2026.

Excluded gain is also free of the 3.8% net investment income tax. Gain you cannot exclude under the new 50% and 75% tiers is taxed at up to 28% under IRC §1(h)(4), not 20%, so a three-year sale is better than nothing but much worse than waiting for year five.

For example, a founder who paid $1,000 for shares has a cap of $15 million on new stock, because 10 times basis is only $10,000. On a $15 million gain held five years, the exclusion saves about $3.57 million of federal tax at 23.8%.

Five requirements must be met:

1. The stock is issued by a domestic C corporation. S corps, LLCs and partnerships do not qualify, although an LLC that converts to a C-Corp can issue QSBS going forward.
2. The corporation's aggregate gross assets did not exceed the limit ($75 million for new stock) at any time before the issuance and immediately after it, including the cash raised in that round.
3. You acquired the stock at original issuance, directly from the corporation, for money, property other than stock, or services. Stock bought from another shareholder does not qualify.
4. During substantially all of your holding period, at least 80% of the company's assets by value are used in the active conduct of a qualified trade or business.
5. The business is not in an excluded field. Section 1202(e)(3) excludes services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage, plus banking, insurance, financing, leasing, investing, farming, certain mining and extraction, and hotels and restaurants.

The gross-asset test is measured when the stock is issued, so early stock is the easiest to qualify. Gross assets means cash plus the adjusted tax basis of other property, with one exception: property contributed to the company counts at its fair market value when contributed.

Once a company's gross assets exceed the limit, stock issued after that point does not qualify. Stock issued earlier keeps its status. A company approaching $75 million after a large round should look at whether option exercises or grants of restricted stock planned for later can sensibly happen before the next closing. The higher OBBBA threshold gives Series A and many Series B companies more room than the old $50 million test did.

Timing changes the federal tax on the same QSBS gain from about $952,000 to zero. Take a hypothetical founder in a state with no income tax who holds stock issued after July 4, 2025 and sells it for a $4 million gain, well under the $15 million cap.

• No QSBS (or held under 3 years): $4,000,000 times 23.8% (20% capital gains plus 3.8% NIIT) is $952,000.
• Sold after 3 years (50% exclusion): $2,000,000 is excluded. The other $2,000,000 is taxed at 28% ($560,000) plus 3.8% NIIT ($76,000), for $636,000.
• Sold after 4 years (75% exclusion): $3,000,000 is excluded. The remaining $1,000,000 is taxed at 31.8% combined, for $318,000.
• Sold after 5 years (100% exclusion): $0 of federal income tax and NIIT.

The gap between year three and year five is $636,000 on this example. For older stock issued on or before July 4, 2025, there is no partial tier: a sale before five years gets no exclusion (though a §1045 rollover may help), and a sale after five years gets 100%.

If the gain exceeds the cap, only the capped amount is excluded and the excess is taxed normally. Always run the numbers with your actual basis, holding period and state of residence.

The QSBS holding period starts when you actually acquire the stock, not when you receive a right to it. That rule produces different start dates for common startup instruments:

• Restricted stock with an 83(b) election: the purchase date, for the whole grant.
• Restricted stock without an 83(b): each tranche's vesting date.
• Stock options (ISOs or NSOs): the exercise date. Time spent holding the option does not count, which is why early exercise with an 83(b) is popular at low-value companies.
• RSUs: the settlement date, when shares are delivered.
• Convertible notes: generally the conversion date, since a note is debt.
• SAFEs: unsettled. Some advisors treat a SAFE as equity from the investment date, others start the clock at conversion. The IRS has not ruled, so plan on the conservative date.

For an LLC that converts to a C-Corp, §1202(i) treats stock received for property as having a basis of at least the property's fair market value at the conversion, so only appreciation after conversion can be excluded. The holding period for QSBS purposes starts at the conversion date. Converting early, while the business is worth little, keeps more of the eventual gain eligible.

Stock that qualified at issuance can still lose QSBS status through company redemptions or by failing the active-business tests later. The rules most likely to bite a startup:

1. Redemptions from you or a related person. Under Treas. Reg. §1.1202-2(a), stock is not QSBS if the company buys back more than a de minimis amount of stock from you or a related person in the four-year window starting two years before your stock was issued. De minimis means $10,000 or less, or 2% or less of the stock held by you and related persons.
2. Significant redemptions. Under §1.1202-2(b), stock fails if, in the two-year window starting one year before issuance, the company redeems more than a de minimis amount and the redeemed stock exceeds 5% of the total value of all its stock. This catches founder secondary sales structured as company buybacks around a financing.
3. Too much idle cash or investments. Assets count as used in the business if they are reasonably required working capital, or are expected to fund research or working capital within two years, but after the company is two years old no more than 50% of its assets can qualify that way under §1202(e)(6).
4. Portfolio stock and real estate. A company fails the active-business test for any period in which more than 10% of its net asset value is stock or securities of non-subsidiaries, or more than 10% of its total assets is real property not used in the business.

Before approving any buyback, tender offer or treasury investment policy, the board should ask how it affects QSBS for every holder.

The cap is per taxpayer, per issuer. Gifts of QSBS keep their qualified status and the donor's holding period under §1202(h), so a gift to a child or a non-grantor trust can create an additional cap for the recipient. Spouses do not automatically double the cap; §1202(b)(3) has special rules for married taxpayers. Trusts formed mainly to multiply exclusions face IRC §643(f) anti-abuse risk, so this is estate-attorney territory.

Section 1045 lets you defer gain on QSBS held more than six months by buying replacement QSBS within 60 days of the sale. The holding period of the old stock carries over to the new stock, so the clock toward the exclusion does not restart.

Most states with an income tax start from federal income and follow Section 1202, but not all. California does not conform: California residents pay state tax on the full QSBS gain at rates up to 13.3%. Pennsylvania also does not follow the federal exclusion. New York currently conforms; a 2026 New York Senate proposal to decouple was not included in the enacted budget. Texas, Florida and Nevada have no personal income tax. Washington has no income tax but does have a separate capital gains excise tax, so Washington founders should check how it applies to their sale.

Since OBBBA made Section 1202 more generous, some legislatures have debated decoupling from it. Check your state's current treatment before any sale.

For California founders expecting a large exit, moving domicile out of state before the sale can change the result, but the Franchise Tax Board closely audits residency changes that occur near a liquidity event. Rules here were checked October 17, 2026; this is general information, not tax advice for your specific facts.