§1202 of the Internal Revenue Code, the Qualified Small Business Stock (QSBS) exclusion, is one of the most powerful tax incentives for founders, early employees, and investors. With the recent enactment of the One Big Beautiful Bill Act (OBBBA), its benefits have become even more significant, offering a path to potentially eliminate millions in federal capital gains tax.
What is Qualified Small Business Stock?
For stock to qualify for §1202 benefits, it must meet specific criteria related to both the shareholder and the issuing corporation.
- C-corporation status: the stock must be from a domestic C corporation.
- Original issuance: a taxpayer must acquire the stock at its original issuance directly from the corporation in exchange for money, property (not stock), or as compensation for services.
- Gross assets test: on the date the stock is issued, the corporation's aggregate gross assets must not have exceeded $50 million. [OBBBA update: for stock issued after 4 July 2025, the OBBBA increases the ceiling to $75 million, to be adjusted for inflation after 2026.]
- Active business requirement: for 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 a "qualified trade or business." Certain businesses are excluded, such as those in health, law, accounting, consulting, and financial services.
- Holding period: to qualify for the exclusion, the stock must be held for a minimum period. For stock acquired after 27 September 2010, a 100% exclusion is available if held for more than five years. [OBBBA update: for stock acquired after 4 July 2025, a tiered exclusion applies based on the holding period: more than 3 years = 50% exclusion, more than 4 years = 75% exclusion, and more than 5 years = 100% exclusion.]
Tax benefits of QSBS
The §1202 exclusion offers substantial federal tax savings by allowing non-corporate taxpayers to exclude capital gains. The maximum gain eligible for exclusion per taxpayer, per issuer is the greater of:
- $10 million (reduced by prior exclusions from the same issuer). [OBBBA update: for stock acquired after 4 July 2025, the dollar limit is increased to $15 million ($7.5 million for married individuals filing separately) and will be adjusted for inflation after 2026.]
- 10 times the aggregate adjusted basis of the QSBS sold during the year.
Additional tax exemptions: gains excluded under §1202 are also exempt from the 3.8% Net Investment Income (NII) tax and the Alternative Minimum Tax (AMT).
Key planning options to maximise benefits
- Gifting ("stacking") QSBS: the exclusion limit applies per taxpayer. Gifting QSBS to family members or certain trusts can multiply the available exclusion amounts, as each recipient may claim their own separate limit. The OBBBA's higher $15 million exclusion makes this strategy even more powerful.
- §1045 rollovers: if you sell QSBS held for more than six months but less than the required holding period for exclusion, you can defer the capital gains tax by reinvesting the proceeds into new QSBS within 60 days. This allows the holding period from the original stock to "tack" onto the new stock.
- Entity conversions and restructuring: partnerships or S corporations can convert to a C corporation to enable future stock issuances to qualify. Planning is essential to manage the company's growth relative to the gross assets test.
- §83(b) election: for founders with restricted stock, making an 83(b) election within 30 days of issuance starts the holding period early. This is crucial for locking in QSBS status while the company's assets are still below the $50 million (or the new $75 million) threshold.
- §1244 ordinary loss treatment: if a stock that qualifies under the stricter rules of §1244 is sold at a loss or becomes worthless, you can treat the loss as an ordinary loss rather than a capital loss, up to $100,000 ($50,000 for single filers).
Potential pitfalls to avoid
- Redemptions: a corporation's repurchase of its stock around the time your shares were issued can disqualify them from QSBS treatment.
- Partnership contributions: contributing QSBS to a partnership generally causes the stock to lose its qualifying status.
- Passthrough ownership: while you can hold QSBS through a partnership or S corp, the rules are rigid. A partner can only exclude gain based on their interest at the time the stock was acquired, and they must be a partner for the entire holding period.
- State tax considerations: §1202 is a federal tax exclusion. Not all states conform to these rules. States such as California, Pennsylvania, and New Jersey do not conform, meaning a gain that is 100% excluded for federal purposes may still be fully taxable at the state level.
Where this leaves you
The rules for QSBS are intricate, and recent law changes have raised the stakes. To build a compliant and effective tax strategy, connect with our tax team at AlignMyTax.
Disclaimer. This article is for informational purposes only and does not constitute legal or tax advice. International tax rules turn on the specific facts and circumstances of each case, and thresholds and procedures change. Please consult a qualified tax professional before acting on anything here. Reading this does not create a client relationship.