If you invested in a startup or small business (founders, employee exercise of stock options, business owner), you need to know about qualified small business stock. If eligible, you may be able to exclude up to 100% of the gain from federal taxes when you sell your shares through the capital gains tax exclusion. The potential tax savings simply cannot be understated.
Qualified small business stock (also called QSBS or Section 1202) has the potential to save millions (even tens of millions) in taxes. But before you can claim a capital gains exclusion on section 1202 stock, you must understand eligibility requirements and be able to support it.
What is Qualified Small Business Stock (Section 1202 Shares)?
Using IRS Section 1202, taxpayers can sell stock potentially free of federal capital gains taxes if the requirements are met. This article is meant to be an easily-digestible introduction to QSBS. It is not personal legal/tax/financial advice or an exhaustive discussion of the exclusion.
OBBB Expands QSBS in 3 Key Ways
The One Big Beautiful Bill (OBBB) significantly expands the benefits of Qualified Small Business Stock (QSBS) through three key provisions. However, these expanded benefits apply only to taxpayers who acquire shares after the bill’s enactment date.
Effective Date: These provisions apply to QSBS issued after July 4, 2025 (including qualifying new exercises and stock purchases).
Important Note: Stock acquired before the OBBB enactment date remains subject to the original QSBS rules, as outlined throughout this article.
Here’s a breakdown of the key changes:
- Tiered Gain Exclusion: The previous requirement of a five-year holding period for a 100% exclusion is replaced with a tiered system:
- 50% exclusion for stock held for at least 3 years
- 75% exclusion for stock held for at least 4 years
- 100% exclusion for stock held for at least 5 years
- Increased Per-Taxpayer Gain Exclusion Cap:
- The maximum per-issuer gain exclusion cap increases from $10 million to $15 million. This new cap will be adjusted for inflation starting in 2027. Taxpayers will still benefit from the annual calculation using the greater of the lifetime exemption or 10x basis.
- Increased Aggregate Gross Assets Threshold:
- The corporate-level aggregate gross asset threshold for a company to qualify as a small business (and therefore issue QSBS) increases from $50 million to $75 million. This threshold will be adjusted for inflation starting in 2027.
How Do You Qualify for QSBS?
Rules and Eligibility Requirements to Sell Startup Shares Tax-Free
To qualify for the small business capital gain exclusion, the following key requirements must be met:
- Stock issuance and type:
- Acquired at original issuance on or after August 11, 1993
- Domestic C corporation
- Shares must be exchanged for money, property (excluding stock), or compensation for services
- Gross asset test:
- Aggregate gross assets (generally cash and adjusted tax basis of property) must be less than or equal to $50 million immediately before and after the stock issuance¹
- Threshold is $75 million for stock acquired after July 4, 2025
- Holding period:
- The stock must be held for at least 5 years
- Stock acquired after July 4, 2025: holding period is 3 years: 50% exclusion; 4 years: 75% exclusion, 5 years: 100% exclusion
- Clock starts on exercise date for stock options
- Generally, the original purchaser of QSBS must be the seller claiming the Section 1202 exclusion.²
- Active business:
- At least 80% of assets must be used in qualified trades or businesses
- Excludes businesses where the principal asset is the reputation or skill of one or more employees (e.g., professional services, consulting, law, health, financial services, farming, and others)
- Excessive non-operating real estate, cash, or portfolio assets can disqualify stock from tax exemption
- Redemptions:
- Significant stock buybacks by the company can disqualify shares
- Redemption tests:
- No buybacks from you (the shareholder) or related party 2 years before or after issuance
- No significant buybacks from any shareholder 1 year before or after issuance³
Other rules apply; not tax or legal advice
This list is only a summary of the primary elements.
For more detailed information on qualifying, refer to this article. Given the complexities, consult with your CPA to discuss your specific circumstances. Careful structuring of transactions and planning for capital gains exclusions related to QSBS are crucial for federal income tax purposes.
Video: Qualified Small Business Stock (QSBS): Qualification and Exemption
QSBS Tax Benefits
For those holding Section 1202 shares, the amount of gain eligible for exclusion from federal long-term capital gains tax depends on the gain itself and the stock’s acquisition date. If you acquired shares through stock options, the exercise date is considered the acquisition date.
Gain Exclusion: The Greater of $10 Million or 10x Basis
Each year, a taxpayer holding Section 1202 shares can exclude the greater of the following two amounts:
- $10 Million Cap: This is a lifetime limit, reduced each year by any previous QSBS sales from the same issuer where this $10 million cap was used. (Note: The OBBB raised this to $15 million for acquisitions after July 4, 2025.)
- 10x Basis: Calculated annually when QSBS is sold, per taxpayer, per issuer. This is ten times the stock’s adjusted basis.
Example (stock acquired before July 4, 2025):
Jack acquired QSBS-eligible stock in 2011 with a total fair market value of $15 million. This year, he sells enough stock to reach the $10 million gain exclusion cap. Next year, he sells an additional $2 million worth of stock with an aggregate adjusted basis of $5,000. His gain exclusion will be $50,000 ($5,000 x 10). The remaining gain from that sale will be subject to long-term capital gains taxes.
Percentage Limitations for Stock Issued Before September 28, 2010
In addition to the limits above, the exclusion may be further reduced depending on the stock’s acquisition date:
- August 11, 1993 – February 17, 2009: 50% exclusion
- February 18, 2009 – September 27, 2010: 75% exclusion
- After September 27, 2010: 100% exclusion
Stock not eligible for the 100% exclusion will have slightly different tax treatment. The portion of the gain that is taxable due to these percentage limitations is subject to a 28% tax rate and the 3.8% net investment income tax (Medicare). Furthermore, 7% of the excluded amount is considered a preference item for the alternative minimum tax (AMT).
Remember, this is a summary of the tax implications for section 1202 of the tax code; it’s not tax advice! Discuss your situation with a tax advisor.
Avoid Disqualifying Your Qualified Small Business Stock
Certain company actions can jeopardize its QSBS status, thereby affecting shareholders’ ability to claim the QSBS tax exclusion. For example, even investing business assets in money market funds can impact QSBS eligibility.
Other actions that could disqualify QSBS include company share buybacks exceeding a certain threshold or surpassing the $50 million gross asset threshold through fundraising or inventory. Companies should regularly monitor their QSBS eligibility to avoid inadvertent disqualification and consult with corporate legal and tax advisors to ensure compliance.
State Tax Treatment May Differ
State tax benefits related to QSBS may not align with the federal income tax treatment described above. While this article focuses on federal tax treatment, states may have their own regulations. For instance, California does not follow the federal QSBS tax treatment.
Massachusetts previously had its own QSBS rules, but sales after January 1, 2022, now conform to federal guidelines. However, the Commonwealth also enacted a “millionaire tax,” which adds a 4% surtax to taxable income exceeding $1 million (indexed for inflation), even for one-time wealth events.
Additional Section 1202 Tax Planning Considerations
The Future of QSBS
While Section 1202 was recently expanded in 2025, lawmakers have historically sought to limit the tax benefits of qualified small business stock. Therefore, it’s important to stay informed about potential legislative changes.
QSBS and Employee Stock Options
Founders and early startup employees often hold shares that could qualify for QSBS if properly managed. To help ensure eligibility for these small business stock tax benefits, consider purchasing restricted stock or exercising stock options early on, even before the shares vest.
Planning for Gains Exceeding $10/$15 Million
The Section 1202 gain exclusion is applied on a per taxpayer basis. To maximize tax benefits beyond the 10x/$10M/$15M limits, explore strategies such as gifting stock to family members, as each taxpayer has their own individual limits. Consult with an attorney regarding tax planning strategies involving QSBS and trusts.
Another strategy involves structuring sales of Section 1202 stock to first sell low-basis stock (up to the $10M/$15M cap), followed by high-basis stock (to utilize the annual 10x basis limit). Additional strategies may be available depending on your specific circumstances.
Navigating Early Startup Acquisitions
Most successful startups are acquired rather than going public through a traditional IPO. What happens if you haven’t met the holding period requirements, or the acquisition involves stock of the acquiring company? Depending on the deal terms and the goals of major shareholders, there may be unique planning opportunities. While many factors and structuring options exist, here are two ways founders can potentially extend their 1202 runway during an acquisition:
Section 1045: QSBS Rollover and Reinvestment
Jeff Krueger, CPA, a tax advisor with Seaport Financial Partners in Boston who specializes in equity compensation for founders and employees, suggests considering a tax-free rollover into replacement QSBS under Section 1045. He notes that serial entrepreneurs often use QSBS rollovers to defer taxes and extend the holding period to meet the requirements.
Under Section 1045, investors can transfer their original QSBS holding period to replacement stock by reinvesting in a company that currently meets the QSBS criteria within 60 days.
While finding suitable replacement QSBS investments can be challenging, this approach offers flexibility in determining the amount to defer and the specific investment. Deferred gains reduce the cost basis in the replacement QSBS. If the rollover stock is later sold and meets Section 1202 requirements, it may be fully tax-free, subject to the limits. Otherwise, the taxpayer would pay tax at capital gains tax rates or consider another 1045 QSBS reinvestment.
QSBS Exchange
Another method for extending the holding period of original QSBS involves a Section 351 exchange or a Section 368 reorganization. These options can potentially retain the tax benefits of Section 1202 and provide for tax deferral (either full or partial) upon completion of the buyout. Krueger emphasizes that these strategies must be evaluated by the deal team, including corporate lawyers and accountants. It’s common for company acquisitions to require a certain amount of rollover equity, particularly for founders and key shareholders.
Essentially, when properly executed and all conditions are met, these avenues have the potential to preserve the full gain exclusion under Section 1202 if the buyer’s stock qualifies as QSBS. If it doesn’t, the exclusion can still apply when the shares are ultimately sold, but only on the gain that was deferred at the time of the exchange.
M&A transactions are highly complex and require guidance from both corporate and personal advisors. While exploring your options with your team, remember to consider the present value of the deal. Businesses can fail, and sometimes it’s best to accept the payout and pay the tax.
Converting to a C corporation
In certain situations, converting an S corporation to a C corporation and issuing new stock may be beneficial. Other entity structures may also qualify newly issued stock for Section 1202 benefits. However, this approach can be complex. More established companies may struggle to meet the gross asset requirements when issuing new shares. Like other advanced strategies discussed here, this method can be difficult and costly to implement (or even impossible), so consult with an attorney and tax advisor.
Understanding Hedging Restrictions
Taking an “offsetting short position” during the initial five-year holding period can disqualify stock from QSBS treatment. This includes actions such as buying a put option, writing a call option, or shorting the stock.
Documenting a QSBS Claim
While no specific documentation is required when initially filing a QSBS gain exclusion claim, taxpayers must be prepared to substantiate their claim in the event of an audit. No additional supporting documentation (such as Form 8949 and Schedule D) is submitted with the initial filing.
One common challenge is that stockholders often don’t realize they could have QSBS at the time of issuance, or they may be unaware of QSBS benefits altogether. We have identified QSBS eligibility for clients in numerous instances, resulting in significant tax savings. It’s a real benefit!
Ultimately, securing the substantial tax advantages of qualified small business stock may depend on maintaining thorough records and retaining those documents for several years. Stockholders are responsible for keeping documentation that proves their QSBS eligibility in case of an IRS audit. At a minimum, Krueger recommends retaining records of:
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- Stock certificates, purchase agreements, and 83(b) elections;
- Balance sheets before and after issuance (ideally, reviewed or audited financial statements);
- A copy of the capitalization table showing changes over time to confirm no redemptions; and
- Articles of incorporation and bylaws.
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Ideally, Krueger suggests that companies obtain an opinion letter from a reputable firm (perhaps a Big 4 accounting firm) after reaching the asset threshold and distribute it to employees. Other helpful records include a QSBS eligibility checklist (signed by the CFO) and corporate tax returns coinciding with stock purchases.
Employees should proactively gather documentation whenever possible.
Get Help from a Stock Option Advisor
As evidenced by the length of this summary on the qualified small business stock exclusion from capital gains, the subject matter is complex. You may never have QSBS, and if you do, you may not be fortunate enough to qualify more than once. Strongly consider engaging a personal team of tax and financial advisors to help guide you through the process.
Darrow Wealth Management is a financial fiduciary and fee-only registered investment advisor. We specialize in financial planning for an IPO, acquisition, or sale of a private business. By now you know we don’t provide legal or tax advice, but we do help clients build a team of tax/legal specialists to tackle issues around company stock. Through ongoing financial advice and asset management, we aim to help our clients make the most of a sudden wealth event.
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Footnotes
¹ Property contributed to the corporation is based on the fair market value when contributed. Certain related subsidiaries (controlled group) will count towards the $50M/$75M minimum. There are other considerations to discuss with your tax professional and/or tax attorney.
² There are some exceptions to this rule for QSBS acquired by gift, at death or as a distribution from a pass-through entity (partnerships, S corporations, regulated investment companies or common trust funds).
³ Consult a tax advisor as previously mentioned to discuss your situation. Calculating this is often tricky. Significant generally means an amount greater than 5% of the value of the stock. There are also certain purchases than may be disregarded including ‘de minimis’ redemptions.
Information in this article is for informational purposes only and should not be misinterpreted as personalized advice of any kind or a recommendation for any specific investment product, financial or tax strategy. This is a general communication should not be used as the basis for making any type of tax, financial, legal, or investment decision.
[Last reviewed January 2026]
