Entity Tax · Guide · Working level
Qualified small business stock: the Section 1202 exclusion after the OBBBA
Section 1202 lets noncorporate shareholders exclude gain on qualified small business stock — up to 100% after five years, and, for stock issued after the OBBBA's July 4, 2025 enactment, on a new tiered schedule starting at three years with a $15 million cap.
Section 1202 is the largest permanent tax benefit available to startup founders and early investors, and the least attended-to in real time. It lets a noncorporate shareholder exclude gain — historically up to 100% after a five-year hold — on qualified small business stock (QSBS): original-issuance stock of a domestic C corporation that was small when the stock was issued and runs an active business. The exclusion is capped, per issuer, at the greater of a fixed dollar amount or ten times the shareholder's basis, and the excluded gain also escapes the net investment income tax and (for 100%-exclusion stock) AMT preference treatment.
The One Big Beautiful Bill Act, enacted July 4, 2025 (H.R. 1, 119th Congress), expanded the regime substantially for stock issued after enactment: a tiered exclusion that begins at three years, a $15 million dollar cap, and a $75 million gross asset ceiling. Stock issued on or before enactment keeps the old rules. Two vintages of QSBS now coexist, and every cap table has to be read with the issuance date in hand.
What has to be true at issuance?
Section 1202(c) and (d) of the Internal Revenue Code impose the tests as of the moment the stock is issued:
- Domestic C corporation. Not an S corporation, not an LLC taxed as a partnership. The issuer must remain a C corporation during substantially all of the shareholder's holding period.
- Original issuance. The shareholder acquired the stock from the corporation — for money, property (not stock), or services. Stock bought from another shareholder never qualifies, which is why secondary purchases in later rounds carry no QSBS.
- Gross asset test. The corporation's aggregate gross assets (cash plus adjusted basis of property, with contributed property counted at fair value) must not exceed the ceiling at all times before and immediately after issuance — $50 million for pre-OBBBA issuances, $75 million (inflation-indexed) for stock issued after July 4, 2025. Crossing the ceiling later does not disqualify stock already issued; it only stops new QSBS from being created.
- Shareholder is not a corporation. Individuals, trusts, and estates qualify; pass-through entities can hold QSBS and pass the exclusion through to their owners who held interests when the stock was acquired.
What has to stay true afterward?
Active business requirement. During substantially all of the holding period, at least 80% of the corporation's assets (by value) must be used in the active conduct of a qualified trade or business — which excludes, under Section 1202(e)(3), businesses whose principal asset is the reputation or skill of employees (law, accounting, consulting, health, financial services), plus banking, insurance, farming, extraction, and hospitality. Most technology, manufacturing, and product companies qualify; services firms mostly do not, and the line — heavily fact-dependent — is a recurring private-ruling topic. Working capital held for research or reasonably required needs counts as active-business assets, with limits after two years.
Redemption taint. Section 1202(c)(3) disqualifies stock if the corporation redeemed stock from the holder (or related persons) within two years either side of issuance, or made "significant" redemptions — more than 5% of aggregate stock value — from anyone within one year either side. Routine buybacks around a financing can quietly destroy the round's QSBS. De minimis exceptions and carve-outs for terminated employees exist in Treas. Reg. §1.1202-2 at eCFR Title 26, but redemptions near an issuance deserve counsel before, not after.
The two vintages: pre- and post-OBBBA stock
The regimes are best seen side by side (as of mid-2026 — the OBBBA changes are new, guidance is thin, and details such as indexing conventions should be verified against current IRS guidance before relying).
| Feature | Stock issued on or before July 4, 2025 | Stock issued after July 4, 2025 |
|---|---|---|
| Exclusion at 3 years | 0% | 50% |
| Exclusion at 4 years | 0% | 75% |
| Exclusion at 5+ years | 100% (for post-9/27/2010 stock) | 100% |
| Per-issuer dollar cap | $10 million | $15 million, inflation-indexed |
| Alternative cap | 10× basis | 10× basis |
| Gross asset ceiling at issuance | $50 million | $75 million, inflation-indexed |
| Non-excluded QSBS gain rate | 28% + NIIT | 28% + NIIT |
Older vintages linger: stock issued before February 18, 2009 carries a 50% exclusion, and 2009–September 27, 2010 stock 75%, with the non-excluded portion taxed at 28% and an AMT preference. For the partial tiers, the same 28%-rate treatment applies to the included portion — so the three-year 50% tier is real money but not half of a top capital gains bill; model it before celebrating.
Stacking, gifting, and Section 1045 rollovers
The per-issuer cap applies per taxpayer, which invites multiplication. QSBS transferred by gift or at death keeps its character and tacks the transferor's holding period under Section 1202(h) — so a founder can gift shares to non-grantor trusts for family members, each trust claiming its own cap. "Stacking" of this kind is aggressive in degree but grounded in the statute's text; multi-trust arrangements with no substance beyond cap replication draw scrutiny, and the OBBBA's larger cap reduces the need for heroics.
Section 1045 supplies the escape hatch for early exits: a shareholder who has held QSBS more than six months can roll the proceeds into replacement QSBS within 60 days, deferring the gain and tacking the holding period. A founder whose company sells in year two can preserve the clock by redeploying into the next venture — a 60-day window that closes fast in practice.
Two adjacent hazards. Convertible notes and SAFEs are not stock; the holding period and the gross asset test run from conversion, which can matter enormously when a company crosses the asset ceiling between the SAFE and the conversion. And option holders acquire QSBS at exercise, not grant — early exercise starts the clock and fixes the asset test at a smaller moment.
Why R&D-credit startups should track QSBS from day one
The population claiming the Section 41 payroll tax offset — C corporation startups under $5 million in gross receipts — is almost exactly the population issuing QSBS, and both benefits are proven with contemporaneous records assembled long before anyone asks. The research credit file documents wages and experimentation year by year; the QSBS file documents the entity's status and size at each issuance. Build them together. The checklist in our startup R&D credit checklist pairs naturally with a QSBS folder containing: certificate of incorporation and any conversion documents; a gross asset computation dated at each stock issuance (board-approved, ideally); the cap table with issuance dates and consideration; redemption history; and an annual memo on the active-business test.
The entity-choice implication runs the other direction too. Post-OBBBA, a research-heavy startup choosing between an LLC and a C corporation is weighing partnership flexibility against a package only the C corporation offers: Section 174A expensing, the 21% rate, investor-grade preferred stock, and QSBS. An LLC can incorporate later — pre-incorporation appreciation becomes basis (helpfully inflating the 10× cap) but is never excluded, and the clock starts at incorporation. The full trade-off is mapped in entity choice and tax credits and, from the S corporation side, in the S corporation complete guide — remembering that S corporation stock is categorically ineligible.
When QSBS does not work — and what the IRS challenges
The exclusion fails more often in diligence than in audit. Common defeats: the company was an LLC or S corporation when "founder stock" was issued; a disqualifying redemption within the taint windows; the gross asset test blown by a contributed-property fair value adjustment nobody computed; a services business that never met Section 1202(e)(3); or a holding period broken by hedging (Section 1202(j) suspends the exclusion for offsetting short positions). On exam, the IRS challenges qualified-trade-or-business characterization, valuation supporting the gross asset test, and stacking structures lacking substance. And QSBS is worthless in some hands: corporate venture investors get nothing (corporate holders are excluded), several states — California most prominently — do not conform, so state tax survives the federal exclusion, and a company that never exits above its owners' basis has spent diligence money on an exclusion of zero. The benefit costs little to preserve and everything to reconstruct; preserve it.
Frequently asked questions
- What is qualified small business stock under Section 1202?
- QSBS is stock in a domestic C corporation, acquired at original issuance for money, property, or services, where the corporation's aggregate gross assets did not exceed the statutory ceiling at issuance and the corporation runs an active qualified trade or business. Noncorporate shareholders who hold QSBS long enough can exclude some or all of the gain on sale — up to the greater of a fixed dollar cap or 10 times basis.
- How did the OBBBA change QSBS?
- For stock issued after the OBBBA's enactment on July 4, 2025, the law added a tiered exclusion — 50% at three years, 75% at four, 100% at five — raised the per-issuer exclusion cap from $10 million to $15 million (inflation-indexed), and raised the gross asset ceiling from $50 million to $75 million (indexed). Stock issued on or before enactment keeps the prior rules, including the five-year minimum and $10 million cap.
- Can S corporation or LLC owners claim the QSBS exclusion?
- Not on their current equity. Section 1202 requires C corporation stock at original issuance, and the issuer must be a C corporation for substantially all of the holding period. An LLC can incorporate and issue QSBS going forward — appreciation before incorporation is locked in as basis, not excluded — but S corporation stock never qualifies, and converting an S corporation cannot cure its already-outstanding shares.
- What is a Section 1045 rollover?
- Section 1045 lets a taxpayer who sells QSBS held more than six months defer gain by reinvesting the proceeds in new QSBS within 60 days. The holding periods tack, so a founder who sells early in an acquisition can preserve progress toward the exclusion. The election is made on the return for the sale year.
- Does claiming the R&D credit affect QSBS qualification?
- No — the two regimes are independent, and most venture-backed startups claiming the Section 41 credit are C corporations that can qualify for both. The connection is practical: the same early-stage recordkeeping that supports the payroll tax offset should include the QSBS file — incorporation documents, a gross asset test at each issuance, and stock records — because qualification is proven at issuance, years before the exit.