The qualified small business stock (QSBS) exclusion under Internal Revenue Code §1202 lets eligible shareholders exclude some or all of their gain on the sale of stock in a qualifying C corporation from federal income tax. For stock issued after July 4, 2025, the exclusion can reach 50% after three years, 75% after four, and 100% after five, up to the greater of $15 million or ten times basis per company. Stock issued earlier follows the prior rules, which generally require a five-year hold and cap the exclusion at the greater of $10 million or ten times basis.
Founders and early investors often learn about QSBS only when an acquisition offer arrives, and by then the facts that decide eligibility are years in the past. The time to plan is at formation and at each stock issuance. Here is how the exclusion works today.
What Changed in 2025
The 2025 budget reconciliation law commonly called the One Big Beautiful Bill Act, signed July 4, 2025, expanded §1202 for stock issued after that date:
- Tiered holding periods. 50% of eligible gain is excluded after three years, 75% after four years, and 100% after five years.
- Higher per-issuer cap. The cap rises from $10 million to $15 million (or ten times basis, if greater), with inflation adjustments scheduled to begin after 2026.
- Larger companies qualify. The gross asset limit rises from $50 million to $75 million, also indexed for inflation after 2026.
Stock issued on or before July 4, 2025 keeps the old rules. For stock acquired after September 27, 2010, that generally means a 100% exclusion after more than five years, with a $10 million or ten-times-basis cap. Older stock may qualify for only a 50% or 75% exclusion depending on when it was acquired.
When only part of the gain is excluded, the taxable portion is generally taxed at a 28% maximum federal rate rather than the usual 20% long-term capital gain rate, and the 3.8% net investment income tax may also apply. A partial exclusion is still valuable, but the math is closer than the headline percentage suggests.
The Core Requirements
To qualify, the stock and the company must meet several tests:
- C corporation. The issuer must be a domestic C corporation when the stock is issued and during substantially all of your holding period. S corporation stock does not qualify, and stock issued while a company was an S corporation does not become QSBS after a conversion. An LLC that has elected to be taxed as a corporation can generally qualify.
- Original issuance. You must acquire the stock directly from the company in exchange for money, property other than stock, or services. Stock bought from another shareholder does not qualify, although stock received by gift or inheritance can keep its status.
- Gross asset test. The company’s aggregate gross assets cannot exceed the applicable limit ($50 million, or $75 million for post-July 4, 2025 issuances) at any time before and immediately after the stock is issued. Later growth past the limit does not disqualify stock already issued.
- Active business test. During substantially all of your holding period, at least 80% of the company’s assets by value must be used in the active conduct of a qualified trade or business.
- Eligible holder. Individuals, trusts, and estates can claim the exclusion, including through certain pass-through entities. C corporation shareholders cannot.
Businesses That Do Not Qualify
Section 1202 excludes several categories of business, including:
- Services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services
- Any business whose principal asset is the reputation or skill of its employees
- Banking, insurance, financing, leasing, and investing
- Farming, certain oil, gas, and mining businesses, and hotels, motels, and restaurants
These lines are not always clear. Software, healthcare technology, and AI companies with consulting-like revenue should analyze classification carefully and document their reasoning.
How the Cap Works
The exclusion is measured per taxpayer, per issuing company. Each shareholder can exclude gain up to the greater of the dollar cap or ten times their adjusted basis in the stock sold during the year. Because the cap applies per taxpayer, some holders give shares to family members or non-grantor trusts so that more than one person can claim a cap. That planning can work, but it must be done carefully and well before a sale, and it draws IRS attention.
Common Pitfalls
- Redemptions. If the company repurchases stock from you or a related person, or makes significant repurchases from other shareholders, within certain windows around your issuance date, your stock can lose QSBS status. Founder buybacks and secondary-style repurchases are frequent culprits.
- Starting as an LLC or S corporation. Converting to a C corporation can work, but the holding period generally starts at conversion, and the value of contributed property at that time affects the cap and the asset test.
- Excess cash or investment assets. Holding too much in investments unrelated to working capital needs can jeopardize the active business test.
- Vesting founder stock. Restricted stock without a timely 83(b) election may be treated as acquired only when it vests, which can delay your holding period.
- Poor records. Buyers and tax preparers will ask for proof of gross assets at each issuance and of active business use.
Choosing the right entity at the outset matters. Our business formation team can help weigh a C corporation against other structures.
Section 1045 Rollovers
If you sell QSBS held for more than six months but before you qualify for the exclusion, §1045 lets you defer gain by reinvesting the proceeds in other QSBS within 60 days. The replacement stock generally inherits your holding period, which can let you keep working toward the exclusion.
California Does Not Conform
California does not follow §1202. A California resident who excludes gain federally generally owes California income tax on the full gain. Moving out of state before a sale is sometimes discussed, but residency rules are strict and should be planned with a tax advisor well in advance.
The Takeaway
The QSBS exclusion is one of the most valuable tax benefits available to startup founders and investors, and the 2025 changes made it more flexible for newly issued stock. The benefit depends on facts established early: entity type, issuance terms, asset levels, and the company’s activities. Plan at formation and protect eligibility through every financing and repurchase. For how QSBS plays out in a sale of the company, see our article on Section 1202 QSBS in an acquisition.
Frequently Asked Questions
How long do I need to hold QSBS to get the exclusion?
For stock issued after July 4, 2025, a partial exclusion is available after three years and the full exclusion after five years. For stock issued on or before July 4, 2025, you generally need to hold the stock for more than five years. Holding periods can carry over in certain gifts, conversions, and rollovers.
Does an S corporation or LLC qualify for QSBS?
S corporation stock does not qualify. An LLC taxed as a partnership does not issue QSBS, but it can convert to a C corporation, and stock issued after conversion may qualify. An LLC that elects to be taxed as a corporation can generally issue qualifying stock.
What is the maximum QSBS exclusion?
For stock issued after July 4, 2025, the cap is the greater of $15 million, indexed for inflation after 2026, or ten times your basis per company. For earlier stock, the cap is the greater of $10 million or ten times basis. The cap applies per taxpayer for each issuing company.
Does California recognize the QSBS exclusion?
No. California does not conform to §1202, so California residents generally pay state income tax on the full gain. The federal exclusion still applies.
How Sutter Law Can Help
We help founders and investors set up companies with QSBS in mind, document eligibility at each issuance, and review repurchases and financings that could affect the exclusion. We coordinate with your tax advisors on sale planning. Contact us for a free consultation.
This article is general information, not legal advice. Reading it does not create an attorney-client relationship.
