Qualified Small Business Stock (Section 1202) Basics

Section 1202 of the Internal Revenue Code allows certain taxpayers to exclude part or all of the gain from the sale of qualified small business stock. It is one of the most valuable provisions available to founders and early investors of certain C corporations, but it also has strict requirements. Because legislation has recently changed some parameters, verify current rules before relying on any figure in this guide.

What the Provision Does

If the stock qualifies and the holding period is met, the taxpayer may exclude a percentage of the gain from federal income, up to a limit. Historically, the exclusion could be as high as 100 percent for stock acquired after certain dates, subject to a per-issuer cap based on a dollar amount or a multiple of basis. Recent legislation introduced tiered exclusions based on holding period for stock issued after a specified date in 2025, and raised the dollar cap and the corporate asset threshold. Details should be confirmed with an advisor.

Basic Eligibility Requirements

To qualify, the stock generally must meet these conditions:

• C corporation. The issuing company must be a domestic C corporation. S corporations and LLCs taxed as partnerships do not qualify unless they are converted, and the timing of conversion has consequences.
• Original issuance. The stock must be acquired at its original issuance, generally in exchange for money, property, or services, not purchased from another shareholder.
• Active business. During substantially all of the holding period, at least 80 percent of the company's assets, by value, must be used in the active conduct of one or more qualified trades or businesses.
• Excluded businesses. Certain fields are excluded, including many professional services, banking, insurance, farming, mining, and hotels and restaurants.
• Asset test. The company's aggregate gross assets must not exceed a specified amount at the time of issuance and immediately after.
• Holding period. The stock must be held for a minimum period, and recent legislation established shorter periods with lower exclusion percentages for stock issued after a certain date.

Planning Points for Founders

Entity choice at formation matters. A founder who starts as an LLC taxed as a partnership and later converts to a C corporation may face questions about the value at conversion and the treatment of stock issued at that time. Founders sometimes plan to organize as a C corporation from the start when they expect to raise capital and qualify for QSBS treatment. This decision should weigh the other consequences of C corporation status.

Documentation is critical. Keep records of the date and manner of issuance, the company's gross assets at issuance, the nature of the business, and any redemptions of stock. Redemptions can taint stock issued around the same time. The company can help by maintaining a QSBS file and periodically confirming eligibility.

Gifts, Trusts, and Multiple Owners

The per-taxpayer limit can apply separately to each taxpayer, so owners sometimes consider gifting shares to family members or trusts before a sale to multiply the exclusion. These arrangements have technical requirements and can carry gift tax, income tax, and anti-abuse considerations. They should be planned with legal counsel.

Rollovers and State Taxes

If a taxpayer sells QSBS and reinvests within a limited period into other qualified stock, gain deferral may be available under a separate rollover provision. States may not follow the federal exclusion, so the state tax result can differ. Some states tax the gain fully.

A Hypothetical Illustration

Suppose a founder forms a C corporation, receives shares at formation, and the company operates an eligible technology business with modest assets. After a holding period that satisfies the rules, the company is sold. The founder's advisor analyzes whether the shares qualify, computes the exclusion using the applicable limit, and identifies the state consequences. The example is hypothetical and does not imply that any particular business would qualify.

Common Pitfalls

• Assuming stock qualifies without checking the excluded business list.
• Missing the asset test at issuance.
• Buying stock from another shareholder and assuming it qualifies.
• Redemptions that disqualify stock.
• Converting entity form without valuing the impact.

Questions to Ask

1. Does my business fall within a qualified trade or business?
2. What are the corporation's gross assets today and at issuance?
3. How long have shares been held?
4. Are there planning steps, such as gifting, worth considering?
5. What state tax effects apply?

Related reading: C Corporation Tax Strategy for Owners.

Keep a QSBS File from Day One

Set up a file for stock issuance that includes the board approval, the stock ledger, the subscription agreement, a snapshot of the balance sheet at issuance to support the asset test, a description of the business, and any correspondence about eligibility. Update it after any financing round, redemption, or restructuring. Investors and acquirers frequently ask for this information during diligence, and a ready file can make a sale run more smoothly.

Get Legal Advice Early

Because QSBS depends on corporate law, tax law, and facts about the business, coordinate with corporate counsel when issuing shares or changing the capital structure.

Educational purposes only. This page is general education and is not tax, legal, or accounting advice. Tax laws change and outcomes depend on individual facts, so consult a qualified professional before acting. No result is guaranteed.