Section 1202 (QSBS Exclusion)

Internal Revenue Code Section 1202 provides an exclusion of up to 100% of capital gains on the sale of qualified small business stock (QSBS) held for at least 5 years. The exclusion is among the most powerful tax provisions for U.S. startups and early-stage investors, properly structured QSBS investments can generate millions of dollars of tax-free gain on exit. Section 1202 has been amended multiple times to expand its scope, most recently with the One Big Beautiful Bill Act (OBBBA) reforms expanding asset thresholds and gain exclusion limits.

The exclusion percentages

Section 1202 exclusion percentage depends on stock acquisition date: (1) before Feb. 18, 2009, 50% exclusion; (2) Feb. 18, 2009 - Sept. 27, 2010, 75% exclusion; (3) after Sept. 27, 2010 and on or before July 4, 2025, 100% exclusion after more than five years; (4) after July 4, 2025, 50% after 3 years, 75% after 4 years and 100% after 5 years. The 100% exclusion makes post-2010 QSBS particularly valuable, qualifying gain is entirely excluded from federal income tax (with parallel exclusion from federal Net Investment Income Tax and AMT for 100% category). Pre-2010 stock has reduced exclusions and partial AMT preference treatment.

The dollar cap, $10M or $15M, or 10x basis

The maximum gain excludable per issuer per taxpayer is the greater of: (1) $15 million for stock acquired after July 4, 2025 (indexed for inflation after 2026), or $10 million for stock acquired on or before that date, in each case reduced by gain excluded for that issuer in earlier years; (2) 10x adjusted basis of the stock sold in the year. Example, for stock acquired on or before July 4, 2025: investor purchases QSBS for $200K; can exclude up to $10M gain (the greater amount); for $500K basis, can exclude up to $10M (still); for $2M basis, can exclude up to $20M (10x); for $5M basis, can exclude up to $50M (10x). Higher-basis investors benefit substantially from the 10x multiplier. Multiple QSBS investments in different issuers each have their own $10M/10x cap, the cap is per-issuer.

Qualified small business, asset test

Section 1202(d) requires the issuer to be a "qualified small business", historically defined as C corporation with aggregate gross assets of $50 million or less at all times from August 10, 1993 until the issuance and immediately after the issuance. The 2025 OBBBA reforms increased the asset threshold to $75 million for stock issued after the effective date, expanding QSBS eligibility for slightly larger companies. The asset test is at issuance, not at sale; companies that grow substantially after QSBS issuance retain QSBS qualification.

Active business requirement

The issuer must conduct a "qualified trade or business", generally any business EXCEPT: (1) professional services, health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage, or any business whose principal asset is the reputation or skill of one or more employees; (2) banking, insurance, financing, leasing, investing; (3) farming; (4) extraction of natural resources, oil, gas, mining; (5) hotels, restaurants, similar businesses. Most technology companies, manufacturers, retailers, and many service businesses qualify. The exclusions reflect Congressional judgment about which industries deserve QSBS preferential treatment.

Original issuance requirement

QSBS must be acquired by the taxpayer at original issuance, not from a prior holder. Acquisition methods: (1) direct from issuer, most common; (2) tax-free exchanges, typically from another QSBS issuer in §351 or §368 transactions; (3) gift, recipient inherits original issuance status; (4) death, heir inherits original issuance status. Secondary purchases of QSBS (from a prior holder) do NOT qualify, buyer's gain is not QSBS-eligible. This requirement makes QSBS planning particularly important at financing rounds.

Holding period

Stock acquired on or before July 4, 2025 must be held for more than five years to qualify for any exclusion. Stock acquired after that date qualifies for a partial exclusion after 3 years and the full exclusion after 5. Sales before the minimum holding period: (1) regular capital gain, no QSBS exclusion; (2) §1045 rollover, sale plus reinvestment in new QSBS within 60 days defers gain and tacks holding period. The 5-year requirement aligns QSBS with long-term investment horizons. Holding period typically begins: SAFE, at conversion to stock; convertible note, generally at conversion, because stock received in exchange for property other than money or stock is treated as acquired on the date of the exchange; preferred stock, at issuance.

Section 1045 rollover

Section 1045 permits a taxpayer other than a corporation to defer gain on the sale of QSBS held more than 6 months if the proceeds are reinvested in other QSBS within 60 days. Mechanics: (1) sale of QSBS with gain; (2) reinvestment within 60 days in replacement QSBS; (3) gain deferred rather than recognized; (4) basis of the replacement QSBS reduced by the deferred gain; (5) holding period tacks from original investment.

Stack structures and family planning

Some QSBS planning seeks to use the per-issuer cap more than once within a family: (1) spouses, the statute halves the dollar cap for a married person filing separately and splits excluded gain equally between spouses on a joint return, and whether spouses who each hold stock get separate caps is not settled; (2) non-grantor trusts, a gift of QSBS keeps its status under § 1202(h) and each trust may claim its own cap, though the IRS can challenge trusts formed mainly to multiply the cap, including under the multiple-trust rule of § 643(f); (3) charitable planning, donations of QSBS to charity provide deductions and avoid recognition. Stack structures require careful tax planning but can substantially expand QSBS benefit.

Companion article: Selling Your Business