QSBS: excluding gain on qualified small business stock under Sections 1202 and 1045

How it works

If you buy stock directly from a qualifying C corporation (at original issue, for money, property or services) and hold it long enough, Section 1202 removes some or all of the gain from income when you sell (IRC 1202(a), (c)). The One Big Beautiful Bill Act, signed July 4, 2025, created a second set of rules for stock acquired after that date. Older stock keeps the old rules.

The cap is cumulative per company: prior years' excluded gain from that issuer reduces it (IRC 1202(b)). The dollar caps and the asset test are indexed for taxable years beginning after 2026.

The company tests

• C corporation, domestic, at issuance and during substantially all of your holding period.
• Gross assets (cash plus adjusted basis of other property, with contributed property counted at fair market value) not over the limit at all times before and immediately after the issuance (IRC 1202(d)).
• Active business: at least 80% of assets by value used in a qualified trade or business (IRC 1202(e)(1)).
• Excluded fields: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage, any business whose principal asset is the reputation or skill of its employees, banking, insurance, financing, leasing, investing, farming, oil, gas and mineral extraction, and hotels, motels and restaurants (IRC 1202(e)(3)).
• Converting an LLC or S corporation: stock received for property is treated as acquired on the exchange date with basis no lower than the property's fair market value (IRC 1202(i)). Only appreciation after the conversion can be excluded, and the clock starts at conversion.

Who it fits, and who it does not

Good fit: founders, early employees and angel investors in growth C corporations; owners who incorporated early and can sell stock, not assets; families that planned gifts of stock to children or nongrantor trusts before a sale.

Poor fit: owners of professional service firms, restaurants, hotels, farms and finance businesses; S corporations and LLCs, whose interests are not stock in a C corporation; sellers whose buyer insists on an asset purchase (the corporation then pays tax on the asset gain, and Section 1202 does not reach corporate-level gain); stock bought on the secondary market, which is not original issue.

Worked example

Assumptions (illustrative): married couple filing jointly in Texas, $200,000 of other income, 2026 federal tables used for every year. A founder bought stock at original issue in September 2025 for $500,000 (10 times basis is $5,000,000). The stock is sold in 2030, more than 5 years later, for a $20,000,000 gain. Taxes computed with the Big Sale Tax engine.

Federal tax includes income tax and the 3.8% net investment income tax; the gain above the cap is ordinary long-term capital gain. In 2030 the cap will be the indexed amount, slightly higher than $15,000,000. If the same stock were sold after 4 years instead, 75% of the eligible $15,000,000 ($11,250,000) would be excluded; the other 25% is "section 1202 gain" taxed at a maximum 28% federal rate (IRC 1(h)(4), (h)(7)), and the $5,000,000 above the cap is taxed as regular long-term gain.

Section 1045: rolling QSBS gain into new QSBS

If you have held QSBS for more than 6 months, you can elect to defer the gain by buying other QSBS within 60 days after the sale. Gain is recognized only to the extent the amount realized exceeds the cost of the new stock, the new stock's basis is reduced by the deferred gain, and its holding period includes the old stock's for most purposes (IRC 1045; IRC 1223(13)). This helps a founder who sells before the 3 or 5 year mark, or whose gain exceeds the cap, and who is ready to invest in another qualifying company. Finding qualifying stock inside 60 days is the practical limit.

Stacking the cap

The cap applies per taxpayer, per company. Stock given away keeps its QSBS status and holding period (IRC 1202(h)), so gifts to children or to separate nongrantor trusts before a sale can create additional caps. A married couple filing jointly generally shares one cap, and a grantor trust is the same taxpayer as its grantor. Multiple trusts with substantially the same grantor and beneficiaries, formed mainly to avoid tax, can be treated as one trust (IRC 643(f)). See QSBS stacking and gifting shares before a sale.

IRS stance and audit risk

Section 1202 is statutory and the IRS accepts it when the facts support it. Audits focus on proof: the corporation's gross assets at issuance, the 80% active business test throughout the holding period, whether the business falls in an excluded field, original issue, redemptions around the issuance date (which can disqualify stock under IRC 1202(c)(3)), and the basis used for the 10 times test. Keep the company's balance sheets, a QSBS representation from the company and the stock purchase records. Stock acquired after September 27, 2010 has no alternative minimum tax preference for the excluded gain (IRC 57(a)(7)). California does not allow the exclusion, so a California resident pays state tax on the full gain.

Costs and fees

The main costs are legal and accounting: a QSBS analysis or opinion, documentation of the asset and active business tests, and, for stacking, trust drafting and gift tax returns. Converting an existing LLC or S corporation to a C corporation has its own cost: entity-level tax on profits while you wait for the holding period, and the risk that a buyer wants assets instead of stock.

How it compares with a Section 453 installment sale

QSBS removes gain; an installment sale only spreads it. When the whole gain fits under the cap after 5 years, there is little left to defer. The two work together when gain exceeds the cap or the exclusion is partial: a stock sale on a seller note recognizes gain as payments arrive, the exclusion applies as the gain is recognized, and the cap is tracked across the years. Unlike Section 453, QSBS requires a C corporation stock sale, so an asset deal needs a different plan.

Frequently asked questions