QSBS (qualified small business stock) lets a noncorporate shareholder exclude some or all of the gain on selling stock of a qualifying C corporation from federal income tax. For stock acquired after July 4, 2025, the exclusion is 50% after three years, 75% after four and 100% after five, capped per company at the greater of $15 million or 10 times basis. Stock acquired on or before that date keeps the older rules: a five-year hold and a $10 million or 10x cap.
The qualified small business stock exclusion sits in Section 1202 of the Internal Revenue Code, and the One Big Beautiful Bill Act (Public Law 119-21, signed July 4, 2025) rewrote large parts of it. This guide covers both sets of QSBS rules, the company tests, redemptions, the Section 1045 rollover, state conformity and a worked example.
The statute calls July 4, 2025 the "applicable date," and the column that applies depends on when the shareholder acquired the stock.
| Rule | Stock acquired on or before July 4, 2025 | Stock acquired after July 4, 2025 |
|---|---|---|
| Minimum holding period | More than 5 years | At least 3 years |
| Exclusion percentage | 100% if acquired after Sept 27, 2010 (75% for Feb 18, 2009 to Sept 27, 2010; 50% earlier) | 50% at 3 years, 75% at 4 years, 100% at 5 years or more |
| Per-issuer dollar cap | $10,000,000, less gain excluded in earlier years | $15,000,000, less gain excluded in earlier years and pre-July 2025 stock gain excluded this year |
| Alternative to dollar cap | 10 times aggregate adjusted basis of stock sold that year | Same |
| Gross asset test at issuance | $50,000,000 when the stock was issued | $75,000,000 |
| Inflation indexing | None | $15M cap and $75M asset test indexed for taxable years beginning after 2026 |
Two details in the new cap matter for founders who hold both old and new stock in the same company. The $15 million limit is reduced by any gain from that issuer already excluded in prior years, and also by gain from pre-July 2025 stock excluded in the current year. A founder cannot stack a full $10 million on old shares and a fresh $15 million on new shares from the same corporation.
The statute also includes a hard stop: if a shareholder's eligible gain in a year from post-July 2025 stock of one issuer exceeds the dollar limit, the limit for that issuer is zero in later years, regardless of later inflation increases. As of late October 2026 the IRS had not yet published the first indexed figures, which apply from 2027.
The per-issuer cap is the greater of the dollar limit or 10 times the aggregate adjusted basis of the QSBS of that corporation sold during the year. For the 10x test, basis ignores additions made after the stock was originally issued.
The 10x alternative is what makes property contributions valuable. Under Section 1202(i), when someone transfers property other than money or stock to a corporation for stock, the stock's basis for QSBS purposes is never less than the property's fair market value at the time of the exchange, and the holding period starts on that date. Founders who incorporate an existing business through a Section 351 transfer can therefore get a larger 10x cap, though gain that built up before the exchange is outside the exclusion.
Gain that is excluded never enters gross income. The IRS confirms in its net investment income tax Q&A that the 3.8% surtax "does not apply to any amount of gain that is excluded from gross income for regular income tax purposes," so excluded QSBS gain also escapes the 3.8% NIIT.
The portion left taxable by a 50% or 75% exclusion is treated differently from ordinary long-term gain. Section 1(h)(7) defines "section 1202 gain" as the gain that would have been excluded but for the percentage limit, minus the gain actually excluded, and that amount is 28% rate gain. The IRS's Topic 409 puts it plainly: "The taxable part of a gain from selling section 1202 qualified small business stock is taxed at a maximum 28% rate." Gain above the per-issuer cap is ordinary long-term capital gain at the usual 0%, 15% or 20% rates.
On the alternative minimum tax, the 7% preference in Section 57(a)(7) now reaches only stock acquired on or before September 27, 2010. Stock acquired after that date, including stock covered by the new tiered rules, carries no AMT preference for the excluded gain.
Section 1202 tests the corporation at issuance and throughout the holding period.
Domestic C corporation. The issuer must be a domestic C corporation when the stock is issued and during substantially all of the holding period. LLCs taxed as partnerships and S corporations cannot issue QSBS. Our C corp guide explains the double-tax tradeoff, and the LLC vs C corp comparison covers when converting makes sense.
Gross assets test. Aggregate gross assets must not exceed the limit ($75 million for post-July 2025 issuances) at all times before the issuance and immediately after it, counting the cash received in that issuance. Gross assets means cash plus the adjusted basis of other property, with contributed property counted at fair market value when contributed. Members of a more-than-50% parent-subsidiary group are treated as one corporation. A company that crosses the limit can still have earlier-issued QSBS outstanding, but new shares issued after that point do not qualify.
Original issuance. The shareholder must acquire the stock at original issue, directly or through an underwriter, for money, property other than stock, or as compensation for services. Shares bought from another shareholder on a secondary market do not qualify. Transfers by gift, at death, or certain distributions from a partnership carry over the transferor's status and holding period, which is why QSBS often features in gift tax planning on Form 709. Founders who receive restricted shares for services usually file an 83(b) election so that the stock is treated as issued at grant.
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 one or more qualified trades or businesses. Assets used in start-up activities and research count as active even before the company earns revenue.
Several limits catch cash-rich startups:
Section 1202(e)(3) excludes these trades or businesses from the definition of a qualified trade or business:
DISCs, regulated investment companies, REITs, REMICs and cooperatives are also ineligible corporations. In practice, software, manufacturing, consumer products and many technology-enabled companies tend to fit, while advisory and professional practices usually do not.
Stock buybacks around an issuance can taint the new shares even if the shareholder had nothing to do with them. Section 1202(c)(3) has two separate tests:
Check founder buybacks at a financing round and repurchases from departing employees against these windows before closing. Our guide to Section 302 stock redemptions covers how the selling shareholder is taxed, which is a separate question from whether other holders' QSBS survives.
Section 1045 helps a noncorporate holder who sells QSBS held more than six months but before the Section 1202 holding period is met. If the seller elects and buys replacement QSBS within the 60-day period beginning on the sale date, gain is recognized only to the extent the amount realized exceeds the cost of the replacement stock.
The deferred gain reduces the basis of the replacement stock, and the holding period of the old stock carries over for Section 1202 purposes. IRS Publication 550 explains that the replacement stock must continue to meet the active business requirement for at least the first six months after purchase, and that the election is made on Form 8949 by entering code "R" in column (f) with the postponed gain as a negative adjustment. The election is due by the return due date, including extensions. Section 1202 exclusions use code "Q" on the same form, as covered in our Schedule D and Form 8949 guide.
The federal exclusion does not automatically carry into state returns. California is the best-known holdout. The FTB's 2025 Schedule D (540) instructions state that "California does not conform to the qualified small business stock deferral and gain exclusion under IRC Sections 1045 and 1202," and direct taxpayers to enter the entire gain. A California resident with a fully excluded federal gain therefore still owes state tax on all of it.
Other states follow the federal exclusion, decouple from it, or conform to a fixed Code date that may predate the 2025 changes. Our article on coordinating federal and state tax strategies covers how conformity gaps show up in planning.
Both scenarios are illustrative and assume a single filer already in the top brackets, a 20% long-term capital gain rate, the 28% rate on section 1202 gain, and the 3.8% NIIT on any gain left in income. State tax and AMT are ignored.
Scenario A: stock acquired in 2019 (old rules). Maya bought founder shares at original issue for $200,000 and sells them in 2026 for $14,200,000.
Scenario B: stock acquired in September 2025 (new rules). Arjun invests $1,000,000 for shares at original issue and later sells for $9,000,000, a gain of $8,000,000. The cap is the greater of $15,000,000 (or the indexed figure) and $10,000,000, so the entire gain is eligible.
| Holding period at sale | Excluded | Section 1202 gain at 28% + 3.8% | Federal tax | Effective rate on $8M gain |
|---|---|---|---|---|
| 3 years | $4,000,000 | $4,000,000 x 31.8% | $1,272,000 | 15.9% |
| 4 years | $6,000,000 | $2,000,000 x 31.8% | $636,000 | 7.95% |
| 5 years | $8,000,000 | $0 | $0 | 0% |
| No QSBS | $0 | $8,000,000 x 23.8% | $1,904,000 | 23.8% |
The 3-year sale still saves $632,000 compared with no QSBS, but waiting from year three to year five saves another $1,272,000. Because the unexcluded portion is taxed at 28% rather than 20%, a partial exclusion is worth less than its percentage suggests.
Build the QSBS file at issuance:
Investors increasingly ask for this during diligence, which is one more reason to prepare startup finances for investor due diligence early. If the company fails and the stock becomes worthless, look at Section 1244 ordinary loss treatment instead.
What is QSBS and who can use the exclusion? QSBS is stock acquired at original issue from a domestic C corporation that met the gross asset test at issuance and the active business test during the holding period. Any taxpayer other than a corporation can claim the exclusion.
How long do I need to hold QSBS? For stock acquired after July 4, 2025, the exclusion starts at 50% after three years, rises to 75% after four and reaches 100% after five. For stock acquired on or before that date, you must hold for more than five years to get any exclusion.
Is the $15 million QSBS cap per person or per company? It applies per taxpayer, per issuing corporation, and it is reduced by gain already excluded from that company.
Does my LLC or S corporation qualify for QSBS? No. An LLC taxed as a partnership or disregarded entity, or an S corporation, cannot issue QSBS. After converting to a C corporation, the QSBS holding period generally starts at conversion, and gain built up before conversion stays outside the exclusion because the stock's basis is set at the fair market value of the contributed property.
Do I pay state tax on a QSBS sale? That depends on your state of residence. California does not conform to Sections 1202 or 1045 and taxes the full gain, while many other states follow the federal exclusion in whole or part.
What happens if I sell QSBS before three years? The Section 1202 exclusion is unavailable. If you held the stock more than six months, a Section 1045 election lets you defer the gain by buying replacement QSBS within 60 days.
Madras Accountancy supports founders, startups and US CPA firms with bookkeeping, tax preparation, cap table and asset-test records, and CFO and advisory work that keeps QSBS documentation ready for an exit. To discuss your situation, contact our team.
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