§1202 QSBS: 100% Capital Gains Exclusion for Startup Investors

100% Exclusion After 5 Years (50% at 3, 75% at 4 for stock acquired after July 4, 2025) • $10M ($15M post-July 4, 2025) / 10x Basis Cap • C-Corp Only • Active Business Test • §1045 Rollover
IRC §1202IRC §1045OBBBA P.L. 119-21
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Section 1202 provides one of the most powerful tax incentives in the Code: investors who hold qualified small business stock acquired after September 27, 2010 and on or before July 4, 2025 for more than five years, or stock acquired after July 4, 2025 for five years or more, may exclude 100% of their capital gain from federal income tax (stock acquired after July 4, 2025 and held at least three years qualifies for 50%, and at least four years for 75%), subject to a per-issuer limit of the greater of $10 million ($15 million for stock acquired after July 4, 2025) or 10 times the taxpayer's basis in the stock. For a founder or early investor in a successful startup, this exclusion can shelter millions of dollars of gain from federal tax entirely. But the requirements are strict - the company must be a C-corporation, it must meet an active business test that excludes many service businesses, and the stock must be acquired at original issuance directly from the company.

§1202 Core Requirements

C-corporation: The issuing company must be a domestic C-corporation at the time of issuance and during substantially all of the taxpayer's holding period. S-corporations, LLCs, and partnerships do not qualify. A company that converts from C-corp to another form after issuance may disqualify existing QSBS.

Gross assets test: The corporation's aggregate gross assets must not have exceeded $50 million (for stock issued on or before July 4, 2025) or $75 million (for stock issued after July 4, 2025) at any time before or immediately after the stock issuance. This is a facts-and-circumstances test that includes cash raised in the funding round that creates the QSBS.

Active business test: 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. Excluded businesses include: professional services in law, health, engineering, financial services, and consulting; banking and insurance; hotels and restaurants; and any business where the principal asset is the reputation or skill of its employees.

Original issuance: The stock must be acquired at original issuance directly from the corporation in exchange for money, property, or services. Secondary market purchases do not qualify.

Five-year holding period: For stock acquired on or before July 4, 2025, the stock must be held for more than five years. For stock acquired after July 4, 2025, a 50% exclusion applies after three years, 75% after four years, and 100% after five years. Gain recognized before the applicable holding period is taxable (subject to the §1045 rollover option).

The Exclusion: 100% After September 27, 2010

The exclusion percentage depends on when the stock was acquired. Stock acquired after September 27, 2010 qualifies for a 100% exclusion of eligible gain. Stock acquired between February 18, 2009 and September 27, 2010 qualifies for a 75% exclusion. Stock acquired before February 18, 2009 qualifies for a 50% exclusion under the original §1202 rules. For startup founders and investors acquiring stock today (after July 4, 2025), the 100% exclusion applies after a five-year holding period; the 50% (three-year) and 75% (four-year) tiers apply to shorter holds.

The per-issuer limit is the greater of $10 million or 10 times the taxpayer's adjusted basis. A founder who received QSBS with a $200,000 basis can exclude up to $10 million of gain (the $10 million dollar limit exceeds 10x basis of $2 million). An investor who paid $1.5 million for QSBS can exclude up to $15 million of gain (10x basis). The dollar limit ($10 million, or $15 million for stock acquired after July 4, 2025) is a floor that protects investors with low basis stock. Each taxpayer applies the limit separately - spouses each have their own limit if each holds QSBS directly, but a married individual filing a separate return is limited to $5 million ($7.5 million for stock acquired after July 4, 2025) under §1202(b)(3)(A). Trusts and entities holding QSBS have their own limits but complex pass-through rules apply.

State Tax Conformity: The California Problem

Federal §1202 exclusion does not guarantee state tax exclusion. California does not conform to §1202 and taxes QSBS gains at the full California income tax rate (up to 13.3%). A California-resident founder who excludes $20 million of federal QSBS gain pays zero federal tax but still owes California income tax on the full $20 million - potentially $2.66 million in California state tax. Other states that do not conform to §1202 include Pennsylvania and New Jersey. Planning for the state tax impact before a QSBS exit is essential for residents of non-conforming states.

§1045 Rollover: Preserving QSBS Status Before 5 Years

If QSBS is sold before the five-year holding period is complete, §1045 allows the taxpayer to roll the proceeds into new QSBS within 60 days and defer the gain. The new QSBS inherits the holding period of the old QSBS for purposes of the five-year test. An investor who holds QSBS for 3 years, sells, and reinvests in new QSBS under §1045 only needs to hold the new QSBS for 2 more years (not another full 5 years) to qualify for the 100% exclusion. The §1045 rollover is available only to non-corporate taxpayers and requires the reinvestment to be in QSBS of a different corporation.

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Authority: IRC §1202(a) (exclusion of gain from certain small business stock - 100% exclusion for stock acquired after September 27, 2010 and on or before July 4, 2025 held more than 5 years; for stock acquired after July 4, 2025, 50% at 3 years, 75% at 4 years and 100% at 5 years or more; 75% for stock acquired February 18, 2009 through September 27, 2010; 50% for earlier acquisitions); IRC §1202(b) (limitation on exclusion - per-issuer limit greater of $10 million ($15 million for stock acquired after July 4, 2025) or 10 times aggregate adjusted basis; applied separately per taxpayer); IRC §1202(c) (qualified small business stock requirements - C-corporation; domestic; active business test; original issuance for money property or services); IRC §1202(d) (qualified small business - aggregate gross assets not exceeding $50 million, or $75 million for stock issued after July 4, 2025); IRC §1202(e) (active business requirement - 80% of assets used in active conduct of qualified trade or business; excluded businesses include health law engineering financial services consulting banking insurance restaurants hotels); IRC §1045 (rollover of gain from qualified small business stock - deferral of gain when QSBS sold before 5 years; reinvestment in new QSBS within 60 days; holding period carries over; available to non-corporate taxpayers); OBBBA P.L. 119-21 (modifications to §1202 rules - verify current exclusion percentage and any changes to gross asset threshold or excluded business list under 2025 legislation); California Revenue and Taxation Code §18152.5 (California does not conform to §1202 federal QSBS exclusion - QSBS gains taxable in California at ordinary income rates up to 13.3%).