Section 1202 is available only to holders of C corporation stock. An LLC or S-corp can be converted later, but stock and units issued before C-corp status never qualify — and the holding-period clock doesn't start until conversion. If venture capital or a significant exit is on your roadmap, entity choice on day one is a Section 1202 decision, whether you make it deliberately or not.
For the full eligibility rules, see QSBS & Section 1202: The Complete Founder's Guide. This post covers one requirement — C corporation status — because it's the one you can't fix retroactively.
What C-Corp Status Is Worth
Run a founder's numbers. You incorporate, pay a nominal amount for founder stock, hold more than five years, and sell your stake in an acquisition for $16 million. Your gain is effectively $16 million.
Without §1202: federal long-term capital gains tax at 23.8% (20% rate plus the 3.8% net investment income tax) is about $3.8 million. You net roughly $12.2 million before state tax.
With §1202, stock issued on or before July 4, 2025: the exclusion is capped at the greater of $10 million or 10× basis. With nominal basis, the 10× prong is irrelevant — you exclude $10 million, pay 23.8% on the remaining $6 million (about $1.43 million), and net roughly $14.6 million. The exclusion is worth about $2.4 million in federal tax.
With §1202, stock issued after July 4, 2025: the cap is the greater of $15 million or 10× basis (indexed beginning in 2027). You exclude $15 million, pay 23.8% on $1 million, and keep about $3.6 million that would otherwise have gone to federal tax.
For an investor the 10× prong does the work: put $2 million into qualifying stock and the cap is $20 million of excluded gain, regardless of issuance date. Model your own numbers with the QSBS calculator.
None of this is available if the equity was issued by an LLC or S-corp.
Why Only C-Corporations Qualify
Section 1202(c)(1) requires stock in a C corporation acquired at original issuance, and §1202(c)(2)(A) requires the issuer to be a C corporation during substantially all of the taxpayer's holding period. Congress built the exclusion to push long-term capital into closely held C-corps; pass-through owners already avoid entity-level tax, so they were left out of the bargain.
What that means by entity:
- LLC (default or S-elected): units are not stock in a C corporation. No QSBS.
- S-corp: stock issued while an S election is in effect is not C corporation stock at issuance. Revoking the election later doesn't cure it — issuance is tested when the stock is issued, and a mid-hold S election can independently violate §1202(c)(2)(A).
- Partnership / sole proprietorship: no stock at all. No QSBS.
- C-corp: eligible, if the other tests are met — aggregate gross assets under $50 million at issuance ($75 million for post-July 4, 2025 issuances), active qualified trade or business, original issuance, holding period.
The LLC-to-C-Corp Conversion: What You Keep and What You Lose
Founders often start as LLCs for pass-through losses and simplicity. Converting to a C-corp (typically a §351 incorporation) does not taint the equity going forward: the shares issued at conversion are original-issuance C corporation stock and can qualify as QSBS from the conversion date.
Two costs come with the late start:
- The clock restarts. Convert in Year 3, and your holding period runs from Year 3 — for pre-OBBBA-style full exclusion, you're waiting until Year 8. The LLC years earn nothing under §1202.
- Pre-conversion appreciation is outside the exclusion. Gain that accrued in the LLC before conversion isn't §1202 gain. The partial offset: §1202(i)(1)(B) sets your basis at no less than the fair market value of the property you contributed, which shields the built-in gain from a second tax on sale — and a high FMV basis can dramatically expand your 10× cap.
There's also a gross-assets wrinkle cutting the other way: convert after the business has real value and you may be closer to the $50M/$75M ceiling than a day-one incorporation would have been.
The S-Corp Trap: Why Converting Later Doesn't Help
An S election is a tax classification, not an entity. Incorporate, file Form 2553, and you are a corporation taxed as a pass-through — but stock issued during the election period is not C corporation stock for §1202 purposes. Revoking the election prospectively doesn't retroactively qualify that stock, and because §1202(c)(2)(A) tests C-corp status over substantially all of the holding period, an S election at the wrong time can disqualify stock that started clean.
If QSBS matters to you, the rule is simple: C corporation status on the day of issuance, and no S election while you hold. How prior LLC or S-corp history gets handled in the paper trail is covered in the C-corp confirmation section of a QSBS attestation letter.
Common Founder Mistakes
Starting as an LLC, planning to "fix it later." The most common one. By the time institutional money forces the conversion, the value created inside the LLC is outside §1202 forever, and the holding period hasn't started. The conversion fixes the future, not the past.
Misjudging the holding period. For stock issued on or before July 4, 2025, the five-year cliff still applies — exit in Year 4 and the exclusion is zero. For stock issued after that date, OBBBA replaced the cliff with tiers: 50% exclusion at three years, 75% at four, 100% at five. Note also when the clock starts: for restricted stock, the holding period runs from vesting unless you filed an 83(b) election, in which case it runs from the transfer date. That filing deadline is 30 days and unforgiving.
Assuming your accountant is watching this. Early-stage CPAs are doing payroll and expensing, not §1202 planning. By the time an exit-stage advisor asks about QSBS, the entity decision is years old. Raise it yourself at formation.
Raising in an LLC or S-corp and converting under deal pressure. Most institutional investors require a C-corp anyway. If the conversion happens after years of operation, you get the split outcome above: pre-conversion value locked out, post-conversion shares on a fresh clock.
Timing: What Has to Be True, and When
- C-corp at issuance — the entity question this post is about.
- Original issuance (§1202(c)(1)(B)): acquired from the company for money, property (not stock), or services — not bought from another shareholder.
- Gross assets (§1202(d)): aggregate gross assets must not have exceeded $50 million at any time before or immediately after issuance — $75 million for stock issued after July 4, 2025 (indexed from 2027). Tested tranche by tranche: seed stock can qualify while Series C stock doesn't.
- Qualified trade or business (§1202(e)(3)): most operating companies qualify; excluded fields include health, law, consulting, financial services, banking, hospitality, and farming.
- Holding period (§1202(b), as amended): five years for full exclusion; 3/4/5-year tiers at 50/75/100% for post-July 4, 2025 stock.
When to Incorporate as a C-Corp vs. an LLC
Choose a C-corp from day one if you plan to raise institutional capital, expect a significant exit, want §1202 for yourself and your investors, or are issuing meaningful early equity to cofounders and employees. Choose an LLC if you're building a business that will distribute profits rather than exit, need early losses on your personal return, and are genuinely not on the venture path. For venture-track startups this is not a close call — the full analysis is on the entity selection page.
How OBBBA Changed the Numbers
For stock issued after July 4, 2025, the One Big Beautiful Bill Act raised the per-issuer cap from $10 million to $15 million and the gross-assets ceiling from $50 million to $75 million (both indexed beginning in 2027), and replaced the all-or-nothing five-year cliff with the 50/75/100% tiers at three, four, and five years. Stock issued on or before that date keeps the old numbers. The C-corp-only rule didn't move. Full analysis: OBBBA: A New Era for QSBS.
Practical Action Steps
Not yet incorporated: form a Delaware C-corp, issue founder stock immediately, and file 83(b) elections within 30 days so the holding period starts now. Note the QSBS intent in the records.
Already an LLC or S-corp with VC plans: convert before the round — your investors will require it anyway — and go in understanding what the conversion does: post-conversion shares can qualify from the conversion date; pre-conversion appreciation stays out; §1202(i)(1)(B) basis protects the built-in gain and feeds the 10× cap. Get the §351 mechanics and the valuation at conversion documented carefully.
Approaching an exit short of the holding period: for pre-OBBBA stock, 4.5 years is worth zero and 5 years may be worth millions — if the deal allows any flexibility on timing, model it before you sign. For post-OBBBA stock, know which tier you're in. And document the position while records are fresh — that's what a QSBS attestation letter is for.
The Bottom Line
Entity choice is a §1202 election you make by default. C corporation stock can carry an exclusion of $10–15 million or more per issuer; LLC units and S-corp stock carry none, and no later restructuring reaches back. If a venture raise or a sale is plausibly in your future, incorporate as a C-corp before the first share is issued.
Disclaimer: This article is for general informational purposes only and does not constitute legal or tax advice. Consult a qualified attorney or tax advisor about your specific situation.
