QSBS & Section 1202: The Complete Founder's Guide

Summary

QSBS can let eligible shareholders exclude some or all federal gain on a qualifying stock sale. Acquisition date (after applicable holding-period tacking) sets the tier and dollar-cap regime; issuance date sets the gross-assets ceiling.

Qualified small business stock (QSBS) can let an eligible shareholder exclude some or all federal gain on a qualifying stock sale under Section 1202. The result depends on the company, how and when the shares were acquired, the holding period, and the shareholder’s available gain limit.

Keep two dates separate from the start: the acquisition date, after applicable §1223 holding-period tacking, sets the tiered-exclusion and dollar-cap regime; the issuance date sets the applicable $50 million / $75 million gross-assets ceiling. Section 1202 applies to shareholder gain; it does not exempt the corporation’s operating income or automatically shelter a corporate asset sale.

Acquisition Dates and Holding Periods

The July 4, 2025 law created earlier partial exclusions for newly acquired QSBS. Older stock keeps its existing rules. Determine the acquisition date after applicable holding-period tacking; a new certificate or exchange does not automatically put shares into the newer regime.

Holding period and percentage of eligible gain excluded
Stock acquired	Required holding period	Exclusion percentage
September 28, 2010–July 4, 2025	More than 5 years	100%
After July 4, 2025	At least 3 but less than 4 years	50%
After July 4, 2025	At least 4 but less than 5 years	75%
After July 4, 2025	At least 5 years	100%

Stock acquired before September 28, 2010 generally falls under older 50% or 75% regimes, with special historical rules. Stock acquired on or before July 4, 2025 does not receive the new three- and four-year tiers.

As noted above, acquisition timing (after applicable tacking) and issuance timing answer different Section 1202 questions. The 2025 law changed both. The table above addresses holding-period tiers; the gross-assets ceiling still follows issuance timing even when the tier and dollar-cap regime follow acquisition timing. See the 2025 QSBS changes for additional detail.

Reaching the next holding-period tier can increase the exclusion. Compare the incremental tax savings with the risk of a lower sale price, your liquidity needs, and the possibility of losing the buyer. A larger exclusion does not by itself justify postponing a sale.

Calculating the Available Exclusion

First determine the qualifying gain, then apply the per-issuer gain limit, then apply the exclusion percentage. The gain limit is the larger of:

The remaining dollar limit: generally $10 million for acquisitions on or before July 4, 2025, or $15 million for later acquisitions, with indexing of the $15 million amount after 2026. Reduce the applicable limit for prior eligible gain and apply the coordination rules for older and newer stock, including same-year sales. These are not additive allowances.
The 10× basis alternative: ten times the aggregate adjusted basis of that issuer’s QSBS disposed of by the taxpayer during the year, disregarding additions to basis after original issuance.

For example, assume an investor sells qualifying shares with $2 million of basis for the 10× calculation and realizes at least $20 million of eligible gain. That alternative permits $20 million of eligible gain. At the 50% holding-period tier, the exclusion is $10 million. The eligible-gain limit and the amount actually excluded are different numbers. For a worked example of the 10× basis limitation at the post–July 4, 2025 gross-assets ceiling, see the $750 million boundary illustration.

At the 50% and 75% tiers, the nonexcluded portion may face a maximum 28% Section 1202 gain rate and, if applicable, 3.8% net investment income tax. Gain above the available limit remains taxable even at the 100% tier.

The limits apply per issuer and per taxpayer, with special rules for married individuals. Section 1202(b)(3) halves the dollar limit for married separate returns and allocates gain on a joint return equally between spouses for subsequent years. Whether spouses filing jointly can each claim a full dollar limit on separately owned qualifying shares is disputed. Do not assume a joint return doubles the limit. See Can Both Spouses Claim the QSBS Exclusion?

Company Requirements

C Corporation Status and Entity Choice

The issuer must be a domestic C corporation when the stock is issued and remain a C corporation during substantially all of the shareholder’s holding period. Federal tax classification matters: an interest in an LLC taxed as a partnership or disregarded entity is not qualifying stock of that LLC. An LLC electing C corporation taxation requires a different analysis.

Stock issued while an S election is effective does not become QSBS merely because the election ends. An LLC membership interest itself is not QSBS. A partnership or disregarded LLC may incorporate or elect corporate taxation, and the C-corporation stock received in that incorporation can potentially satisfy the original-issuance requirement if the other Section 1202 tests are met. Section 1202(i) applies special basis and acquisition rules to contributed property; pre-incorporation appreciation is not transformed into excludable QSBS gain merely by incorporating. Prior ownership of the business’s assets does not supply the QSBS holding period. See Treas. Reg. §301.7701-3 and §1202(i).

A charter-only conversion of an existing C corporation into a Delaware public benefit corporation does not itself change federal tax classification or restart the stock holding period. Public-benefit status alone does not establish QSBS eligibility.

When choosing an entity, compare the potential exclusion with corporate and distribution taxes, the likely sale structure, and the business’s operating needs. See C corporations and QSBS eligibility.

Gross Assets at Issuance

The threshold is $50 million for stock issued on or before July 4, 2025, and $75 million for later issuances, with indexing of the latter amount after 2026. The company and its predecessors must not have exceeded the applicable threshold at any time on or after August 10, 1993, and before issuance. Gross assets immediately after issuance must also remain within the threshold. Include issuance proceeds and apply the required controlled-group aggregation rules.

Gross assets generally mean cash plus the adjusted tax basis of other property. Contributed property is measured using fair market value at contribution for this test. A financing valuation is a different measure. Preserve the historical calculations supporting each issuance. See §1202(d).

Active Business and Asset Use

During substantially all of the holding period, at least 80% of the company’s assets, by value, generally must be used in one or more qualified active businesses. Apply the subsidiary look-through rules and special rules for startup activities, research, and working capital.

Cash is not automatically disqualifying. After the corporation has existed for at least two years, however, no more than 50% of its assets can qualify through the working-capital rule. Separate limits on portfolio stock and nonbusiness real estate also apply; passing the 80% test alone is insufficient. See §1202(e).

Excluded Businesses

Section 1202 excludes these trades or businesses:

Services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage; also a business whose principal asset is the reputation or skill of one or more employees.
Banking, insurance, financing, leasing, investing, or similar businesses.
Farming, including raising or harvesting trees.
Production or extraction businesses involving products eligible for specified depletion deductions.
Hotels, motels, restaurants, or similar businesses.

An excluded business line does not automatically disqualify an entire corporation with mixed activities. Determine which activities qualify, then whether at least 80% of the company’s asset value is devoted to qualified businesses.

Software Companies With Consulting or Engineering Services

For a software and services business, examine three separate questions: whether its activities fall in an excluded field; whether employee reputation or skill is the business’s principal asset; and whether it passes the 80% asset-value test. Revenue percentages, job titles, and invoice labels do not resolve those questions.

PLR 202319013 found that a cloud-services company’s principal asset was its proprietary processes and methodology packages. The IRS expressly declined to decide the consulting exclusion or the 80% test.
PLR 202144026 addressed medical software used as a tool by healthcare providers; the software company itself did not diagnose or treat patients.
PLR 202342013 concerned data-migration and management services. Advice was ancillary to implementation work and not separately billed. The ruling does not create an invoice-bundling safe harbor.

Review the actual services, contracts, work product, and asset use throughout the relevant period. These rulings are fact-specific and cannot be used or cited as precedent by other taxpayers under §6110(k)(3). Software or intellectual property does not automatically establish qualification.

Shareholder and Stock Requirements

The exclusion is available to eligible noncorporate taxpayers. The shareholder generally must acquire the stock at original issuance, directly or through an underwriter, for money, property other than stock, or qualifying services to the issuer. An ordinary secondary purchase does not qualify. Sections 1202(f) and (h) provide specified conversion and transfer exceptions.

For stock held through a qualifying pass-through entity, §1202(g) generally requires the owner to hold an interest when the entity acquires the stock and continuously through its sale. The benefit is limited by the owner’s interest when the stock was acquired.

Can a founder claim QSBS on a secondary sale?

Yes, potentially. A founder who acquired qualifying shares at original issuance may claim the Section 1202 exclusion when selling those shares to another investor, if the applicable holding period and other requirements are satisfied. “Secondary sale” describes the transaction; it does not automatically disqualify the seller’s gain.

The buyer has a different question. An ordinary purchase from an existing shareholder generally fails the original-issuance requirement. The buyer does not inherit QSBS treatment simply because the seller’s shares qualified. Specified gifts, transfers at death, and other statutory exceptions require separate analysis. See Section 1202(c), (f), and (h).

Founder sells original-issue shares to an investor: Review seller eligibility, holding period, basis, gain, and the available per-issuer limit.
Investor buys existing shares from a founder: An ordinary secondary acquisition generally does not qualify the buyer.
Investor buys newly issued shares from the company: Test the new issuance independently, including the gross-assets requirement.
Company repurchases shares: Review the transaction and redemption rules separately.

Before a partial sale, identify the exact lots being sold and retain records for the remaining shares. Use the QSBS eligibility checklist to organize the review.

Founders and Investors

Founder shares acquired for a nominal price and an investor’s original-issue shares can both qualify. For a low-basis founder, the dollar-limit branch will usually exceed the 10× basis alternative. Neither a low purchase price nor a large investment guarantees an exclusion: the company, shares, holding period, actual gain, and available limit all matter.

Employees and Contractors

Stock received for qualifying services, including shares acquired by exercising an option, can qualify. An option grant itself does not start the QSBS holding period. Exercise into vested shares generally starts the stock holding period; unvested shares require a separate Section 83 analysis, including any timely, effective 83(b) election. ISO early exercises require separate review. See Treas. Reg. §1.83-4(a) and the equity compensation guide.

Redemptions and Repurchases

Review company repurchases around the issuance date. Section 1202’s redemption rules can disqualify shares even when the repurchase involves a different shareholder. The relevant windows, thresholds, related-person rules, and exceptions require review before a buyback.

Conversions and Exchanges

Same-corporation conversions under §1202(f) and qualifying Section 351 or 368 transactions under §1202(h)(4) can preserve QSBS treatment, subject to their conditions and potential built-in-gain limits. They generally preserve the original acquisition date.

Do not assume that a recapitalization, exchange, reorganization, or replacement issuance can move existing QSBS into the newer regime. Sections 1202(h), 1223, and the rules governing the particular transaction can preserve or affect acquisition dates and holding periods. Analyze the transaction rather than treating newly issued paper as a reset. An exchange outside the statutory exceptions may also fail the original-issuance requirement.

Section 1045 Rollovers

When a sale does not qualify for a full Section 1202 exclusion, Section 1045 may defer gain through investment in replacement QSBS. It has no dollar cap on deferred gain, but the amount reinvested and the statutory conditions limit the benefit.

Rollover Requirements

A noncorporate taxpayer must elect treatment for qualifying stock actually held for more than six months. Holding-period tacking does not satisfy that initial test.
Purchase qualifying replacement stock during the 60-day period beginning on the sale date. Full deferral generally requires replacement-stock cost at least equal to the amount realized, not merely the gain. Deferred gain reduces replacement-stock basis.
For the rollover, the replacement issuer must satisfy the C corporation and active-business requirements during substantially all of the first six months of the taxpayer’s replacement-stock holding period.

A later Section 1202 exclusion separately requires company compliance during substantially all of the replacement-stock holding period. Under §1223(13), the old issuer’s holding period does not tack for that active-business test.

The original holding period generally does tack for the shareholder’s exclusion holding period and acquisition-date regime. A rollover therefore does not automatically move older stock into the post-July 4, 2025 rules. Compare the available exclusion, reinvestment amount, and replacement-investment risks, including for a sale after three years. See the Section 1045 rollover guide.

Gifts, Trusts, and Estates

Start by identifying the taxpayer who will recognize the gain. A transfer can preserve QSBS treatment only if the applicable rules and the recipient’s circumstances support it.

Grantor Trusts

For the portion treated as owned by the grantor for income tax purposes, the grantor reports the gain and claims any available exclusion. Moving shares into that portion of a grantor trust generally does not create a new taxpayer, an additional exclusion, or a new holding period. Confirm the trust’s tax treatment and the transaction’s terms.

Non-Grantor Trusts

A non-grantor trust is generally a separate taxpayer. Whether it can use a separate §1202 limitation depends on whether it recognizes qualifying gain, meets the stock and transfer rules, and survives aggregation and anti-abuse analysis (including §643(f)). Creating a trust does not automatically create a separate $15 million exclusion, and unused trust capacity does not shelter the grantor’s gain. Multiple beneficiaries of one trust do not automatically produce multiple exclusions.

Gifting QSBS

A qualifying gift generally preserves the donor’s acquisition manner and holding period under §1202(h), with carryover basis. The recipient must satisfy the applicable exclusion requirements.

For multiple trusts, analyze Section 643(f) and its regulations. Certain trusts with substantially the same grantors and primary beneficiaries, and a principal federal income-tax-avoidance purpose, are aggregated for subchapter J purposes. Review the implications for the proposed QSBS structure; separate trust documents alone do not establish separate exclusions.

Estates and Inherited QSBS

A transfer at death can preserve QSBS acquisition manner and the decedent’s holding period under §1202(h)(1)–(2). Whether a Section 1014 date-of-death basis adjustment enlarges the 10× basis limit is unsettled. Section 1202 generally disregards basis additions after original issuance, and practitioners disagree about the interaction. Do not assume an inherited-basis adjustment increases that limit.

Compare lifetime gifts with retention until death, including their different exclusion and basis consequences. For rules, examples, and limits on QSBS stacking, gifts and trusts, see the informational guide. For attorney-led structuring and coordination with estate planning counsel, see QSBS Trust Stacking Planning.

State Taxes

The federal exclusion does not settle the state tax result. State treatment depends on the sale year and sometimes the stock’s acquisition date. Residency, source, and the taxpayer recognizing the gain also matter.

As of September 2026, examples include:

California does not allow the federal Section 1202 exclusion or Section 1045 deferral.
New Jersey allows the exclusion for tax years beginning on or after January 1, 2026.
Oregon requires an addback for tax years beginning on or after January 1, 2026.
Illinois requires an addback for tax years ending on or after December 31, 2026.

These examples are not a complete survey. Use the state-by-state conformity guide for dated rules and primary sources.

Washington founders should review the separate Washington capital gains tax and new income tax discussions when modeling an exit. The Washington tax calculator, state tax resource page, and Washington income tax guide ($49.99) provide further resources.

Records and Attestation Letters

There is no formal IRS process for certifying stock as QSBS and no Section 1202 form to file at issuance. Qualification depends on the facts at the dates the statute tests, and the taxpayer bears the burden of proof. Preserve:

Issuance, payment, transfer, and ownership records identifying the shares, acquisition dates, basis, and holding periods.
Historical gross-assets calculations, including issuance proceeds, contributed property, predecessors, and required aggregation.
Evidence of C corporation status, business activities, and asset use throughout the relevant holding period.
Repurchase and restructuring records, prior exclusions for the issuer, and the shareholder or trust facts affecting the claim.

In Ju v. United States, No. 22-1815T (Fed. Cl. Mar. 18, 2024), the court rejected QSBS treatment for one block of shares because of original-issuance and holding-period problems. For another block, ownership timing and the issuance-date gross-assets test remained unresolved, and the court denied both sides summary judgment. The lesson is to preserve records for the dates the statute actually tests.

An attestation letter can organize a substantiation file for the shareholder’s tax preparer and the IRS. Identify the shares and tested dates, separate company facts from shareholder questions, and state assumptions, missing records, and unresolved issues. A letter cannot establish eligibility by itself or replace the underlying evidence.

Section 1202 does not prescribe an attestation-letter form or require an annual letter. Reviewing the file annually and after material events is a practice recommendation. See what a QSBS attestation letter should address.

Use the QSBS records worksheet to organize each stock lot, supporting documents, and unresolved questions before a professional review.

Need Help With QSBS Planning?

The QSBS Issue-Spotting Review is a fixed-fee engagement to identify qualification issues before a sale, financing, restructuring, or major planning decision. For a substantiation file and signed analysis, see QSBS attestation services or book an attestation intake.

For broader questions beyond QSBS, see Seattle startup counsel. For other questions, book a 20-minute introductory call. Share only party names and a brief, non-confidential description until a conflicts check is complete and a written engagement agreement is signed.

QSBS eligibility checklist
Startup Law Tools — calculators and planning tools
Services — engagements for founders and investors

Disclaimer: This guide is provided for informational purposes only and does not constitute legal or tax advice. Section 1202 is complex and fact-specific — always consult with a qualified attorney or tax advisor regarding your particular situation. Joe Wallin is a corporate and tax attorney at Carney Badley Spellman, P.S. in Seattle, Washington.