The Washington Founder's QSBS Playbook: How to Qualify, Document, and Defend Your §1202 Exclusion

Section 1202 can exclude some or all of the eligible gain on a qualifying stock sale. The result depends on the acquisition date, holding period, issuer eligibility and per-issuer gain limitation. Washington founders should document both the company-level requirements and their own stock history.

There are now effectively two §1202 regimes that founders need to track:

• Stock acquired on or before July 4, 2025 — generally a $10 million or 10× basis eligible-gain limit, subject to the statutory reductions. More than five years of holding is required. The 100% exclusion applies to stock acquired after September 27, 2010; earlier qualifying vintages generally receive 50% (acquired on or before February 17, 2009) or 75% (acquired February 18, 2009 through September 27, 2010). Stock issued on or before July 4, 2025 is subject to the $50 million gross-assets ceiling.
• Stock acquired after July 4, 2025 — generally a $15 million or 10× basis eligible-gain limit, subject to the statutory reductions; 50%, 75% and 100% exclusions after at least three, four and five years. The $75 million gross-assets ceiling applies to stock issued after July 4, 2025. Both dollar amounts are inflation-adjusted after 2026. Acquisition dates take statutory holding-period tacking into account, so issuance and acquisition dates are not interchangeable.

Most operating companies will eventually hold a mix. A founder who incorporated in 2022, raised a Series A in 2024, and a Series B in 2026 has both pre- and post-OBBBA stock outstanding, with two different sets of rules running in parallel.

That mixed reality is one of the reasons annual documentation matters more under OBBBA, not less.

Gain excluded federally under Section 1202 is also outside Washington’s capital gains tax. The amount excluded depends on the applicable percentage and eligible-gain limit; documentation alone does not establish eligibility or turn a partial exclusion into a full exclusion.

Most founders I work with arrive at the closing table with one of three problems: they're not sure they qualify, they can’t prove they qualify, or they did something years ago that quietly broke the exclusion. The IRS does not send reminders, and it will not give you the benefit of the doubt.

This is the playbook I wish every Washington founder had on day one — the eligibility rules for both regimes, the documentation discipline, the annual practice, and the specific traps that disqualify exclusions that should have worked.

If you do nothing else: bookmark this page, set a calendar reminder for the same week every year, and run the checklist at the end.

What §1202 actually does (plain English)

§1202 lets a non-corporate taxpayer exclude gain on the sale of qualified small business stock from federal income tax. There are now two parallel regimes:

The §1202(b)(1) cap applies to eligible gain before the exclusion percentage is applied. On a 50% tier with a $15 million applicable limit, the excluded amount is $7.5 million, not $15 million. The two dollar figures are also coordinated rather than independent: §1202(b)(4)(A) reduces the $10 million limit by eligible gain from the same issuer taken into account in prior years, and §1202(b)(4)(B) reduces the $15 million limit by that prior-year gain and by current-year eligible gain from stock acquired on or before July 4, 2025 — a single taxpayer does not get a $10 million allowance and a separate $15 million allowance against the same issuer.

Under Section 1202(d)(1), the issuer and its predecessors must remain within the applicable gross-assets ceiling at all times on or after August 10, 1993 before issuance, and the issuer must meet the ceiling immediately after issuance, including the proceeds. A prior breach of the applicable ceiling is not cured by reducing assets before a later issuance. Apply the statutory aggregation and contributed-property rules. Later growth does not by itself disqualify previously qualifying stock. Section 1202(a)(6) governs acquisition dates, including tacking.

Acquisition date drives the exclusion percentage. Under §1202(a), the general rules are:

• Acquired on or before February 17, 2009 — generally 50% after more than five years.
• Acquired February 18, 2009 through September 27, 2010 — generally 75% after more than five years.
• Acquired September 28, 2010 through July 4, 2025 — 100% after more than five years.
• Acquired after July 4, 2025 — 50% at three years, 75% at four years, and 100% at five years or more.

Each tier remains subject to the eligibility requirements and the per-issuer gain limitation. Determine the acquisition date under the applicable holding-period tacking rules — §1202(a)(6)(B) fixes it as the first day the stock was held by the taxpayer after applying section 1223. Keep that separate from the issuance-date rule that sets the gross-assets ceiling: issuance date decides whether the $50 million or $75 million ceiling applies, while acquisition date decides the exclusion percentage and the dollar limit. The two dates are not always the same share-by-share.

The stacking leverage. Because the cap is per-shareholder per-issuer, adding holders adds capacity. A family that gifts QSBS to eligible non-grantor trusts or to adult children can multiply the cap. Married couples are the unsettled case: whether spouses filing jointly have one dollar limitation or two is unresolved, and the argument for two is strongest where each spouse separately acquired qualifying stock at original issuance. This is one of the most underused planning levers in §1202 — and it depends entirely on having clean attestation documentation for each holder.

Why Washington founders care more than most. Washington has no broad personal income tax until January 1, 2028, and Washington capital gains that are excluded under §1202 are not subject to the Washington capital gains tax. The federal exclusion controls. That means a properly documented §1202 exclusion in Washington is worth materially more than the same exclusion in California (which does not conform to §1202 and still imposes ~13.3% on the gain).

The seven eligibility tests (in order of how often founders blow them)

The holding-period clock: issuance, transfers and redemptions

The holding period is the test that founders most often think they understand and most often get wrong in the details. Five anchor points:

1. Founder stock at incorporation. If the stock is vested when issued, the clock starts on the issuance date. If it is subject to a vesting schedule, it is §83 property, and under Treas. Reg. §1.83-4(a) the holding period begins just after the stock substantially vests — unless a timely §83(b) election is filed, in which case it begins just after the transfer. For restricted founder stock, the §83(b) election is what preserves the issuance date as the start of the §1202 clock.

2. Option exercises. The clock starts at exercise, not grant — but only if the shares received are vested. Shares from an early-exercised option that remain subject to a repurchase right are substantially nonvested §83 property, so the holding period does not begin until they vest unless a timely §83(b) election is filed. Early exercise starts the §1202 clock early only when that election is made; without it, the exercise date buys nothing.

3. LLC-to-C-corp conversion (where the LLC was taxed as a partnership). Clock starts at the date the C-corp issues stock in the conversion. Pre-conversion LLC time does not count. The basis you bring in does matter — and §1202(i)(1)(B) treats it as not less than the FMV of the property contributed at conversion, so an appreciated LLC sets a high floor for the 10× basis cap at exit. That floor applies only for §1202 purposes — it does not change your ordinary tax basis, and it does not make pre-contribution appreciation excludable.

4. §1045 rollover. A noncorporate taxpayer who sells QSBS held for more than six months may elect Section 1045 deferral by purchasing replacement QSBS 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. The applicable holding-period rules can tack the prior period onto the replacement stock. Section 1202(a)(6) takes tacking into account when determining the acquisition date for the pre- or post-July 4, 2025 regime; a later replacement purchase does not automatically obtain the new regime. Check all statutory requirements and the amount eligible for deferral.

5. Redemptions that taint the holding period. Certain corporate redemptions occurring within prescribed windows around the issuance can disqualify stock for §1202 purposes — even for shareholders who had nothing to do with the redemption. This is the silent killer of QSBS exclusions.

The termination-of-services exception is narrower than a general employee-buyback exemption. Under Treasury Regulation §1.1202-2(d)(1)(i), the seller must have acquired the stock in connection with services as an employee or director, and the repurchase must be incident to retirement or another bona fide termination of those services. A repurchase from a departing employee does not qualify merely because employment ended. Review other buybacks under the applicable redemption windows, thresholds and exceptions; a shareholder-to-shareholder secondary sale is not automatically a corporate redemption. Read the regulation.

This is exactly the kind of event that an annual review catches in the year it happens — when it can still be planned around — rather than at exit, when it is too late to fix.

The Active Business Test: the one most founders ignore

This is the test that breaks exclusions silently. The statute requires that during substantially all of the taxpayer's holding period for the stock, the corporation meets the active business requirements of §1202(e) and remains a C corporation.

Two words in that sentence do enormous work: substantially all. The statute does not require continuous compliance. It requires substantial compliance across the holding period. Short, isolated periods of non-qualification do not automatically destroy the exclusion — but persistent or extended periods do.

That ambiguity is exactly why the annual practice matters. "Substantially all" is a fact-pattern test. The founder who can produce five dated annual memos showing the company met the test each year is in a fundamentally stronger position than the founder reconstructing the analysis at exit and arguing about what "substantially" means under pressure.

The trap scenarios: a company that raises a large round and parks $40M in T-bills can drift out of compliance in a year where investment assets dominate the balance sheet. A company that pivots toward real estate or holding-company activities can drift out. A company whose subsidiary mix shifts toward passive holdings can drift out. None of these necessarily blow the exclusion — but each one creates a documentation question you need to answer in real time, not in hindsight.

What this means in practice: You run the test annually, document the result, and build a contemporaneous record. Not at exit. Annually. This is the foundation of the annual attestation practice — and the reason a one-time analysis at sale is not enough.

The Washington overlay

For Washington founders, the math on §1202 is even better than it looks on the federal side.

The headline: Washington capital gains that are excluded under §1202 are not subject to the Washington capital gains tax. The federal exclusion controls. If your gain qualifies for §1202, the state tax follows the federal treatment — you owe nothing at either level on the excluded portion. The same logic carries to Washington's new 9.9% income tax: because gain excluded under §1202 never enters your federal adjusted gross income, it never reaches Washington base income either — so it sits outside the 2028 income tax as well, not only the capital gains tax.

That is a meaningful planning fact. It means a Washington founder who properly documents §1202 eligibility can take a $10M exclusion and pay $0 in federal tax and $0 in state tax on the same gain. Compare that to a California founder, who pays 0% federal but still owes California's ~13.3% on the gain — California does not conform to §1202.

This is the single largest reason to take the annual attestation practice seriously if you live and work in Washington. The combined value of the exclusion is materially higher here than almost anywhere else in the country.

Further reading on the Washington overlay (linked posts coming — each is its own deep-dive):

• Washington founder domicile and the §1202 exit
• Timing a move out of Washington against a liquidity event
• ING / DING trust strategies for high-value §1202 exits
• B&O tax considerations for QSBS-issuing entities

How to defend the exclusion under audit

An examination can require evidence of both issuer and shareholder eligibility at the relevant times. Contemporaneous records help establish the facts, but do not guarantee an exclusion. Later reconstruction may support a claim when it rests on reliable evidence; its adequacy depends on the record.

The right documentation set, at minimum, includes:

• Formation documents and any conversion documents (if the company started as an LLC)
• Stock issuance records, with dates and basis for each share
• Historical gross-assets records for the issuer and its predecessors, plus immediately-after-issuance calculations
• Annual financials documenting the active business test calculation
• Records of any redemptions, including the parties, dates, amounts, and reason
• Any annual factual certifications and legal analyses, with the underlying supporting records

Annual letters can organize the evidence, but their number does not determine eligibility or how quickly diligence or an examination will conclude. Preserve the records supporting each statement and identify any gaps or assumptions.

The annual practice: maintain the evidence as facts change

Annual review is a useful recordkeeping practice. Also review material events when they occur; a year-end letter may not capture an intervening change in eligibility.

Here is what the annual practice looks like.

Every year, by the same date, you confirm:

1. The company still meets the active business test (run the 80% calculation)
2. No redemptions, recapitalizations, or transactions have occurred that could taint your holding period
3. Each new issuance satisfied the applicable historical gross-assets lookback and immediately-after-issuance test
4. Your trade or business has not drifted into a disqualified category
5. Each shareholder's holding period is documented and current

A dated review memo or factual certification should identify the stock and periods reviewed, supporting records, assumptions and unresolved issues. A legal opinion is a separate analysis; neither document substitutes for satisfaction of the statutory requirements.

Most founders never build this practice. They either don't know they need to, or they don't want to think about it until the exit is on the table. By then, fixing it is expensive — sometimes impossible.

We built a productized version of this practice for the Washington founders we serve. It runs on a fixed annual fee, includes the attestation letter and a planning call, and replaces the ad-hoc "call the lawyer in a panic" model with predictable, calendared discipline.

→ Learn about QSBS Sentinel™, our annual attestation service

The annual QSBS checklist

Print this. Tape it to your desk. Run it every year on the same date.

1. Confirm C-corp status — no conversion or change in entity classification
2. Confirm domestic-corporation status
3. Confirm the company has not engaged in a redemption that would taint stock under §1202(c)(3)
4. Run the active business (80%) test for the year — document the calculation
5. Confirm the trade or business has not drifted into a §1202(e)(3) excluded category
6. For each issuance, verify the applicable $50M or $75M gross-assets ceiling, with applicable indexing, throughout the statutory lookback for the issuer and its predecessors and immediately after issuance, including proceeds
7. Update the stock ledger with any new issuances and document basis
8. For each tranche, record the acquisition date after tacking, the resulting exclusion percentage, and the applicable per-issuer dollar limit
9. For any option exercises during the year, document the exercise date and basis
10. For any §1045 rollovers, document more than six months of holding, the election, the 60-day replacement period, amount realized, replacement cost and tacked holding period
11. Confirm cap-table holders' addresses (for state-residency planning)
12. Document any material events (financings, secondaries, recaps, pivots)
13. Issue or update the annual §1202 attestation letter for the company and for each significant shareholder

Frequently asked questions

Does Washington tax §1202-excluded gain? No. Washington capital gains that are excluded under §1202 are not subject to the Washington capital gains tax. The federal exclusion controls at the state level.

What if I converted from an LLC? If your LLC was taxed as a partnership, the §1202 holding period starts at the date the new C-corp issues stock to you in the conversion. Pre-conversion LLC membership time does not count toward the applicable Section 1202 holding period. The 10× cap does not run on your carryover basis. Under §1202(i)(1)(B), the basis of stock received for contributed property is — for §1202 purposes only — not less than the property's fair market value at the exchange, a floor that can sit well above your ordinary tax basis. Keep the two figures apart: ordinary basis determines your actual gain, the §1202 floor determines the 10× calculation. Incorporating an appreciated LLC does not make the appreciation that accrued before the contribution excludable; the floor measures §1202 gain from the contribution forward.

Can I claim §1202 if I bought my stock on a secondary? Generally no. §1202 requires that the stock be acquired at original issuance from the corporation. Secondary purchases do not qualify, with limited exceptions for gifts, inheritance, and certain partnership distributions.

Do options qualify for §1202? The underlying stock qualifies if it otherwise meets the requirements. The applicable holding-period clock starts at exercise date rather than grant. If the shares received are subject to vesting, they are §83 property, and the holding period does not begin until they substantially vest unless a timely §83(b) election is filed.

What happens if my company pivots? A pivot can affect the qualified trade or business test or the active business test, depending on what the company moves into. The "substantially all" standard gives some room, but persistent or extended periods of non-qualification put the exclusion at risk. This is exactly the kind of fact pattern that benefits from annual review.

Does §1045 rollover preserve my QSBS treatment? A noncorporate taxpayer who sells QSBS held for more than six months may elect Section 1045 deferral by purchasing replacement QSBS 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. The applicable holding-period rules can tack the prior period onto the replacement stock. Section 1202(a)(6) takes tacking into account when determining the acquisition date for the pre- or post-July 4, 2025 regime; a later replacement purchase does not automatically obtain the new regime. Check all statutory requirements and the amount eligible for deferral.

How do I stack the exclusion across family members? The §1202 cap is per-shareholder per-issuer, so stacking works by adding taxpayers — most often eligible non-grantor trusts and gifts to adult children. Spouses are different: Section 1202 does not say whether a joint return carries one dollar limitation or two, and the question is unresolved. A couple in which each spouse separately acquired qualifying post-July 4, 2025 stock at original issuance has a credible argument for as much as $30 million of combined dollar-limit exclusion, but that is a position rather than settled law; the competing reading is one shared $15 million limitation. Either way, the planning and documentation discipline required to make stacking work is non-trivial.

Can I claim QSBS if I moved out of Washington? Yes — §1202 is a federal provision and applies regardless of state of residency. State tax treatment depends on your state of residency at the time of sale. Domicile and timing are their own planning topics — covered in a follow-up post.

What's a §1202(h) recapitalization? §1202(h) addresses how stock acquired through certain conversions and recapitalizations is treated for §1202 purposes. Done correctly, the new stock can step into the shoes of the original QSBS. Done incorrectly, it can blow the exclusion.

What documents do I need at exit? Formation and conversion documents, stock issuance records, historical gross-assets records for the issuer and its predecessors, immediately-after-issuance calculations, active-business records, redemption records and any supporting factual certifications and legal analyses.

Joe Wallin is a Seattle-based startup attorney at Carney Badley Spellman. He has spent the bulk of his career representing founders, early-stage companies, and the investors who back them, with a particular focus on the equity, tax, and securities issues that determine what a founder actually keeps at exit. He writes The Startup Law Blog.

Nothing in this post is legal advice. Reading this post does not create an attorney-client relationship.