One of the largest tax planning opportunities in a business exit is the Section 1202 qualified small business stock exclusion.

Disclaimer

This content is educational and may not apply to your specific tax situation. QSBS rules are complex and depend on individual facts. Consider speaking with a qualified tax advisor before relying on this information.

If you're selling business stock or planning an exit, taxes are likely a major concern. A hefty capital gains tax bill can take a painful chunk out of your investment, and many shareholders only learn about these rules once the deal is already moving.

This blog post will expand on Section 1202 and the qualified small business stock exclusion (QSBS), but here’s what you should know right now about it: QSBS can reduce or even eliminate federal capital gains tax when you sell, if your stock qualifies.

One question we often hear is:

What are the requirements to qualify for the Section 1202 QSBS exclusion?

In most cases, you need all of the following:

• The company is a US C corporation
• You’re an eligible taxpayer (generally an individual, trust, or estate, not a C corporation)
• You received the stock directly from the company at original issuance
• The company meets the QSBS rules, including the gross assets limit (generally $50 million or less before and immediately after issuance)
• The business meets the active business requirement (including that it’s a qualified trade or business and not in an excluded industry)
• You meet the holding period requirement before you sell (generally more than 5 years)

In this post, you'll learn the QSBS rules that matter most, what can kill the exclusion, and what to confirm before you sign a deal.

The 3 Core Tests for QSBS Eligibility

Section 1202 can feel overwhelming at first. It has legal terms, timing rules, and several ways to get disqualified without realizing it.

But in real exit planning, QSBS eligibility usually comes down to a few core tests. Think of these as gates. If you miss one gate, the QSBS exclusion usually doesn't apply, even if everything else looks fine.

1) The Company Test: Is the Company a US C Corporation?

QSBS only applies to stock issued by a domestic US C corporation.

Section 1202 may apply when a company converts an LLC to a C corporation, issues equity to investors or employees, or begins preparing for a sale. If the company isn't a C corporation at the right time, QSBS usually stops right there.

Asset limit: Was the company under the gross assets ceiling when it issued the stock?

The company also must meet a gross assets limit when it issues the shares. This part matters because the IRS doesn't look at your company today. It looks at the company’s asset level at the time the stock was issued.

The limit depends on when the company issued your shares:

• Stock issued on or before July 4, 2025: The limit is generally $50 million
• Stock issued after July 4, 2025: The limit is now $75 million

If the company was over the limit when it issued your stock, your shares usually don't qualify as QSBS, even if the business later shrinks or restructures.

2) The Shareholder Test: Are You a Non-Corporate Taxpayer?

Section 1202 is designed for non-corporate taxpayers, not C corporations.

In most cases, this means the benefit applies when the stock is held by:

• An individual
• Certain trusts
• An estate
• A partnership or pass-through structure, as long as the gain flows through to eligible owners

This is an easy place to make a wrong assumption. You can have “good QSBS stock,” but still lose the exclusion if the shares are held in a way that doesn't qualify. That’s why ownership structure matters just as much as the company itself.

3) The Acquisition Test: Did You Receive the Stock Directly from the Company?

QSBS usually requires original issuance, which means the company issued the stock to you directly.

This matters because many people first learn about QSBS after a deal has started, then realize they bought shares from another shareholder rather than receiving them from the company. A secondary purchase can change the tax outcome.

A quick way to think about it:

• If the company issued the shares to you, that’s usually a good sign
• If you bought shares from another shareholder, you need to slow down and confirm whether QSBS rules still apply

4) The Clock Test: How Long Did You Hold the Stock?

Even if the company qualifies and you qualify as the shareholder, the holding period still matters.

For stock issued after July 4, 2025, the rules now follow a tiered schedule based on how long you hold the shares:

• 3 years: 50% exclusion
• 4 years: 75% exclusion
• 5 years: 100% exclusion

For stock issued on or before July 4, 2025, the traditional rule still applies. In most cases, you need a full 5-year holding period to qualify for the full exclusion.

This is why timing matters so much in exit planning. If you sell too early, you may still get some benefit under the new rules, but you may also leave a significant part of the exclusion on the table.

How Much Tax Can You Actually Save?

If you qualify for the Section 1202 qualified small business stock exclusion, the savings can be very large because it can wipe out federal tax on the gain you would normally pay when you sell.

For many shareholders, this is the difference between paying millions in federal taxes and paying little to nothing on the portion of the sale excluded from federal tax.

The New Cap for Newer QSBS Stock

For newer QSBS issuances (after July 4, 2025), the maximum gain you can exclude increased to $15 million, or 10 times your basis, whichever is greater.

So if your gain is above $15 million, the cap matters. If your gain is below $15 million, the cap usually doesn't limit you.

Why are the Savings More Than $3,000,000?

A lot of people stop at the 20% federal long-term capital gains rate:

$15,000,000 x 20% = $3,000,000

But many taxpayers also owe the 3.8% Net Investment Income Tax (NIIT) on top of that:

$15,000,000 x 3.8% = $570,000

That's how you get to the total:

$3,000,000 + $570,000 = $3,570,000

If your gain is fully excluded under QSBS, you're not just avoiding the 20% federal capital gains tax. You're also avoiding the 3.8% NIIT on that excluded gain.

Technical Nuances: SAFEs, Options, and Conversions

Once you have met the basic QSBS requirements, the next part becomes more personal.

You start asking questions such as:

• Does my equity count as QSBS stock yet?
• When did my holding period actually start?
• Did I already mess this up without knowing?

These are fair questions. Most shareholders don't start with simple common stock. Many deals involve SAFEs, options, restricted shares, or entity conversions. Those details matter because Section 1202 rewards you for holding qualifying stock for a sufficient period. It doesn't reward you for “being involved in the business” for a certain number of years.

So the clock only starts when you actually own qualifying stock. Below are the three situations that create the most timing surprises.

The Exercise Trap: Options and Warrants don't Start the QSBS Clock

If you have stock options or warrants, you have the right to buy shares at a later date. But you don't own the shares yet.

That distinction matters because the QSBS holding period usually starts when you exercise and receive the stock, not when the company grants the option.

So if you were granted options three years ago and exercise them next month, your QSBS clock usually starts then.

This shows up often when option holders wait to exercise because they want to:

• Avoid paying the exercise cost
• Delay taxes
• Avoid dealing with paperwork

But if a sale is approaching, waiting can cost you time. And with QSBS, time is the entire point.

The 83(b) Rule: Restricted Stock Only Starts Early if You File the Election

Restricted stock often comes with vesting. That means the shares can be subject to forfeiture, even if the company issues them to you.

An 83(b) election lets you treat those shares as owned for tax purposes at the time of grant, rather than waiting until they vest.

That matters for QSBS because the holding period can shift depending on whether you filed the 83(b) election.

If you filed it on time, you can often start the QSBS clock at the grant date.

If you didn't file it, the clock may start later, which can delay your qualification.

This is a common problem because shareholders don't always remember:

• whether they received restricted stock
• whether they filed the election
• whether the form was filed correctly and on time

If you’re not sure, don't guess. Confirm it now, while you still have time to plan around it.

LLC to C Corporation Conversions: Your QSBS Clock Usually Starts at Conversion

Many companies start as an LLC because it’s simple and flexible.

As your business grows, you may bring in investors, start acquisition talks, or begin planning for a sale. That's usually when QSBS becomes relevant.

This is often when the conversion question hits:

If I convert my LLC to a C corporation, do the earlier years of my LLC still count toward QSBS?

In most cases, no. QSBS generally requires qualifying C corporation stock. So the QSBS holding period usually starts when the business becomes a C corporation and issues stock that can qualify under Section 1202.

So even if you operated the business for five years as an LLC, converting today can still mean your QSBS clock starts today.

That's why conversion timing can affect real exit decisions.

This part matters if you’re relying on the “10 times basis” rule.

Your basis is the amount the tax rules treat as your investment in the stock. When you convert an LLC into a C corporation, the value assigned at conversion can affect that basis.

• If your basis is low, the 10-times basis limit may limit your exclusion sooner.
• If your basis is higher, you may be able to exclude more gain under that rule.

You don't want to discover this after the sale is negotiated.

The "Silent Killers": Mistakes That Kill Your Exclusion

You can do everything right at the beginning and still lose the Section 1202 benefit later.

That's what makes QSBS stressful. The rules aren't just about qualifying once. Some mistakes can quietly disqualify your stock without a clear warning sign. You often find out when a buyer starts due diligence or when your CPA runs the final numbers.

Here are two of the biggest problems we see.

Stock Redemptions: When a Share Buyback Can Taint Your QSBS Stock

A stock redemption is when a company repurchases its own shares from shareholders. On its own, that can be normal. Companies do buybacks for clean up, investor exits, or cap table management.

But under Section 1202 rules, certain buybacks can create a serious QSBS problem.

If the company redeems stock within the wrong window, it can “taint” the issuance and disqualify an entire round of shares from QSBS treatment.

This is one of the most dangerous issues because shareholders often don't connect a buyback from years ago to today's tax outcome.

If you had a buyback near the time of issuance, don't assume it’s harmless. You need to review timing, amounts, and who was involved.

The 80% Active Business Test: Cash Drag and Business Pivots

Section 1202 also requires the company to operate an active qualified business.

That's where two problems show up.

Cash drag: holding too much idle cash

If the company holds too much cash that isn't being used in the active business, it can create issues under the active business requirement.

This comes up after:

• a big funding round
• a strong cash year
• a pause in hiring or expansion

The business might still feel active, but the balance sheet can tell a different story.

Pivoting into an excluded industry

Some industries are excluded from QSBS treatment. Even if the company started in a qualifying trade or business, a pivot can create risk.

This tends to happen when a business shifts into areas like:

• real estate
• finance
• professional services

A pivot doesn't always kill QSBS. But it’s a known risk area, and it needs a clean review if you plan to rely on the exclusion.

State Tax Realities: Does Your State Follow Section 1202?

Many shareholders read about QSBS and assume the tax savings will apply everywhere.

That isn't how it works.

Section 1202 is a federal tax rule. Your federal tax bill can drop to zero on the excluded gain, but your state can still tax the sale like a normal capital gain. That difference catches people off guard, especially when they’re planning an exit based solely on federal numbers.

New Jersey Update (2026)

New Jersey used to be on the list of states that didn't follow the federal QSBS exclusion.

That changes in 2026.

As of January 1, 2026, New Jersey now conforms to Section 1202, which means eligible QSBS gains that qualify federally may also qualify for the New Jersey exclusion.

The Non-Conformers: States That Still Tax QSBS Gains

Some states still don't follow the Section 1202 exclusion. That means your sale can be federally tax-free, but still fully taxable at the state level.

Three states that often come up in QSBS planning are:

• California
• Pennsylvania
• Alabama

If you live in one of these states, the QSBS benefit may still help you at the federal level, but you shouldn't assume it will reduce your state tax bill.