QSBS Checklist: Section 1202 Tests, Holding Period, and Gain Exclusion

Qualified small business stock qualifies for the Section 1202 exclusion only when three sets of QSBS eligibility requirements line up at once: the issuing corporation has to meet the statute’s structural and business tests, you have to acquire the stock in a way the statute recognizes, and you have to hold it long enough. Miss any one element and the full gain is taxable at regular capital gains rates.¹ The checklist below walks through each requirement, flags the acquisition scenarios that most often break eligibility, and notes what you should be keeping in a file in case the IRS asks.

What the Corporation Has to Be

The issuer must be a domestic C corporation on the date the stock is issued. Shares put out by an S corporation, LLC, partnership, or foreign entity cannot be QSBS. If a company converts from S corp to C corp status, only shares issued after the conversion can potentially qualify; shares that existed during the S corp period never become QSBS, no matter how long you hold them.

The Gross Asset Ceiling

The corporation’s aggregate gross assets cannot exceed $75 million at any point before or immediately after your stock is issued. For stock issued on or before July 4, 2025, the ceiling was $50 million. The $75 million figure is scheduled to adjust for inflation starting in 2027.¹

“Aggregate gross assets” means cash plus the adjusted tax basis of everything else the company owns, with one twist: property contributed to the corporation is counted at its fair market value on the contribution date, not the contributor’s basis. A founder who contributes intellectual property worth $20 million but with near-zero tax basis adds $20 million to the balance for this test. The proceeds of the stock issuance itself also count, so a large funding round can push a company over the line at exactly the moment new shares go out.

The test only has to be met at your issuance. If the company’s assets balloon later, your shares stay qualified. But every subsequent round has to pass the test independently on its own issuance date.

The 80% Active Business Test

At least 80% of the corporation’s assets, by value, must be used in the active conduct of a qualified trade or business, and that must be true for substantially all of your holding period.¹ Assets held for research, startup activities, and reasonable working capital count toward the 80%. A company sitting on cash it doesn’t need, or holding real estate as a passive investment, risks failing. Holding companies and businesses that generate most of their revenue from passive sources are the usual problem cases.

Excluded Industries

Some businesses are disqualified regardless of size or activity. The statute knocks out:¹

Professional services: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, and any business whose principal asset is the reputation or skill of one or more employees
Financial services: banking, insurance, financing, leasing, investing, and brokerage
Farming, hotels, motels, restaurants, and businesses claiming percentage depletion deductions (such as mining and oil extraction)

The “reputation or skill” catch-all is where most disputes arise. A software company that ships products qualifies. A consulting firm that sells the expertise of its principals doesn’t. Businesses that mix product revenue with professional services need a hard look at where their real value sits.

What You Have to Be, and How You Have to Acquire the Stock

A Non-Corporate Taxpayer

Only individuals, trusts, and estates can claim the exclusion. A C corporation holding stock in a qualifying small business cannot treat those shares as QSBS. Partnerships and S corporations can hold QSBS and pass the exclusion through to their individual partners and shareholders, but only if the individual held their interest in the entity on the date the entity acquired the QSBS and holds it continuously through the sale.² Buying into a fund after it already acquired the QSBS closes the door on the exclusion for that stock.

Original Issuance

You must acquire the stock directly from the corporation in exchange for cash, other property (not stock), or services. Buying shares from an existing shareholder on the secondary market disqualifies the stock entirely.¹ This is one of the most common ways people lose the exclusion: someone buys shares privately from a departing employee or early investor, assumes QSBS status carries over, and finds out at exit that it doesn’t. The statute rewards direct capital going into the business, not reshuffling of existing ownership.

Stock received as compensation for services counts as originally issued to you. Keep the W-2 or 1099-NEC, the grant agreement, and any board resolutions authorizing the issuance.

No Disqualifying Redemptions

The corporation’s buyback activity around your issuance date can retroactively kill eligibility. Two separate rules apply:¹

Targeted redemptions: your stock fails if, at any point during the four-year window starting two years before your issuance date, the corporation bought back any stock from you or a related party.
Significant redemptions: all stock issued during a defined period fails if, during the two-year window starting one year before your issuance date, the corporation repurchased shares worth more than 5% of the total value of its outstanding stock.

Before you rely on the exclusion, walk the cap table and confirm no buybacks fell inside those windows.

The Holding Period

For stock acquired on or before July 4, 2025, you must hold the shares more than five years to claim any exclusion at all. Selling one day early means zero exclusion and full gain recognition.

For stock acquired after July 4, 2025, the One Big Beautiful Bill Act (OBBBA) replaces the all-or-nothing rule with a tiered schedule:¹

At least three years but less than four: 50% exclusion
At least four years but less than five: 75% exclusion
Five years or more: 100% exclusion

The clock starts on the date the stock is issued to you. For an exercised option, that’s the exercise date, not the grant date. For restricted stock subject to vesting, the clock ordinarily starts at each vest unless you file a Section 83(b) election within 30 days of the grant, which starts the holding period on day one regardless of the vesting schedule. For someone whose stock could be worth millions at exit, that election can determine whether the exclusion is available at all.

Stock splits, stock dividends, and tax-free reorganizations under Section 368 generally let you tack the original holding period onto the shares you end up with. If QSBS is exchanged for stock of another corporation in a qualifying reorganization or Section 351 transaction, the replacement stock is treated as QSBS acquired on the same date as the original, though the excludable gain may be capped at the gain that would have been recognized without the tax-free treatment. Gifts and inheritances follow the same principle: you step into the prior owner’s shoes and inherit their acquisition date and holding period.³

How Much of the Gain the Exclusion Covers

Eligibility only matters against the cap. For stock acquired after September 27, 2010, and on or before July 4, 2025, the exclusion is 100% of eligible gain. Shares acquired between February 18, 2009, and September 27, 2010, get a 75% exclusion. Anything older is limited to 50%.¹

Every exclusion is capped per issuer. For stock acquired after July 4, 2025, the cap is the greater of $15 million or ten times your aggregate adjusted basis in that corporation’s QSBS. For stock acquired on or before that date, the cap is the greater of $10 million or the same ten-times-basis alternative.¹ The $15 million figure inflates starting in 2027. Because the cap runs per issuing corporation, holding QSBS in three different qualifying companies gives you three separate caps.

Acquisition Scenarios That Commonly Break or Preserve Eligibility

Stock Options

Options themselves are not stock for Section 1202 purposes. When you exercise and receive actual shares from the corporation, the exercise is treated as an original issuance, and the holding period begins on the exercise date. Anyone counting down to a tier deadline should count from exercise, not grant.

Convertible Notes and SAFEs

Convertible debt that converts into stock can produce QSBS, and the holding period of the note may tack onto the shares under Section 1202(f). Treatment depends on whether the instrument is characterized as debt or equity, and if the issuer treats a convertible note as debt but the holder wants to argue it was really equity for holding-period purposes, the holder must disclose that inconsistent treatment on their return. SAFEs sit in a grayer zone because they fit neither category cleanly. This is an area to work through with a tax adviser before the sale, not after.

S Corp Conversions

When an S corp elects C corp status, only shares issued after the election can qualify. Founders’ pre-conversion shares never become QSBS. The typical fact pattern: a startup converts before a priced round, the new-money shares can qualify, and the founders’ original stock cannot.

Selling Before Five Years: Section 1045 Rollover

If you need to sell before hitting the required holding period, Section 1045 lets you defer the gain by reinvesting the proceeds into replacement QSBS within 60 days. You must have held the original stock more than six months, and the replacement corporation must independently satisfy every Section 1202 requirement at the time of the new issuance.⁴

Gain is deferred only to the extent you reinvest. Sell for $2 million and put $1.5 million into replacement stock, and $500,000 in gain is recognized now. The deferred gain reduces basis in the replacement shares, so tax is delayed rather than eliminated, but the holding period of the original stock tacks onto the replacement stock for Section 1202 purposes, keeping the five-year clock running. Elect the rollover on a timely filed return for the year of the sale; the election is generally irrevocable without IRS consent through a private letter ruling.

State Conformity

Section 1202 is federal. Not every state follows it. California disallows the exclusion outright and taxes the full gain at state rates. Pennsylvania, Mississippi, and Alabama likewise do not conform. New Jersey came into conformity for tax years beginning in 2026, with limitations. Most other states generally follow federal treatment, but the specifics vary. If you live in or have income sourced to a non-conforming state, the state tax bill on a large QSBS gain can be substantial and belongs in your exit planning well before you sign a deal.

Documentation You Need to Prove Eligibility

The burden of proof is entirely on you. The IRS won’t confirm QSBS status in advance, and on audit you have to produce records for every element above. Keep at least the following:

The stock purchase or subscription agreement, showing issuance date, consideration paid, and direct acquisition from the corporation
The certificate of incorporation, confirming domestic C corp status
Balance sheets dated immediately before and after issuance, showing aggregate gross assets under the applicable threshold ($50 million before July 5, 2025; $75 million after)
Cap table records confirming primary issuance rather than a secondary transfer, plus any redemption activity in the relevant windows
A company representation letter confirming the active business test was met, the industry qualifies, and the gross asset test was satisfied on your issuance date
Compensation records if you received stock for services: W-2 or 1099-NEC, grant agreement, board resolution, and any 83(b) election filing
A holding period log showing the exact issuance date, any reorganizations that affected the shares, and the eventual sale date

Most founders and investors wait until a sale is imminent to gather this material, which is often too late. Companies get acquired, records vanish, and finance staff turn over. The workable practice is to assemble these documents within 90 days of issuance and refresh them annually. Some taxpayers commission a formal QSBS compliance opinion from an accounting firm; these typically run between $3,500 and $15,000 depending on how complicated the corporate history is. Whichever route you take, the goal is the same: on the day the IRS asks whether every eligibility requirement was satisfied, the answer sits in a folder rather than a memory.

1
Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock
2
Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock – Section: Treatment of Pass-Thru Entities
3
Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock – Section: Certain Tax-Free and Other Transfers
4
Office of the Law Revision Counsel. 26 USC 1045 – Rollover of Gain From Qualified Small Business Stock to Another Qualified Small Business Stock