Section 1202 QSBS Exclusion: Eligibility, Holding Period, and Caps

To qualify for the Section 1202 QSBS exclusion, you must hold stock that was issued directly to you by a domestic C corporation with no more than $50 million in gross assets, in exchange for cash, property, or services, in a company that runs a qualifying active business, and you must hold those shares long enough to satisfy the statutory holding period. Meet every one of those tests and you can exclude up to the greater of $10 million or ten times your basis in the stock of that company from federal capital gains tax. Miss any one of them and the exclusion is gone.

Who Can Claim the Exclusion

Only non-corporate taxpayers qualify. Individuals, trusts, and estates can claim the exclusion directly, and investors who hold QSBS through a partnership, LLC taxed as a partnership, or S corporation can claim their share of the gain that flows through.¹ C corporations themselves get nothing, so a holding company structured as a C corp that owns QSBS is a dead end for this benefit.

The pass-through rule has a catch. When a partnership or LLC sells QSBS, only the individuals who were members of the entity at the time it originally acquired the stock can take their share of the exclusion. Buying into the partnership after the QSBS is already on its books does not carry the benefit with it.

The Company Must Be a Qualifying C Corporation

The issuer has to be a domestic C corporation, and it has to keep that status during substantially all of your holding period.¹ S corporations, partnerships, LLCs taxed as partnerships, and sole proprietorships are out. If the company converts to an S corp or merges into an LLC before you sell, you generally lose QSBS status.

The company also has to pass the gross assets test at the time your stock is issued. Immediately before and immediately after the issuance, aggregate gross assets — cash plus the adjusted basis of all other property — cannot exceed $50 million.² The cash or property you pay in counts toward the ceiling. Once the company crosses $50 million, it can no longer issue qualifying stock, but shares already issued do not lose eligibility if the company grows past that threshold through normal operations. The test is applied only at the moment of issuance.

How You Must Acquire the Stock

You have to acquire the stock at original issuance, either directly from the corporation or through an underwriter. Secondary market purchases from another shareholder do not qualify, no matter how small the company is or how long you hold afterward.¹

The consideration must be cash, property other than stock, or services performed for the corporation. Founders who receive stock in exchange for building the company qualify under the services prong. Investors who contribute intellectual property or equipment in exchange for equity qualify too, so long as the contributed property is not itself stock in another entity.

Options and convertible notes have their own timing rule. The holding period does not start when the option is granted or the note is issued. It starts when the option is exercised or the note converts into shares. A founder who receives an option grant in year one but does not exercise until year three cannot sell until at least year eight and still claim the exclusion under the five-year rule.

How Long You Have to Hold the Stock

For QSBS acquired on or before mid-2025, you must hold the shares for more than five years before selling.² The clock starts on the date the stock is officially issued, not the date the term sheet was signed. Hedging or shorting the position during the holding period can pause or reset it.

Legislation modified the rules for stock acquired after mid-2025 and reduced the required holding period to at least three years. Investors who acquired shares in late 2025 or 2026 should read the updated statute carefully, because the dollar caps and exclusion percentages were also revised for newly issued stock.

Selling Early: The Section 1045 Rollover

If you sell QSBS before the holding period is up, you can defer the gain by reinvesting the proceeds into replacement QSBS within 60 days under Section 1045.³ The replacement stock must independently meet all QSBS requirements. Your original holding period tacks onto the replacement shares, so you only need to hold the new stock long enough to finish out the original clock.⁴ Only the portion of proceeds actually reinvested gets the deferral; anything you keep is taxable immediately.

Gifts and Inheritances

QSBS transferred by gift or at death keeps its qualified status. The recipient steps into the original holder’s shoes for both the original issuance requirement and the holding period, so the clock does not restart.² Each recipient also gets their own separate exclusion cap. A donor who gifts QSBS to a child does not reduce their own $10 million cap, and the child receives a full cap of their own. A founder with $30 million in unrealized gain can potentially shelter the full amount by splitting the shares among three recipients.

One important limit: transfers to a grantor trust do not create a separate exclusion. Because the grantor is treated as still owning the trust assets for income tax purposes, the shares remain the grantor’s for the $10 million cap. Only outright gifts to individuals or transfers to non-grantor trusts generate new exclusion capacity.

The Company Must Run an Active Qualifying Business

At least 80% of the corporation’s assets, measured by value, must be used in the active conduct of one or more qualified trades or businesses, and this test must be met during substantially all of your holding period.¹ A startup that passes at issuance but drifts toward passive investments can retroactively disqualify your shares.

Industries That Do Not Qualify

Congress carved out several fields:²

Professional services including health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services, plus any business whose principal asset is the reputation or skill of one or more employees.
Financial businesses including banking, insurance, financing, leasing, and investing.
Farming, including the raising or harvesting of trees.
Natural resource extraction like oil, gas, and mining and other activities eligible for depletion deductions.
Operating hotels, motels, restaurants, and similar hospitality businesses.

The “reputation or skill” language is the most litigated piece. It can potentially reach beyond the named professions to any company built primarily around the personal brand or expertise of its founders, and the IRS has not drawn a clean line.

Real Estate and Idle Cash

A corporation automatically fails the active business test if more than 10% of its assets consist of real property not used in the active business. A headquarters or operating warehouse is fine; investment real estate held on the side is not.

Startups holding large cash reserves after a funding round get relief from a working capital safe harbor. Cash and other investments count as active business assets if the company reasonably expects to use them within two years for research and development or working capital.² For companies that have existed for at least two years, no more than 50% of total assets can qualify under this safe harbor. A five-year-old company with $20 million in assets cannot park $15 million in a money market account and claim it all toward the 80% threshold.

How Much Gain You Can Exclude

The exclusion percentage depends on when the stock was acquired:

Stock acquired from August 10, 1993 through February 17, 2009: 50% exclusion.
Stock acquired from February 18, 2009 through September 27, 2010: 75% exclusion.
Stock acquired after September 27, 2010: 100% exclusion.¹

Virtually all QSBS acquired today falls under the 100% exclusion, meaning zero federal income tax on qualifying gain and no AMT adjustment.

The Dollar Cap

The exclusion is capped at the greater of $10 million or ten times your adjusted basis in the stock disposed of during the tax year. The cap applies on a per-issuer basis, so if you hold qualifying stock in three different companies you get a separate cap for each.² It is also a lifetime cap for each corporation: selling shares across multiple tax years draws down the same $10 million allowance.

The 10-times-basis alternative often matters more than the flat figure. If you paid $3 million for shares, you can exclude up to $30 million in gain from that company. Basis is measured at original issuance without later adjustments. Married taxpayers filing separately have a reduced $5 million per-issuer cap.

For legacy stock in the 50% tier, the non-excluded half is taxed at 28% rather than the standard long-term capital gains rate, and 7% of the excluded portion counts as an AMT preference. The 75% tier avoids the AMT preference but still taxes the non-excluded 25% at 28%. For anyone acquiring QSBS today, these older rules are irrelevant.

Buybacks Can Retroactively Destroy QSBS Status

Two anti-churning rules can wipe out the exclusion if the issuing corporation buys back its own stock around the time your shares are issued. They exist to keep investors from recycling capital through redemptions and reissuances to generate fresh exclusion capacity.

The first rule targets redemptions from you or a related party. If, at any time during the four-year window beginning two years before your stock is issued, the corporation buys back stock from you or a related person, your newly issued shares lose QSBS status.²

The second rule applies to broader buybacks. If the corporation repurchases more than 5% of the aggregate value of all outstanding stock during the two-year period beginning one year before your issuance, all stock issued during that period can be disqualified.² A routine tender offer at the wrong time can taint an entire round of fundraising.

Mergers and Acquisitions

In a tax-free reorganization, treatment depends on what you receive. If you exchange old QSBS for new stock that independently qualifies as QSBS, the holding period and status carry over and the five-year clock keeps running. If you receive stock that does not qualify on its own, QSBS status is preserved under a special rule, but the gain eligible for exclusion is capped at the fair market value of your original shares at the time of the reorganization.¹ Any appreciation in the acquiring company’s stock after the reorganization falls outside the exclusion. If you are heading toward an acquisition exit, the deal structure directly controls how much gain you can shelter.

State Tax Is a Separate Question

Section 1202 is a federal provision, and not every state follows it. Most states either conform or have no income tax, so the gain is tax-free at both levels. A handful do not conform and tax the full gain at ordinary state rates regardless of federal treatment.

California is the biggest non-conforming state given how many startups are based there. California taxes all capital gains as ordinary income at rates up to 13.3% and does not recognize the Section 1202 exclusion. California also does not conform to Section 1045, so a federal rollover still triggers California tax in the year of sale. Alabama, Mississippi, Pennsylvania, and the District of Columbia also do not conform, and Oregon decoupled beginning in 2026.

Claiming and Defending the Exclusion

You claim the exclusion on Form 8949 and it flows through to Schedule D. Report the sale as usual with sale price, date, and cost basis. In column (f), enter adjustment code “Q” for the QSBS exclusion. In column (g), enter the excluded gain as a negative number in parentheses.⁵ The net on Schedule D shows only the taxable portion, if any. No advance election or IRS pre-approval is required.

What the IRS does require, if it audits you, is proof that every element was satisfied. No form or certification establishes eligibility up front, so the burden falls entirely on you to reconstruct the facts, sometimes years later, for a company that may no longer exist. The strongest defense is a written attestation letter from the company at the time of issuance confirming C corporation status, the date and terms of the issuance, aggregate gross assets at issuance, a description of the company’s business activities, and that the stock was issued for cash, property, or services. Keep the stock purchase agreement, board minutes authorizing the issuance, the capitalization table, and the balance sheet as of the issuance date. For the active business test, periodic records of how assets are deployed help, particularly for companies sitting on large cash balances from a funding round.

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 US Code 1202 – Partial Exclusion for Gain from Certain Small Business Stock
3
Office of the Law Revision Counsel. 26 US Code 1045 – Rollover of Gain from Qualified Small Business Stock
4
Internal Revenue Service. Revenue Procedure 98-48 – Section 1045
5
Internal Revenue Service. Instructions for Form 8949