Equity compensation · Section 1202
The QSBS exemption can take the federal tax on your startup gain to zero.
Section 1202 excludes the gain on qualified small business stock (QSBS) from federal income tax. Hold it five years and the exclusion is 100%, on up to $15 million per company or 10 times what you paid, whichever is more.
Updated · Sources
Stock acquired after July 4, 2025
- 100%
- of the gain is excluded at 5 years, 50% at 3 years and 75% at 4.
- $15M
- is the lifetime cap per company, or 10 times your basis if that is more.
- $75M
- is the company’s gross asset limit, before and right after it issues your stock.
Stock acquired earlier needs more than 5 years for 100%, with a $10M cap. Stock issued earlier has a $50M asset limit.
Does your stock qualify?
Your stock must pass all five tests. If it fails one, none of the gain is excluded.
A US C corporation
The company must be a US C corporation when it issues your stock and for substantially all of your holding period. Stock issued while the company was an S corp never qualifies. An LLC can convert and issue QSBS, but gain from before the conversion stays taxable.
Stock from the company itself
The company must issue the stock to you directly for cash, property or services. Stock bought from another shareholder does not qualify.
$75 million or less in gross assets
Under the gross asset test, the company’s gross assets must stay at $75 million or less until right after it issues your stock. That includes the money it just raised. Gross assets means cash plus tax basis, not valuation. The limit is $50 million for stock issued before July 5, 2025.
An active business in a qualifying field
The company must use at least 80% of its assets in an active business, for substantially all of your holding period. Some business types are excluded, including law, health, engineering, consulting, finance and hospitality.
A long enough holding period
You must hold the stock three years for a partial exclusion and five for a full one. Stock acquired before July 5, 2025 needs more than five years for any exclusion.
Individuals, trusts and estates can claim the exclusion. So can partners and S corp shareholders who owned their stake when the entity acquired the stock. A C corporation cannot.
What the QSBS exclusion is worth.
1 to 3 years
$2,380,000
Nothing is excluded. The whole gain is taxed as long-term capital gain at 20% plus 3.8%.
3 years
$1,590,000
Half the gain is excluded. The other half is taxed at 28% plus 3.8%.
4 years
$795,000
Three quarters of the gain is excluded. The other quarter is taxed at 28% plus 3.8%.
5 years
$0
The whole gain is excluded.
These figures use top federal rates, plus the 3.8% net investment income tax on the part not excluded. The new tiers carry no AMT preference. The gain is within the $15 million cap. State tax is separate, and California taxes the full gain.
The QSBS exclusion chart: before and after July 4, 2025.
The One Big Beautiful Bill Act changed Section 1202 for stock acquired after July 4, 2025. Older stock keeps the old rules.
| Old rules | New rules | |
|---|---|---|
| Held 3 years | Nothing excluded | 50% excluded |
| Held 4 years | Nothing excluded | 75% excluded |
| Held 5 years | 100% excluded Over 5 years, if acquired after Sept. 27, 2010 | 100% excluded |
| Cap per company | $10M or 10x basis | $15M or 10x basis Shared with older stock. Indexed for inflation from 2027. |
| Gross assets | $50M or less | $75M or less |
The acquisition date is the day you first held the stock. A gift, an inheritance or a Section 1045 rollover keeps the original date. Old and new stock in the same company share one $15 million lifetime cap. Stock acquired before September 28, 2010 gets less: 50% if acquired by February 17, 2009, and 75% after that.
Where QSBS claims fail.
The company bought back stock
A significant buyback within a year either side of your issue date can disqualify your shares, even if yours were never bought back. A buyback from you or a related person within two years either side can too.
Your state does not follow QSBS
Many states tax the gain anyway. California, Pennsylvania, Alabama and Mississippi do not allow the exclusion. Oregon, Vermont and Illinois stopped allowing it in 2026, and Rhode Island stops in 2027. Maine taxes gain on stock acquired after July 3, 2025, and Hawaii excludes only half. What counts is where you live when you sell.
A partial exclusion spends the whole cap
The $15 million cap counts the full gain, including the part that is still taxed. Sell $15 million of gain at three years and half is excluded, but the whole cap is used up.
You sold too early
Sell before the holding period ends and nothing is excluded. If you held the shares more than six months, a Section 1045 rollover can defer the gain. You must buy new QSBS within 60 days.
The clock started later than you think
The holding period starts at exercise for options, delivery for RSUs and vesting for restricted stock. An 83(b) election moves the start for restricted stock to the transfer date. For options, the gross asset test also applies at exercise, not at grant.
You have nothing on file
The burden of proof is on you. Ask the company for a QSBS letter covering the gross asset and active business tests. Keep your purchase records too.
QSBS planning before you sell.
Valim’s CPAs help founders and early employees with QSBS planning before a sale, and file the return after it.
- We test your shares against every Section 1202 requirement and document the result.
- We help you plan your sale around the three, four and five-year marks and your state of residence.
- We weigh stacking: gifts of shares to family or a non-grantor trust, each of which may get its own cap.
- We plan and report a Section 1045 rollover to defer the gain on an early sale.
- We report the exclusion correctly on Form 8949 with code Q and on your state return.
- Individual return
- from $195
- Business return
- from $495
We quote a flat fee before work starts. We do not bill hourly.
QSBS questions.
What qualifies as QSBS?
Qualified small business stock (QSBS) is stock a US C corporation issues to you directly for cash, property or services. The company’s gross assets must stay at $75 million or less until right after it issues the stock. The limit is $50 million for stock issued before July 5, 2025. The company must use at least 80% of its assets in an active business, not in services like law, health, engineering, consulting or finance.
What is the 80% rule for QSBS?
The 80% rule requires the company to use at least 80% of its assets, by value, in an active qualified business. This must hold for substantially all of your holding period. Cash kept for working capital, or expected to fund research within two years, counts as used, within limits. Other investments do not.
What are the QSBS requirements for 2026?
For 2026, QSBS acquired after July 4, 2025 gets a 50% exclusion at three years, 75% at four and 100% at five. The cap is $15 million per company, or 10 times your basis if that is more. The company’s gross assets must be $75 million or less when it issues the stock. Stock from before July 5, 2025 keeps the old rules: more than five years, a $10 million cap and a $50 million asset limit.
Which states don’t recognize QSBS?
California, Pennsylvania, Alabama and Mississippi tax the full QSBS gain. Oregon, Vermont and Illinois also tax it from 2026, and Rhode Island from 2027. Maine taxes gain on stock acquired after July 3, 2025, and Hawaii excludes only 50%. Massachusetts, Arkansas and South Carolina follow older federal rules. New Jersey allows the exclusion from 2026, and most other states follow the federal rules. What counts is the state you live in when you sell.
How do I report the Section 1202 exclusion on my return?
To report the Section 1202 exclusion, list the QSBS sale on Form 8949 and enter code Q in column (f). Enter the excluded gain as a negative number in column (g). The result carries to Schedule D. For a partial exclusion, the part not excluded goes on the 28% Rate Gain Worksheet.
What is the maximum tax rate on Section 1202 gains?
Section 1202 gain that is not excluded is taxed at up to 28%, plus the 3.8% net investment income tax. With a 50% exclusion, that works out to 15.9% of the whole gain. With a 75% exclusion, it is 7.95%. Gain above the per-company cap is taxed as a regular long-term capital gain, at up to 20% plus 3.8%.
Sources
- 26 U.S.C. § 1202, Partial exclusion for gain from certain small business stock
- Public Law 119-21 (One Big Beautiful Bill Act), § 70431
- IRS, Instructions for Form 8949
- IRS, Instructions for Schedule D (Form 1040)
- 26 U.S.C. § 1045, Rollover of gain from qualified small business stock
- California FTB, 2025 Instructions for Schedule D (540)
- Pennsylvania Department of Revenue, answer 3885 (IRC 1202)
- Alabama Department of Revenue, 2025 Form 40 booklet (Schedule D)
- Mississippi Department of Revenue, individual income tax FAQ
- Hawaii HB 2329 CD1 (Act 35, 2026), HRS 235-2.45
- Massachusetts DOR, 2025 Form 1 instructions
- New Jersey Division of Taxation, new laws (P.L. 2025, c.67)
Reviewed and updated September 2026. General information, not advice for your situation.