Qualified Small Business Stock Section 1202 Exclusion (2026)

Section 1202 can exclude part or all of eligible gain when a noncorporate taxpayer sells qualifying domestic C corporation stock. Start with the stock's acquisition and issuance dates: the 2025 law changed the holding periods, per-issuer dollar limit and gross-assets ceiling for newer stock. Entity status, original issuance, business activity, redemptions and records still determine whether the stock qualifies. The eligible-gain ceiling is the greater of the remaining per-issuer dollar limit or 10 times the adjusted basis of that issuer's QSBS sold during the tax year, ignoring additions to basis after original issuance. The dollar limit is $10 million for stock acquired on or before July 4, 2025, or $15 million for stock acquired after July 4, 2025 (the 2026 amount, with inflation adjustments beginning after 2026). Prior eligible gain from the same issuer reduces the dollar limit; mixed old and new lots require coordination, not two independent allowances. Apply the applicable exclusion percentage to the eligible gain after this limit.

The most useful first step is to establish eligibility by stock lot before estimating savings. An operating company's legal form, ownership history, financing documents and intended sale structure can change the result.

The Core Requirements

The stock must be issued by a domestic C corporation. S corporation stock never qualifies, and stock acquired while the company was an S corporation does not qualify even after a later conversion. Only stock issued after the conversion can qualify.

The stock must be acquired at original issuance from the corporation, in exchange for money, property other than stock, or services. Purchasing shares from an existing shareholder does not qualify, which is a common and expensive surprise for early employees buying from founders.

For stock issued on or before July 4, 2025, aggregate gross assets must not exceed $50 million; for stock issued after July 4, 2025, the ceiling is $75 million in 2026. The test covers the corporation and any predecessor at all times after August 9, 1993 and before issuance, and immediately after issuance including the new proceeds. Parent-subsidiary controlled-group rules also apply. Gross assets generally mean cash plus adjusted tax basis of other property, with contributed property measured using fair market value at contribution. Enterprise valuation is not the same measure.

At least 80% of assets by value must be used in the active conduct of a qualified trade or business throughout substantially all of the holding period.

Stock acquired on or before July 4, 2025 must be held for more than five years. Qualifying stock acquired after September 27, 2010 and on or before July 4, 2025 can receive a 100% exclusion. For stock acquired after July 4, 2025, the exclusion is 50% after at least three years, 75% after at least four years, and 100% after at least five years. These percentages apply to eligible gain after the per-issuer limit, not automatically to all sale proceeds. Acquisition dates reflect applicable holding-period tacking rules.

The Excluded Businesses

IRC Sec. 1202(e)(3) excludes a list of businesses, and it overlaps substantially with the Sec. 199A specified service list but is not identical.

Section 1202(e)(3) excludes services in 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 employees. The named service exclusions do not depend on that additional reputation-or-skill category. Banking, insurance, financing, leasing, investing, farming, specified extraction businesses, and hotels, motels, restaurants and similar businesses are also excluded. A software or manufacturing label does not establish eligibility; review the actual activities and asset use.

Note that engineering and architecture are excluded here while they are permitted under Sec. 199A. The lists are different and must be checked separately.

Technology and manufacturing businesses can qualify, but eligibility depends on actual operations and all statutory tests, not an industry label.

Stacking and Packing

A qualifying gift or transfer at death can preserve the original issuance treatment and holding period under Section 1202(h); it does not reset old stock into the post-July 4, 2025 regime. Separate noncorporate taxpayers may have separate per-issuer limits, but a married couple filing jointly does not get two dollar limits merely by holding shares separately. Grantor trusts do not create additional income-tax taxpayers. Non-grantor trusts require review of ownership, trust aggregation, completed gifts, valuation, gift-tax reporting and assignment-of-income risk. There is no universal safe number of trusts or waiting period.

Under IRC Sec. 1202(h), a recipient by gift takes the transferor's holding period and basis and is treated as having acquired the stock in the same manner. This is the mechanism that makes stacking work.

A separate non-grantor trust may have its own issuer limit only when the ownership and transfer are effective for tax purposes. A gift retains the original acquisition regime; a 2021 share does not get the $15 million base limit because it is given away after July 4, 2025. No number of trusts or elapsed time guarantees the result.

The 10-times-basis alternative can be larger than the remaining dollar limit. A $4,000,000 qualifying original-issue basis can support a $40,000,000 eligible-gain ceiling. Contributed property has special Section 1202(i) fair-market-value and pre-contribution-appreciation rules, and later basis additions are ignored for this ceiling.

The Redemption Traps

Two anti-abuse rules disqualify stock based on the corporation's redemption activity, and they catch ordinary transactions regularly.

Under IRC Sec. 1202(c)(3)(A), stock is not QSBS if the corporation purchased any of its stock from the taxpayer or a related person within a four-year window beginning two years before issuance.

Under IRC Sec. 1202(c)(3)(B), stock is not QSBS if the corporation made significant redemptions, exceeding 5% of aggregate stock value, within a two-year window beginning one year before issuance.

A company that buys back shares from a departing founder and then issues new shares to an incoming investor within a year may have inadvertently disqualified the new shares. De minimis exceptions exist under the regulations, and redemptions from terminating employees have a specific exception, but the rules are unforgiving and should be checked before any buyback.

Section 1045 Rollover

Section 1045 may defer gain when a noncorporate taxpayer sells QSBS held for more than six months, elects rollover treatment, and buys replacement QSBS during the 60-day period beginning on the sale date. Full deferral generally requires reinvesting the amount realized, not just the gain. Deferred gain reduces replacement-stock basis; applicable holding-period tacking must be analyzed. A rollover does not automatically secure a later Section 1202 exclusion or increase its cap.

A sale before the applicable holding period is met may warrant a rollover analysis, but the replacement stock and later sale must independently satisfy the relevant requirements. Reinvestment carries investment risk and does not guarantee an exclusion.

The election is made on a timely filed return and requires the replacement stock to itself be QSBS, which means the acquisition target must satisfy all the same requirements.

State Conformity Is Not Universal

State treatment must be checked for the sale year, residency, sourcing and any trust. California does not conform to the federal Section 1202 exclusion. A federal exclusion therefore does not establish a zero state-tax result, and the 2025 federal expansion should not be assumed to apply in every state. A change of residence or trust location is not an automatic cure for state tax.

For a California founder with $10,000,000 excluded federally, a 13.3% marginal-rate illustration equals $1,330,000. This is a simplified rate illustration, not a calculation using California's progressive brackets or the taxpayer's full return.

Review residency, sourcing and trust facts with state-tax counsel before transferring shares or moving. A favorable trust jurisdiction alone does not determine the state taxation of a settlor, beneficiary or sale.

Worked Example: Founder Exit

Hypothetical historical-cohort example: A founder incorporates a qualifying software C corporation in 2021 and contributes $180,000 in cash and property for 4,000,000 shares. Assume $180,000 is both tax basis and the relevant Section 1202 basis, no pre-contribution built-in appreciation, and the corporation meets all eligibility requirements. Its gross assets never exceed $28,000,000.

In 2023 the founder gives 800,000 shares to each of two genuine separate non-grantor trusts. Assume the gifts are effective, do not assign an already-fixed sale right, and each trust qualifies as a separate taxpayer. Each trust receives $36,000 of allocated basis; the founder retains $108,000.

In 2027 all 4,000,000 shares sell for $96,000,000 after more than five years. The founder receives $57,600,000 of proceeds, less $108,000 basis, for $57,492,000 gain. Each trust receives $19,200,000 of proceeds, less $36,000 basis, for $19,164,000 gain. Transaction costs are omitted.

The 2021 acquisition date remains controlling after the gifts. Assuming no prior issuer gain, the founder and each trust have a $10,000,000 dollar limit, larger than their respective 10-times-basis ceilings. Each excludes $10,000,000, for $30,000,000 excluded in total.

Total gain is $95,820,000. After $30,000,000 of exclusions, taxable gain is $65,820,000: $47,492,000 for the founder plus $9,164,000 for each trust ($18,328,000 across both). State tax and all trust requirements must be analyzed separately.

At an assumed 23.8% federal rate, the $30,000,000 exclusion represents $7,140,000 of illustrated federal tax savings; the two trusts' $20,000,000 exclusions account for $4,760,000. These are scenario calculations, not a client result or a prediction of 2027 rates.

Frequently Asked Questions

Does S corporation stock qualify for Section 1202?

Revoking an S election does not turn existing S corporation shares into QSBS and does not create a deemed new stock issuance. A genuine new original issuance by an eligible domestic C corporation must be analyzed separately. Incorporating an LLC taxed as a partnership or disregarded entity can involve qualifying original-issue C corporation stock in exchange for property, if all requirements are met. The qualifying holding period generally starts at that incorporation, and Section 1202(i) prevents pre-contribution appreciation from becoming excludable gain.

How much gain can I exclude?

The eligible-gain ceiling is the greater of the remaining per-issuer dollar limit or 10 times the adjusted basis of that issuer's QSBS sold during the tax year, ignoring additions to basis after original issuance. The dollar limit is $10 million for stock acquired on or before July 4, 2025, or $15 million for stock acquired after July 4, 2025 (the 2026 amount, with inflation adjustments beginning after 2026). Prior eligible gain from the same issuer reduces the dollar limit; mixed old and new lots require coordination, not two independent allowances. Apply the applicable exclusion percentage to the eligible gain after this limit. Stock acquired on or before July 4, 2025 must be held for more than five years. Qualifying stock acquired after September 27, 2010 and on or before July 4, 2025 can receive a 100% exclusion. For stock acquired after July 4, 2025, the exclusion is 50% after at least three years, 75% after at least four years, and 100% after at least five years. These percentages apply to eligible gain after the per-issuer limit, not automatically to all sale proceeds. Acquisition dates reflect applicable holding-period tacking rules.

Can I multiply the exclusion by gifting stock?

A qualifying gift or transfer at death can preserve the original issuance treatment and holding period under Section 1202(h); it does not reset old stock into the post-July 4, 2025 regime. Separate noncorporate taxpayers may have separate per-issuer limits, but a married couple filing jointly does not get two dollar limits merely by holding shares separately. Grantor trusts do not create additional income-tax taxpayers. Non-grantor trusts require review of ownership, trust aggregation, completed gifts, valuation, gift-tax reporting and assignment-of-income risk. There is no universal safe number of trusts or waiting period.

What if I sell before five years?

Stock acquired on or before July 4, 2025 must be held for more than five years. Qualifying stock acquired after September 27, 2010 and on or before July 4, 2025 can receive a 100% exclusion. For stock acquired after July 4, 2025, the exclusion is 50% after at least three years, 75% after at least four years, and 100% after at least five years. These percentages apply to eligible gain after the per-issuer limit, not automatically to all sale proceeds. Acquisition dates reflect applicable holding-period tacking rules. Section 1045 may defer gain when a noncorporate taxpayer sells QSBS held for more than six months, elects rollover treatment, and buys replacement QSBS during the 60-day period beginning on the sale date. Full deferral generally requires reinvesting the amount realized, not just the gain. Deferred gain reduces replacement-stock basis; applicable holding-period tacking must be analyzed. A rollover does not automatically secure a later Section 1202 exclusion or increase its cap.

Do states honor the Section 1202 exclusion?

State treatment must be checked for the sale year, residency, sourcing and any trust. California does not conform to the federal Section 1202 exclusion. A federal exclusion therefore does not establish a zero state-tax result, and the 2025 federal expansion should not be assumed to apply in every state. A change of residence or trust location is not an automatic cure for state tax.

Can qualified small business stock reduce tax when I sell my C corporation?

Possibly, if the stock satisfies Section 1202's issuance, corporation, asset, trade, holding-period, and other requirements. An existing S corporation interest is not qualified small business stock simply because it later changes tax status.

For the underlying rules, see the official tax guidance. The relevant tax year, entity documents, actual transactions, and state filings determine the result.

Continue with Should I convert my S corporation to a C corporation before a future sale? How are earnouts taxed when I sell my business?, or browse the full owner question guide.

Book a Call to work through your actual figures and records.

Before You Rely on a QSBS Exclusion

Bring formation documents and tax elections, the cap table and each issuance agreement, option or convertible-instrument records, consideration and stock basis, historical balance sheets and contributed-property valuations, active-business records, redemption history, prior Section 1202 claims, trust or gift documents, state residency details, and the proposed sale timeline. Ask for a written lot-by-lot eligibility analysis and a stock-sale versus asset-sale comparison before relying on an exclusion.

A rental or leasing business does not become eligible merely by converting to a C corporation; Section 1202(e) also limits nonbusiness real estate. A useful first engagement should identify which share lots may qualify, missing evidence, the remaining issuer limit, state differences and the proposed transaction structure. Confirm the written scope, responsible tax and legal advisers, timing and fees before proceeding. Request a QSBS eligibility review.

Official Sources

Tax-law review: November 6, 2026. The statute governs newer-stock tiers; the 2025 IRS return instructions also describe eligibility and reporting for that return year. This guide is general information, not a determination that your stock qualifies.

Qualified Small Business Stock: The Section 1202 Exclusion Most Owners Never Claim