QSBS Exclusion: How to Exclude Up to $10M in Capital Gains Under Section 1202
The single largest exclusion available to a business owner on a sale, and the one with the most ways to fail a test years before the exit.
The qualified small business stock exclusion under Internal Revenue Code Section 1202 allows an individual to exclude the greater of $10 million or 10 times basis of gain on the sale of stock in a qualifying domestic C corporation held more than five years. For stock issued after July 4, 2025, the 2025 tax act raised that per-issuer ceiling to $15 million and added a partial exclusion at three and four years. The exclusion is not elective and not retroactive: the stock either satisfied every test at issuance and throughout the holding period, or it did not.
What Section 1202 Actually Does
Section 1202 excludes gain from federal income tax entirely. It is not a deferral and not a rate reduction. Gain that qualifies is never taxed, is not subject to the 3.8 percent net investment income tax, and for stock acquired after September 27, 2010 carries no alternative minimum tax preference.
The ceiling applies per taxpayer, per issuing corporation. An owner with qualifying stock in two unrelated companies has a separate cap for each. That per taxpayer framing is what makes the planning in the trust section below possible, and it is the difference between excluding $10 million and excluding $40 million on the same sale.
State treatment is separate. Most states follow the federal exclusion, several modify it, and a small number disallow it outright. The state answer has to be checked against the state of residence at the time of sale, which is itself a planning variable when a move is already under consideration.
The Five Tests the Stock Has to Pass
All five apply. Failing any one disqualifies the entire position.
1. Domestic C corporation. The issuer must be a C corporation for substantially all of the holding period. S corporation stock never qualifies, and neither does an LLC interest or partnership interest.
2. Original issuance. The stock must be acquired directly from the corporation for money, property, or services. Stock bought from another shareholder does not qualify, though stock received by gift or inheritance can carry the original holder's status forward.
3. The gross assets test. The corporation's aggregate gross assets must not have exceeded $50 million at any point before, and immediately after, the stock was issued. The 2025 act raised this to $75 million for stock issued after July 4, 2025. Assets are measured at adjusted basis, not fair market value, with contributed property measured at fair market value on contribution.
4. The active business test. At least 80 percent of assets by value must be used in the active conduct of a qualified trade or business throughout substantially all of the holding period. Cash and investments held beyond reasonable working capital needs count against this, which is why a company that accumulates a large investment portfolio can fail the test in the years before a sale without anyone noticing.
5. The holding period. More than five years, running from issuance.
What the 2025 Law Changed
The changes apply to stock issued after July 4, 2025. Stock issued on or before that date keeps the prior rules in full, which means many owners now hold two tranches governed by different regimes.
| Provision | Stock issued on or before 7/4/2025 | Stock issued after 7/4/2025 |
|---|---|---|
| Per-issuer cap | $10 million or 10x basis | $15 million or 10x basis, indexed from 2027 |
| Gross assets ceiling | $50 million | $75 million |
| Held 3 years | No exclusion | 50 percent excluded |
| Held 4 years | No exclusion | 75 percent excluded |
| Held 5 years or more | 100 percent excluded | 100 percent excluded |
The tiered exclusion is the practical change. Under the old rules an owner who sold at four years and eleven months received nothing. Under the new rules the same sale excludes 75 percent of the gain, which changes how hard a seller should push to delay a closing.
Which Businesses Qualify, and Which Are Excluded by Name
The statute excludes several categories outright, regardless of size or structure: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services, where the principal asset is the reputation or skill of one or more employees. Also excluded are banking and insurance, farming, businesses eligible for percentage depletion, and any hotel, motel, or restaurant.
That list eliminates a meaningful share of professional service firms, which is why Section 1202 rarely drives the plan for a medical or legal practice. Software, manufacturing, distribution, consumer products, technology services, and most product businesses do qualify.
The line is not always obvious. A business that sells a technology product but delivers substantial implementation services can look like consulting on one set of facts and a product company on another. Where the answer is close, the file should document why the principal asset is the product rather than the people, and that documentation is far easier to assemble at issuance than during diligence.
The S Corporation Problem
Most profitable owner-operated businesses are S corporations, and S corporation stock is permanently outside Section 1202. This is the most common reason the exclusion is unavailable to exactly the owner who would benefit most.
Converting an S corporation to a C corporation starts a new five-year clock, and the basis of the stock deemed issued on conversion is the fair market value of the assets at that date. Only appreciation after the conversion is eligible. An owner converting a business already worth $12 million excludes nothing on that $12 million and starts qualifying only on growth from there.
The conversion also means the corporation pays 21 percent on its earnings, and distributions are taxed again as dividends. That cost is real and recurring, so the conversion only makes sense where the expected exclusion outweighs several years of double taxation. Working that comparison is the reason the entity decision belongs in a model rather than a rule of thumb. Our entity structuring guide covers the same trade-off from the operating side.
Stacking and Packing: Multiplying the Cap
Because the cap is per taxpayer, giving shares to additional taxpayers before a sale multiplies it. Two techniques do this.
Stacking transfers shares to non-grantor trusts, each of which is a separate taxpayer with its own exclusion. A founder with $60 million of qualifying gain and a $15 million cap might gift shares to three irrevocable non-grantor trusts for children, producing four caps and excluding the full amount. The trusts must be genuinely non-grantor, funded well before any binding agreement, and drafted with different beneficiaries to avoid being treated as a single trust under the multiple trust rules.
Packing uses the 10 times basis alternative. A shareholder who contributes appreciated property to the corporation in exchange for stock takes a Section 1202 basis equal to the property's fair market value, so a $5 million contribution supports $50 million of excluded gain rather than $15 million.
Both require lead time. Gifts made after a letter of intent is signed invite an assignment of income argument, and gifts made in the same year as a sale face a valuation that is hard to discount when the sale price is already known. Two years of separation is comfortable, one year is workable, and thirty days is not.
What It Is Worth
Consider a founder selling qualifying stock for $18 million with a basis near zero, resident in a state that follows the federal exclusion.
| Scenario | Taxable gain | Federal tax at 23.8 percent |
|---|---|---|
| No QSBS | $18,000,000 | $4,284,000 |
| QSBS, one $15M cap | $3,000,000 | $714,000 |
| QSBS stacked across four taxpayers | $0 | $0 |
The gap between the second and third rows is entirely a function of work done years earlier. Nothing about the sale itself changes. This is the clearest example on the site of why exit planning has to start before the exit is on the calendar, and it is covered in sequence in the exit tax planning guide.
Key Takeaways
- Section 1202 excludes gain permanently, with no net investment income tax and no AMT preference.
- S corporation stock never qualifies, and converting starts a new five-year clock at current value.
- Stock issued after July 4, 2025 gets a $15 million cap and partial exclusions at three and four years.
- Health, law, accounting, consulting, financial services, and restaurants are excluded by statute.
- The cap is per taxpayer, so non-grantor trusts funded well before a sale multiply it.
- Every test is evaluated at issuance and across the holding period, not at closing.
Start With the Pillar Guide
Frequently Asked Questions
Can I get QSBS treatment if my company is an LLC or S corporation?
Not on the interest you hold now. Section 1202 applies only to stock in a domestic C corporation. An LLC can convert to a C corporation and issue qualifying stock, but the five-year clock starts at conversion and only appreciation after that date is eligible, because basis is set at the fair market value of the contributed assets.
What happens if I sell before five years?
For stock issued after July 4, 2025, a sale at three years excludes 50 percent of the gain and at four years excludes 75 percent. For older stock, a sale before five years excludes nothing. In either case a Section 1045 rollover can preserve the position by reinvesting the proceeds in other qualified small business stock within 60 days, with the original holding period carrying over.
Does the exclusion apply to an asset sale?
No. Section 1202 applies to the sale of stock. If the buyer insists on buying assets, the corporation recognizes the gain and the exclusion is lost, which is one of the few situations where a seller should hold firm on structure. See how to structure your business for sale for how that negotiation usually resolves.
How many trusts can I use to stack the exclusion?
There is no statutory limit, but each trust must be a separate taxpayer with a genuine, distinct beneficial interest and its own purpose. Trusts created on the same day with the same terms and the same beneficiary invite consolidation under the multiple trust rules. In practice three to five trusts with different primary beneficiaries is a defensible structure and ten identical ones is not.
Do I need to do anything to claim the exclusion?
It is reported on the return in the year of sale, but the substantiation is built over the life of the company: the issuance documents, the gross assets calculation at each issuance, and evidence the active business test was met throughout. Companies that never assembled that file end up reconstructing it under diligence pressure, and buyers price the uncertainty.
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