Section 1202 QSBS Exclusion: The $10M Tax-Free Startup Exit Strategy

Executive Summary

Investing in small businesses can be a lucrative endeavor, especially when tax incentives are involved. One such incentive is the Qualified Small Business Stock (QSBS) exclusion under IRC Section 1202. Enacted in 1993, this provision allows noncorporate taxpayers, such as individuals, trusts, and estates, to exclude a significant portion of capital gains from the sale of QSBS, provided certain conditions are met. The primary aim is to stimulate investment in small businesses by offering substantial tax savings. For instance, stock acquired after September 27, 2010, can benefit from a 100% exclusion on gains, subject to specific limits. With recent legislative changes under the One Big Beautiful Bill Act (OBBBA), these benefits have been further enhanced, making QSBS an even more attractive option for investors.

The bottom line: QSBS offers a powerful tax incentive for investing in small businesses, with potential exclusions of up to 100% on capital gains, subject to certain conditions and limits.¹

Critical Warning: Failure to meet the holding period or other qualifying criteria can result in the loss of QSBS benefits, leading to significant tax liabilities.²

---

Understanding Qualified Small Business Stock (QSBS)

Definition and Eligibility Criteria

Qualified Small Business Stock (QSBS) is a unique tax provision under IRC Section 1202 designed to encourage investment in small businesses. To qualify as QSBS, the stock must be issued by a domestic C corporation with gross assets not exceeding $50 million at the time of issuance and at all times thereafter. The corporation must be engaged in a qualified trade or business, excluding industries such as banking, finance, farming, mining, and certain professional services like health, law, and accounting.³

Key Eligibility Requirements:

• Domestic C Corporation: The issuing company must be a C corporation based in the United States.
• Gross Asset Limitation: The corporation's gross assets must not exceed $50 million at the time of issuance and substantially all prior times.
• Qualified Trade or Business: The corporation must operate in a qualified industry, excluding certain specified sectors.

Exclusion Limits and Benefits

The QSBS exclusion allows taxpayers to exclude the greater of $10 million or 10 times the adjusted basis of the stock from capital gains tax. The exclusion percentage varies based on the acquisition date of the stock, with a 100% exclusion available for stock acquired after September 27, 2010.⁴

Example Calculation:

Consider an investor who purchases QSBS with a $1 million basis and sells it for $25 million after six years. The gain is $24 million. The excludable amount is the greater of $10 million or 10 times the $1 million basis, resulting in a $10 million exclusion. The remaining $14 million is taxed at 20% plus a 3.8% Net Investment Income Tax (NIIT), totaling approximately $2.83 million in taxes. Without the exclusion, the tax would be $5.71 million, saving the investor 50% in taxes.

Gain = Sale Price - Basis Gain = $25M - $1M = $24M Excludable = Greater of $10M or 10x$1M = $10M Taxable Gain = $24M - $10M = $14M Tax = $14M * (20% + 3.8%) = ~$2.83M

Reporting Requirements

Taxpayers must report QSBS transactions on Form 8949 and Schedule D, using standard capital gains forms. There is no specific IRS form dedicated to QSBS, unlike other tax provisions.⁵

---

Changes Under the One Big Beautiful Bill Act (OBBBA)

Enhanced Benefits Post-2025

The One Big Beautiful Bill Act (P.L. 119-21), signed into law on July 4, 2025, introduced significant enhancements to the QSBS benefits. These changes aim to further incentivize investment in small businesses by increasing the exclusion limits and adjusting the asset thresholds.

Key Changes:

• Tiered Exclusion: The exclusion is now tiered based on the holding period: 50% for more than 3 years, 75% for more than 4 years, and 100% for more than 5 years.
• Increased Cap: The exclusion cap has been raised to the greater of $15 million or 10 times the adjusted basis, indexed for inflation post-2026.
• Asset Threshold: The gross asset threshold has been increased to $75 million, also indexed for inflation post-2026/2027.⁶

Example Calculation Post-OBBBA

An investor acquires QSBS for $2 million and sells it for $30 million after five years. The gain is $28 million. Under the new rules, the excludable amount is the greater of $15 million or 10 times the $2 million basis, resulting in a $15 million exclusion. The remaining $13 million is taxed at 20% plus a 3.8% NIIT, totaling approximately $2.63 million in taxes.

Gain = Sale Price - Basis Gain = $30M - $2M = $28M Excludable = Greater of $15M or 10x$2M = $15M Taxable Gain = $28M - $15M = $13M Tax = $13M * (20% + 3.8%) = ~$2.63M

Key Takeaways

• Increased Benefits: The OBBBA significantly enhances the benefits of QSBS, making it more attractive for investors.
• Inflation Indexing: Both the exclusion cap and asset threshold are now indexed for inflation, ensuring the benefits keep pace with economic changes.
• Tiered Exclusion: The introduction of a tiered exclusion system provides flexibility based on the holding period.

---

Key Rules and Tacking

Holding Period and Tacking

The holding period for QSBS begins at the time of issuance, exercise, or conversion, such as with options or warrants. The holding period can be "tacked" under IRC §1223 for gifts, inheritance, partnerships, and tax-free exchanges, allowing the recipient to benefit from the original holding period.⁷

Example of Tacking:

An investor receives QSBS as a gift after the original holder held it for three years. The recipient must hold the stock for an additional two years to qualify for the 100% exclusion under the pre-OBBBA rules.

Maintaining QSBS Status

To maintain QSBS status, the stock must qualify as QSBS for "substantially all" (85%-95%) of the holding period. This includes maintaining C-corporation status, adhering to the gross asset threshold, and ensuring at least 80% of assets are used in a qualified trade or business.⁸

Important Note: Changes in business operations, mergers, or acquisitions can jeopardize QSBS status, potentially disqualifying the stock from tax benefits.

Common Mistakes and Pitfalls to Avoid

• Failing to Meet Holding Periods: Investors must be diligent in tracking holding periods to ensure eligibility for the desired exclusion percentage.
• Business Changes: Significant changes in business operations or structure can affect QSBS status, leading to potential tax liabilities.

---

Real-World Scenarios and Examples

Scenario 1: Startup Investment

An investor purchases QSBS in a tech startup for $500,000. After six years, the stock is sold for $10 million. The gain is $9.5 million. Under the pre-OBBBA rules, the excludable amount is the greater of $10 million or 10 times the $500,000 basis, resulting in a $5 million exclusion. The remaining $4.5 million is taxed at 20% plus a 3.8% NIIT, totaling approximately $1.26 million in taxes.

Scenario 2: Post-OBBBA Acquisition

An investor acquires QSBS for $3 million in 2026 and sells it for $40 million after five years. The gain is $37 million. Under the post-OBBBA rules, the excludable amount is the greater of $15 million or 10 times the $3 million basis, resulting in a $15 million exclusion. The remaining $22 million is taxed at 20% plus a 3.8% NIIT, totaling approximately $4.62 million in taxes.

Scenario 3: Gifted QSBS

An individual receives QSBS as a gift, originally purchased for $1 million and held for four years. The recipient holds the stock for an additional year and sells it for $20 million. The gain is $19 million. The excludable amount is the greater of $10 million or 10 times the $1 million basis, resulting in a $10 million exclusion. The remaining $9 million is taxed at 20% plus a 3.8% NIIT, totaling approximately $1.98 million in taxes.

---

Frequently Asked Questions

What is the primary purpose of QSBS?

Answer: The primary purpose of QSBS is to encourage investment in small businesses by offering significant tax exclusions on capital gains, thereby stimulating economic growth and innovation.

Source: Cornell Law School

How does the holding period affect QSBS benefits?

Answer: The holding period determines the percentage of capital gains exclusion available. Under pre-OBBBA rules, a 100% exclusion is available for stock held more than five years. Post-OBBBA, tiered exclusions apply based on holding duration.

Source: Grant Thornton

Can QSBS status be lost after issuance?

Answer: Yes, QSBS status can be lost if the issuing corporation undergoes significant changes, such as mergers or exceeding asset thresholds, which disqualify it from being a qualified trade or business.

Source: Kutak Rock

What are the reporting requirements for QSBS?

Answer: QSBS transactions must be reported on Form 8949 and Schedule D using standard capital gains forms. There is no specific IRS form for QSBS.

Source: IRS

How does the OBBBA impact QSBS exclusions?

Answer: The OBBBA enhances QSBS exclusions by introducing tiered exclusion percentages, increasing the exclusion cap to $15 million, and raising the asset threshold to $75 million, all indexed for inflation.

Source: Grant Thornton

Are there any industries excluded from QSBS eligibility?

Answer: Yes, industries such as banking, finance, farming, mining, and certain professional services like health, law, and accounting are excluded from QSBS eligibility.

Source: Holland & Knight

What happens if the gross asset threshold is exceeded?

Answer: If the gross asset threshold is exceeded, the stock may lose its QSBS status, disqualifying it from the tax benefits associated with QSBS.

Source: Kutak Rock

Can QSBS be transferred through inheritance?

Answer: Yes, QSBS can be transferred through inheritance, and the holding period can be tacked, allowing the heir to benefit from the original holding period for exclusion purposes.

Source: Cornell Law School

---

Footnotes

---

Primary Sources

---

Disclaimer: This guide discusses legal tax optimization strategies only. Tax evasion is illegal and is never recommended. This content is for educational purposes and does not constitute tax, legal, or financial advice. Tax laws vary by jurisdiction and change frequently. Always consult a qualified tax professional (CPA, tax attorney, enrolled agent) before making decisions based on this information. The authors accept no liability for actions taken based on this content.

Footnotes

1. Reference details with source ↩

2. Reference details with source ↩

3. Cornell Law School ↩

4. Plante Moran ↩

5. IRS ↩

6. Grant Thornton ↩

7. Holland & Knight ↩

8. Kutak Rock ↩