The QSBS Gain Exclusion (Section 1202)

How it works

Section 1202 lets a non-corporate taxpayer exclude some or all of the gain on selling qualified small business stock, QSBS for short, once held long enough. At the top tier the excluded gain disappears from regular tax entirely, with no alternative minimum tax preference and no net investment income tax on the excluded portion. This is the most powerful gain-elimination tool in the Code for operating-company equity.

The exclusion is per issuer. Each corporation whose stock a taxpayer holds carries its own cap, and family members or separate non-grantor trusts can each claim their own cap, a technique generally called stacking.

Florida has no individual income tax, so this exclusion is a purely federal play here. What disappears is federal capital-gains tax, up to 20% plus the 3.8% surtax, or 28% plus that surtax on the non-excluded slice of partial-tier stock. Florida does add a cost: the C corporation pays the state's 5.5% corporate income tax while it operates.

Two regimes, split by acquisition date

Everything about the exclusion percentage, the per-issuer cap, and the gross-assets ceiling turns on whether the stock was issued on or before July 4, 2025, or after. That date is when the One Big Beautiful Bill Act, Public Law 119-21, rewrote section 1202 for new stock while leaving stock already issued in place.

Stock from the older window splits further by acquisition date: 50% from August 11, 1993 through February 17, 2009; 75% through September 27, 2010; and 100% from then through July 4, 2025.

Holding QSBS through a pass-through entity

A claim I hear often is that an S corporation cannot hold QSBS. That confuses two rules: the issuer must be a C corporation, but the holder need not be an individual. Section 1202(g) names partnerships, S corporations, regulated investment companies, and common trust funds as eligible holders. An S corporation cannot issue QSBS, but it can hold it, with gain flowing through treated as gain under the exclusion, and the taxpayer's proportionate share of the entity's basis carried into the cap.

This is the rule behind the structure I see most often: an S corporation holding company contributes an operating LLC to a newly formed C corporation and takes back that corporation's stock, an F-reorganization, becoming the QSBS holder rather than any individual. One condition is not optional: an owner shares in the exclusion only if they held their interest on the date the entity acquired the QSBS, and continuously after; anyone added later gets none, permanently, so ownership must be settled before the corporation issues stock.

Who this applies to

Section 1202 is narrow by design, and its gating tests sort out who can use it at all.

• The taxpayer. A non-corporate taxpayer: an individual, or a pass-through entity such as a partnership, S corporation, or trust allocating gain to non-corporate owners. A C corporation cannot claim this exclusion on its own stock.
• The issuer. A domestic C corporation, at issuance and for substantially all of the holding period after. An S corporation cannot issue QSBS, and converting to S status for any meaningful stretch can taint stock already issued.
• The acquisition. Stock acquired at original issue, directly from the corporation or through an underwriter, for money, property other than stock, or services. Buying existing stock from another shareholder never qualifies.

The active-business test also rules out an entire list of fields, regardless of the gross-assets and holding-period numbers:

• health, law, engineering, architecture, accounting, actuarial science, the performing arts, consulting, or athletics;
• financial services or brokerage services, or any business whose principal asset is the reputation or skill of its employees;
• banking, insurance, financing, leasing, investing, or a similar business;
• farming, including raising or harvesting trees;
• an extraction business claiming a depletion deduction; or
• a hotel, motel, restaurant, or similar business.

My own practice sits inside the excluded accounting field, so no structure would make it a QSBS issuer. The farming exclusion has a real exception: it reaches growing and selling agricultural, horticultural, or aquaculture commodities, not developing and selling or licensing the technology behind that work, such as hydroponic or recirculating aquaculture systems, equipment, or environmental controls. That kind of company can qualify, as long as it genuinely sells a product or licenses IP rather than founders' know-how.

What it requires

Aggregate gross assets, cash plus the adjusted basis of everything else, with contributed property counted at fair market value when contributed, cannot exceed the ceiling before issuance and immediately after; a later funding round past the ceiling disqualifies only the shares issued in that round, not shares already outstanding. Separately, during substantially all of the holding period, at least 80% of the corporation's assets by value must be used in the active conduct of a qualified trade or business, and more than 10% of net assets in portfolio securities, or more than 10% of total assets in unused real estate, fails this test alone.

Buybacks around the issuance date can undo a clean issuance. A redemption from the taxpayer or someone related to them, within the four years centered on the issuance date, disqualifies the stock unless it is both $10,000 or less and 2% or less of the relevant stock. A significant redemption from any holder, more than 5% of aggregate stock value, within the two years centered on the issuance date, does the same.

The per-issuer cap, and the mistake around it

The amount excludable per issuer is capped at the greater of a flat dollar limit, $10,000,000 for stock acquired on or before July 4, 2025 or $15,000,000 for stock acquired after that date, indexed for inflation after 2026, or 10 times the aggregate adjusted basis of that issuer's QSBS disposed of that year. The dollar limit is a lifetime figure per issuer, reduced by prior exclusions; the 10-times figure is computed fresh each year. Treating the dollar figure as the ceiling is the mistake worth naming: where a founder paid cash, it usually is, since cash basis already equals fair value.

Where a founder instead contributed appreciated property, section 1202(i)(1)(B) sets that stock's basis, for section 1202 purposes only, no lower than the property's fair market value at the exchange, a floor that often makes the dollar cap non-binding. That appraisal also marks the line between the property's pre-contribution appreciation, not itself excluded and still taxable as long-term capital gain, and the stock's appreciation from the contribution forward, which stands to be excluded. Through a pass-through entity, each owner's cap comes from their share of the entity's basis in the stock.

What gets contributed decides whether that floor exists at all. Section 1202(i) reaches property other than money or stock, so contributing a subsidiary's stock rather than its LLC interests fails the original-issue test and falls outside the floor at the same time, losing QSBS status and the basis floor together. In an F-reorganization, that makes converting a QSub to an LLC before the contribution a substantive step rather than housekeeping.

What you need to document

The defense file gets built at issuance, not at exit, since it documents the event as it happens.

The subscription or stock purchase agreement

Showing the stock was acquired directly from the corporation, or through an underwriter, and what was paid: cash, property, or services.

A QSBS confirmation from the issuer

A representation, obtained near issuance, that the corporation was a domestic C corporation under the gross-assets ceiling and running a qualified trade or business. The IRS issues no QSBS certificate; contemporaneous records stand in for one.

A gross-assets schedule as of the issuance date

The figure the ceiling test is measured against: cash plus the adjusted basis of other property, with contributions valued at fair market value when made.

A description of the business activity

Support for the qualified-trade-or-business characterization, particularly for a business that could be mistaken for an excluded field such as consulting.

The corporation's redemption history

A record of stock buybacks in the years surrounding the issuance, to confirm none fall inside the windows that can taint the stock.

Where it goes wrong

None of this is a listed or reportable transaction; Congress built the exclusion to be used. What gets it disallowed is failing one of the points above, and a few mistakes recur.

Eligibility mistakes

• No proof of original issue. Stock bought from another shareholder rather than subscribed for directly is categorically ineligible; the subscription and cap-table records settle the question.
• The gross-assets ceiling was already blown at issuance. Gross assets exceeding the ceiling right after a round closed means that round's stock never qualified, with no later fix.
• The business gets recharacterized into an excluded field. Consulting and a business whose principal asset is employee reputation or skill are the most litigated categories; a clear, contemporaneous description of the business is the practical defense.
• The issuer's C corporation status breaks. Operating as, or converting to, an S corporation or a partnership for any meaningful stretch defeats the requirement that the issuer stay a C corporation for substantially all of the holding period.
• Counting the holding period from the wrong date. Stock from an option or warrant exercise, or a convertible-note conversion, starts its holding period at exercise or conversion, not at grant.
• Stacking with a trust that is not really separate. A trust the grantor still controls for income-tax purposes is the same taxpayer for this purpose and gets no separate per-issuer cap.

The pass-through trap

The continuous-interest condition above cannot be fixed after the fact. Gifting the QSBS itself carries the exclusion and the donor's holding period under section 1202(h), but gifting shares or units in the holding entity is not a transfer of the QSBS and gets no such tacking. Distributing the stock out does not work either: a corporation's distribution of appreciated property is a deemed sale at fair value, triggering the entire gain. The fix is settling the cap table before the C corporation issues stock.

Two rate traps on top of eligibility

Two costs sit on top of eligibility. Seven percent of excluded gain is an AMT preference item, but only for stock acquired on or before September 27, 2010, reaching the legacy 50% and 75% tiers only; stock acquired later, including the 2025 law's tiers, carries none. Separately, converting from S to C status gives up the net investment income tax carve-out section 1411(c)(4) gives an active S corporation owner; C corporation stock gets no equivalent relief, so the surtax reaches whatever gain the exclusion does not cover, often the pre-contribution gain the 1202(i) floor carves out.

Selling before the holding period is met

Section 1045 lets a taxpayer defer gain rather than lose the exclusion outright, if QSBS is sold before reaching the desired tier: the original stock must be held more than 6 months, and the proceeds reinvested in replacement QSBS within 60 days of the sale, with only the excess over the replacement cost taxed currently. The original holding period does carry forward. Section 1223(13) includes the period the original stock was held when measuring the replacement stock's section 1202 holding period, so stock held four years before the rollover arrives at the replacement with four years already run, and reaches the next exclusion tier a year later rather than starting over. The statute carves out only sections 1202(a)(2) and 1202(c)(2)(A) from that tacking. The separate 6-month rule in section 1045(b)(4)(B) is not the exclusion clock: it applies to the replacement corporation's active-business requirement under section 1202(c)(2).

A situation where this comes up

The version of this I see most often does not start with someone asking about section 1202. It starts with an existing profitable LLC or S corporation whose owner is raising outside capital or planning toward an eventual sale, and section 1202 becomes relevant because a C corporation is already being considered.

The mechanics are usually the F-reorganization described above: a new S corporation holding company contributes the operating business to a newly formed C corporation for its stock, becoming the QSBS holder rather than any individual, with the exclusion flowing to its owners under section 1202(g). What has to happen first is the holding company's own ownership: a spouse, adult child, or trust meant to share in the exclusion has to be an owner before the C corporation issues stock.

What I look at closely here is the property being contributed. Where it has appreciated well above its tax basis, section 1202(i) sets a stock basis for section 1202 purposes at that higher fair market value instead, and that basis is what the per-issuer cap is built from. The trade-off: appreciation the business had before the contribution does not get the exclusion, only what it earns afterward. Getting the appraisal right, and settling the cap table before the stock issues, cannot be corrected later.