QSBS Exemption Guide: How Section 1202 Excludes Up to 100% of Founder Gain

If you founded a startup or joined as an early employee at a US C-corporation, Qualified Small Business Stock (QSBS) under Internal Revenue Code §1202 is potentially the single most valuable tax provision in the code for you. Stock that meets the §1202 qualification can be sold with up to 100% of the gain excluded from federal income tax, capped at the greater of $10 million or 10× your tax basis per issuer. On a $9M founder exit that’s typically a $1.8–$2M federal tax savings — but only if the stock qualifies and you held it long enough.

This is one of those tax provisions that almost looks too good to be true. It survived multiple Congressional repeal attempts and was made permanent by the PATH Act of 2015. Here’s exactly how to qualify and what the calculator behind the curtain checks.

The headline benefit

Under IRC §1202(a), a non-corporate taxpayer who holds qualified small business stock for more than 5 years and sells it can exclude a percentage of the gain from gross income:

Stock acquired at original issuance after September 27, 2010 — and held for 5+ years — qualifies for the 100% exclusion with no AMT preference. That’s a complete federal income-tax holiday on the capped portion of the gain.

The cap: the applicable dollar limit OR 10× basis

The exclusion is capped at the greater of:

• the per-issuer dollar limit (reduced by aggregate prior excluded gain from the same issuer) — $10,000,000 for stock acquired on or before 4 July 2025, and $15,000,000 for stock acquired after that date under §1202(b)(4)(B) as amended by OBBBA §70431(b), OR
• 10× the aggregate adjusted basis of qualifying stock disposed of by the taxpayer during the year

A founder with $1,000 of basis in a pre-OBBBA startup that sells for $50M gets $10M excluded ($10M cap > 10× $1,000 = $10,000); the same founder holding post-4-July-2025 stock gets $15M. An employee who exercised for $500,000 and sells for $20M gets the greater of the dollar cap and $5M (10× basis) — $10M excluded under Regime A, leaving $9.5M taxable, or $15M under Regime B, leaving $4.5M. The 10× basis test only beats the dollar cap when basis exceeds $1M (Regime A) or $1.5M (Regime B). The $15M figure is indexed for inflation for tax years beginning after 2026, and is halved for a married taxpayer filing separately.

The $10M cap is per issuer per taxpayer. A founder holding stock in three separate qualifying companies has three separate $10M caps. On a joint return, gain taken into account is allocated equally between the spouses for applying the cap in later years (§1202(b)(3)(B)), and a married individual filing separately gets half the cap.

The qualification tests

Stock qualifies as QSBS only if all of the following are true:

1. Domestic C-corporation

The issuer must be a domestic C-corp at the time the stock is issued AND at all times during substantially all of the holder’s holding period. LLCs, S-corps, and partnerships do not qualify at the entity level. If your startup converts from an LLC to a C-corp, the QSBS clock starts at the conversion date — not at the original LLC formation.

If the company converts from C-corp to S-corp during your holding period, you lose QSBS qualification on the conversion date. The statute requires C-corporation status during substantially all of your holding period (§1202(c)(2)(A)).

2. Original-issuance acquisition

You must acquire the stock at original issuance from the corporation in exchange for money, property (other than stock), or services to the corporation. Buying QSBS-eligible stock on the secondary market does not give the buyer §1202 status — the new owner starts with non-QSBS basis. Narrow exceptions: (a) gifts, inheritance, and certain partnership distributions can transfer QSBS status under §1202(h); (b) stock acquired solely through conversion of other QSBS of the same corporation keeps QSBS status and the converted stock’s holding period (§1202(f)).

3. Aggregate gross assets test — $50 million, or $75 million post-OBBBA

At all times before AND immediately after the issuance, the corporation’s aggregate gross assets must not exceed the ceiling in §1202(d)(1): $50 million for stock issued on or before 4 July 2025, and $75 million for stock issued after that date (OBBBA §70431(c)(1), indexed for inflation from 2027). “Aggregate gross assets” means cash plus other property held by the corporation, valued at adjusted basis (or fair market value if the property was contributed to the corp). The test is checked at issuance — once the company crosses the ceiling, previously-issued stock remains qualified (the limit doesn’t retroactively disqualify), but newly-issued stock from that point forward is not QSBS.

Note the effective-date wording differs from the cap and tier changes: the gross-assets increase keys on when the stock was issued, so a company that crossed $50M in 2024 cannot use the higher ceiling for shares issued back then.

This is why early employees benefit most: the cap is tested against company size at the time of stock issuance. A founder issued shares at incorporation when the company had no assets clearly qualifies. An employee who joins after a $30M Series B and gets options issued when the company has $35M of cash + IP — also qualifies. An employee joining after a $100M Series D — does not.

4. Active business in a qualified trade

At least 80% of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses. §1202(e)(3) explicitly disqualifies certain trades:

• Services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services, or any trade where the principal asset is the reputation or skill of employees
• Banking, insurance, financing, leasing, investing, or similar businesses
• Farming (including raising or harvesting trees)
• Production or extraction of products from oil, gas, mining
• Hotel, motel, restaurant, or similar lodging/food businesses

Most software, biotech, hardware, and consumer-product C-corps pass this test cleanly. Service businesses (consulting, financial advisory) generally do not.

5. Five-year holding period

This rule now depends on when you acquired the stock — OBBBA §70431(a) split it in two (see the OBBBA section below).

• Stock acquired on or before 4 July 2025: the old rule. Held by the same taxpayer (or a transferee with carryover basis) for more than 5 years, or there is no §1202 exclusion at all, not even partial. Sell at year 4 and 11 months and you get nothing; hold five years and one day and you get the full 100%.
• Stock acquired after 4 July 2025: tiered under §1202(a)(1)(B) and the new §1202(a)(5) table — 50% at 3 years, 75% at 4 years, 100% at 5 or more. Under 3 years is still zero (consider a §1045 rollover).

§1045 rollover: the partial fix for under-5-year sales

If you must sell QSBS before the 5-year mark, IRC §1045 lets you roll the gain into another QSBS investment within 60 days and defer recognition. The rolled basis carries forward, and the holding periods aggregate (with some technical limits). This is how some serial entrepreneurs maintain QSBS treatment across multiple ventures.

State conformity: where QSBS is fully respected vs not

Federal §1202 exclusion does not bind state income tax. States vary widely:

• Follows the federal exclusion: New Jersey, beginning tax year 2026 — P.L. 2025, c.67 exempts QSBS gain from the Gross Income Tax to the extent it is exempt federally under §1202. Before 2026 New Jersey taxed the gain.
• Decoupled — no QSBS exclusion: California does not follow the federal exclusion; its Form 540 instructions list gain on QSBS under IRC §1045 and §1202 as a federal-state difference to adjust on Schedule D (540), and the state taxes the gain as ordinary-rate income. Pennsylvania has no exclusion either: its personal income tax taxes gain on the disposition of any property, including stock, and “makes no provision for capital gains”. Massachusetts applies its own reduced rate to gain on stock in qualifying Massachusetts-domiciled small corporations (M.G.L. c.62 §4(c)). Other states differ — check your state’s revenue department before assuming the exclusion carries over.
• No income tax: Texas, Florida, Washington, Nevada, etc. — irrelevant whether they conform; no state tax either way.

For founders considering pre-IPO state moves, the QSBS conformity gap is one of the biggest single-line items: a $9M federal-excluded gain in California still costs ~$1.2M in state tax; the same gain in Texas costs $0.

Common QSBS mistakes

Assuming the LLC’s history counts after a conversion. When an LLC converts to a C-corp, stock received for property is treated as acquired on the date of the exchange, with a basis of at least the fair market value of the property exchanged (§1202(i)(1)). The holding-period clock starts then, so plan the earliest sale date from the conversion date and document the value at conversion.

Corporate buybacks around issuance. §1202(c)(3) disqualifies stock if the corporation bought any of its stock from the taxpayer or a related person during the 4-year period beginning 2 years before issuance (Treas. Reg. §1.1202-2 allows a de minimis amount), or if its purchases of its own stock in the 2-year period beginning 1 year before issuance exceed 5% of the value of all its stock. Founder-share buybacks during early funding rounds can trip this.

Failing to document the gross-asset test. The corporation should produce an asset roll-forward at each issuance event. If the IRS challenges QSBS years later at sale, you’ll need contemporaneous evidence that aggregate gross assets stayed under the applicable ceiling ($50M, or $75M for stock issued after 4 July 2025) through the issuance date. Most early-stage CPA firms don’t produce this without being asked.

Mixing QSBS and non-QSBS stock. If you hold both qualifying and non-qualifying stock in the same issuer (e.g., some shares acquired at original issuance and others bought on the secondary market), you must track basis and acquisition date by lot. The IRS does not let you cherry-pick which lot you sell.

OBBBA changed §1202 — and it is enacted law, not a proposal

The One Big Beautiful Bill Act (P.L. 119-21) was signed on 4 July 2025, and §70431 “Expansion of Qualified Small Business Stock Gain Exclusion” is in force. It creates two regimes that turn on the date you acquired the stock — that date, not the sale date, is what decides which set of rules applies to you.

Statutory anchors: §1202(a)(1)(B) and the new §1202(a)(5) table for the tiers; §1202(b)(4)(B) for the $15M cap and §1202(b)(3)(A)(ii) for the MFS halving; §70431(c)(1) for the $75M gross-assets figure. The tier and cap changes apply to taxable years beginning after enactment; the gross-assets increase applies to stock issued after enactment.

The tiers are the change that matters most. Under Regime A a sale one day short of five years is worth nothing. Under Regime B a founder who sells at year 3 excludes 50% of the gain and at year 4 excludes 75% — real money on an exit that used to be a total loss of the benefit. Model your own dates in the QSBS Calculator, which implements both regimes.

Key takeaways

• §1202 excludes up to 100% of gain on QSBS held 5+ years, capped at the greater of the per-issuer dollar limit ($10M pre-OBBBA, $15M for stock acquired after 4 July 2025) or 10× basis
• Original-issuance acquisition only — buying QSBS-eligible stock on the secondary market does not transfer the benefit
• C-corp domestic issuer, aggregate gross assets at issuance under $50M ($75M for stock issued after 4 July 2025), active qualified trade or business
• Most professional-services trades disqualify (law, finance, consulting, healthcare); most software/biotech/hardware C-corps qualify
• Holding period depends on your acquisition date — binary at 5 years for stock acquired on or before 4 July 2025, but tiered 50%/75%/100% at 3/4/5 years for stock acquired after that date (OBBBA §70431(a))
• California and Pennsylvania do not follow the exclusion (New Jersey did not before 2026) — state-level tax planning is independent of the federal exclusion
• Document the §351 conversion, the gross-asset test at each issuance, and the original-issuance status — these are the audit attack points

Run your specific scenario in the QSBS Calculator — it computes the federally-excluded portion, the residual taxable gain, and the state tax where the state does not follow the exclusion.