The Art of Timing: Qualified Small Business Stock (QSBS) Exclusion (§1202)

Do you own qualified small business stock? If so, are you aware of the Section 1202 exclusion that gives business owners and investors the ability to exclude up to 100% of capital gains taxes upon the sale or disposition of the shares?  

Investing in small businesses can have huge payouts, especially if you are able to find the next diamond in the rough. However, finding viable tax breaks and exclusions isn't always easy, especially for large capital gains transactions.  

In this article, we'll cover the fundamentals of the QSBS exclusion, including how the IRS defines a small business, who can take advantage of this exclusion, important tax planning opportunities, and reporting requirements. This article isn't a substitute for professional tax advice. If you have any questions about your specific situation, contact one of our team members today.  

The Qualified Small Business Stock (QSBS) exclusion is a tax benefit that allows eligible shareholders to exclude a portion or all of their capital gains tax upon sale. The goal of QSBS is to incentivize startup investments because starting or investing in startups can be riskier. The potential QSBS exclusion offers a tax benefit for taking the risk. The QSBS exclusion is governed by Section 1202 of the Internal Revenue Code. Let’s go through the different eligibility criteria that must be met.  

Qualified Small Business 

First, the company must be considered a qualified small business. This means meeting the following requirements:  

• Active Business – The company must be an active business that is structured as a C Corporation. S Corporations do not qualify.  
• Gross Assets – Gross assets must be $75 million or less at all times before and after equity was issued. However, shares issued before July 4, 2025, are subject to a $50 million gross asset requirement. The threshold was increased under the One Big Beautiful Bill.  
• Asset Use – At least 80% of the company’s assets must be used for qualified business activities. Business activities that are not eligible include: 
• Service-based businesses, like accounting or law 
• Businesses that rely on the owner’s reputation, like endorsements 
• Produce products, such as fossil fuels 
• Hotels, motels, and restaurants 
• Farming businesses  

If each of these three requirements is met, the company is considered a qualified small business.  

Holding Period 

Investors cannot take an immediate exclusion. In fact, you must hold the stock for a specific period of time. Stock issued prior to July 4, 2025, must be held for a minimum of five years to qualify for a 100% exclusion. However, the 100% exclusion only applies to shares acquired on or after September 27, 2010. Shares issued prior to this date are eligible for a 50% or 75% exclusion, depending on the date of issuance.  

The One Big Beautiful Bill Act brought forth transformative changes through amendments to Section 1202. After July 4, 2025, the holding period is a minimum of three years and takes a phased-in approach. Stock held for three years can claim a 50% exclusion, while stock held for four years is eligible for a 75% exclusion. Stock held for five or more years can claim a 100% exclusion.  

Disqualifying Factors 

Since the QSBS exclusion can significantly reduce capital gains taxes, there are other rules and requirements that must be met, including:  

• Share Repurchase – Shares issued within one year prior to and one year after are generally disqualified from the exclusion.  
• Investments – Investing in corporate bonds, money market funds, or other non-cash instruments with a liquidity term of over 24 months can impact QSBS eligibility.  
• Business Activity Change – Changing your business activity to a disallowed activity can void your qualified small business eligibility.  
• Asset Levels – Exceeding asset levels at any time could negate your QSBS status.  

If all eligibility factors are met, a significant portion of your capital gains tax could be eliminated. For shares issued after July 4, 2025, the maximum QSBS exclusion is up to $15 million or 10 times the share cost basis, whichever is higher. Shares issued prior to July 4, 2025, are eligible for an exclusion of up to $10 million or 10 times the share cost basis.  

Let's say that you put $15 million into an eligible QSBS after July 4, 2025. You satisfy the five-year holding period. Since the IRS allows you to exclude $15 million or 10 times your investment, you have the potential to exclude up to $150 million in federal capital gains tax.  

Related Party Transactions 

While related party transactions can qualify for QSBS, there are additional considerations. When a corporation purchases more than 5% of its stock back one year before or one year after, the QSBS exclusion can be disqualified. This threshold is reduced to 2% for related shareholders. At the same time, the time period is extended to two years before and two years after. This means related parties need to be mindful of the additional restrictions to maintain QSBS eligibility.  

When planning exits and mergers around QSBS eligibility, there are a few different strategies you can utilize, including:  

Stacking and Packing Exclusions  

Planning exits and mergers around QSBS eligibility can be done by stacking and packing the exclusion amount. Stacking exclusions through gifting can multiply the total exclusion amount. For example, using irrevocable non-grantor trusts for each family member creates separate taxpayers, each of which is eligible for the exclusion. Making a gift to the trust or a family member when the company's valuation is low can help minimize gift tax and maximize the exclusion amount.  

Another strategy involves strategically maximizing the basis limitation calculation by converting an LLC to a C Corp or contributing property in exchange for QSBS shares. When you convert an LLC to a C Corp, the LLC's fair market value at the time of the conversion serves as the basis. This might be higher compared to the initial basis when forming a C Corp from the start, allowing you to maximize the basis cap. Similarly, contributing valuable property can increase your cost basis in the company, which results in a higher basis cap for the exclusion calculation.  

Time Asset Infusions 

Exceeding the $75 million asset level ($50 million prior to July 4, 2025) could cause your QSBS eligibility to be revoked. This makes it important to carefully time fundraising rounds, inventory, and acquisitions around asset levels. For example, it might make sense to spread fundraising rounds across multiple months or years rather than hold one large round.   

Consider the Exit Timeline 

One of the non-negotiable factors of the QSBS exclusion is the holding period. This makes it important to consider your exit timeline to ensure you are meeting the five-year holding period for the 100% exclusion. One strategy to time your exit is to negotiate a delayed closing. Delaying the closing until the five-year period is met can solidify your exclusion. However, if postponing closing isn't an option, consider using an alternative agreement, like a joint venture.  

Moreover, another option is to stagger the sale of your shares. For example, you might sell your shares over five years. While you might not get the full QSBS exclusion, you can maximize capital gains tax savings in certain years. This strategy is also beneficial if the sale puts you over the annual exclusion cap.  

QSBS Attestation Letter 

If you are purchasing stock or investing in a company that you plan to leverage the QSBS exclusion, having an attestation letter is important. A QSBS attestation letter provides an in-depth review of your eligibility, including confirmation that you qualify for the small business status. This helps support your future QSBS exclusion according to IRS guidelines. Attestation letters should have two components: 

1. Company-Level Summary – This outlines the company's operations and eligibility criteria.  
2. Individual Letter – Each individual shareholder should also have a letter to support tax filings.  

QSBS attestation letters should be created annually to serve as a paper trail if the QSBS exclusion is ever questioned.

The QSBS exclusion is a federal tax benefit. This means that some states do not conform to the same tax treatment. In fact, a few notable states, including Alabama, California, Mississippi, and Pennsylvania, do not allow the QSBS at the state level, which could result in a fully taxable gain for state tax purposes. While the federal tax benefit may be enough to move forward with QSBS investments, it is important to consider the tax impact of state non-conformance.  

Capital gains taxation is generally allocated to the state where the business is run. For example, if the business is active in California, your gain will be taxed there. This gives investors the ability to make selective investments in states that conform to federal QSBS treatment. Let's say that you are choosing between two companies: one in Montana and one in Alabama. You may decide to pursue the investment in Montana if your end goal is to leverage the QSBS exclusion for both federal and state tax purposes.  

Do you own qualified small business stock? If so, it's important to start thinking about the QSBS exclusion years in advance to maximize your tax savings. Reach out to one of our team members today to go over your specific tax situation and uncover viable QSBS tax planning strategies to maximize your exclusion amount.