How QSBS works: the Section 1202 rules founders ask about too late
The qualified small business stock exclusion can remove federal tax on a large gain, but only if conditions set years before the sale were met.
Section 1202 of the Internal Revenue Code can exclude some or all of the federal tax on gain from selling qualifying startup stock. It is one of the most valuable provisions available to founders and early investors, and also one of the easiest to lose through decisions made long before anyone thinks about selling.
The provision covers qualified small business stock, usually shortened to QSBS. Most of the conditions are tested when the stock is issued and during the years you hold it, not on the day of the sale. By the time an acquisition letter arrives, most of the outcome is already fixed.
The core conditions
The issuer must be a domestic C corporation. Stock in an LLC or an S corporation does not qualify while the company has that status, which is one reason entity choice matters early.
You generally must acquire the stock at original issuance, directly from the company, in exchange for money, property other than stock, or services. Shares bought from another shareholder on a secondary market do not qualify in that buyer's hands, although stock received by gift or inheritance can carry the original holder's status.
The company must pass a gross assets test: its aggregate gross assets cannot exceed a statutory ceiling at any time before the stock is issued and immediately after. A company that has raised a very large round before issuing your shares may already be over the line.
During substantially all of your holding period, the company must meet an active business requirement, meaning at least 80 percent of its assets by value are used in the active conduct of a qualified trade or business.
The businesses that are excluded
Not every trade qualifies. The statute excludes businesses whose principal asset is the reputation or skill of employees, along with listed fields including health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage. Banking, insurance, financing, leasing and investing businesses are excluded, as are farming, certain extraction businesses, and hotels, motels and restaurants.
These lines are less clean in practice than on paper. A software company serving hospitals is not the same as a medical practice, but a business that sells expert services wrapped in software may draw a closer look. This is a question for tax counsel, ideally at formation and again whenever the business model shifts.
Holding periods and the size of the exclusion
The exclusion depends on how long you hold the stock and when it was issued. For a long stretch, the rule was that stock had to be held for more than five years, and the percentage of gain excluded depended on when it was acquired, reaching 100 percent for stock acquired after a 2010 change.
Legislation enacted in 2025 changed several parameters for stock issued after its enactment, including partial exclusions for shorter holding periods, a higher per-company cap on excluded gain and a higher gross assets ceiling. Shares issued before and after that date follow different rules, so the issuance date on each certificate matters.
The amount of gain you can exclude from any single company is capped at the greater of a fixed dollar amount or a multiple of your basis in the stock. Because the dollar figures have been revised and some are now indexed, confirm the current amounts with IRS guidance or your adviser rather than relying on a figure you saw in a pitch deck.
How founders lose it without noticing
Starting as an LLC and converting later is common and can work, but the QSBS clock and the basis generally reset at conversion, with basis measured at the value of what was contributed. Certain redemptions, when the company buys back stock from you or related parties around the time of issuance, can disqualify shares. Long periods of holding excess cash or investment assets can threaten the active business test.
Options and convertible instruments raise their own timing questions. The holding period for stock acquired through an option generally starts at exercise, not grant. Treatment of SAFEs and convertible notes is less settled, so ask about it before relying on an earlier start date.
State tax is a separate question. Some states do not follow the federal exclusion, California being the best-known example, so a federally tax-free gain can still produce a state bill.
There is also a rollover rule under Section 1045 that can let you defer gain on QSBS held for more than six months by reinvesting the proceeds in other QSBS within a set window. It is worth knowing exists if you sell early.
What to do now
Keep the paperwork. Store stock certificates or ledger entries showing issue date, what you paid and how. Ask the company to confirm in writing, each year if possible, that it believes it met the gross assets and active business tests, and keep that alongside your records.
If you are forming a company, raise QSBS with your lawyer at incorporation, not at the exit. If you already hold stock, have an adviser review it well before any sale process starts, while there is still time to fix what can be fixed.
This is general information, not tax advice. Rates and thresholds change; confirm current figures with the agencies linked below or with your accountant.
