Qualified Small Business Stock (QSBS)

Qualified small business stock is stock in a domestic C corporation that meets the tests set out in Internal Revenue Code section 1202, held by a noncorporate taxpayer for a minimum period. On a sale of that stock the holder may exclude a percentage of the gain from federal taxable income, up to a cap measured per issuing corporation. The Internal Revenue Code spells the term "qualified small business stock"; practitioners almost always shorten it to QSBS, and the exclusion itself is often called the section 1202 exclusion.

Two things about the definition are worth stating precisely. The stock must have been received directly from the corporation at original issuance, in exchange for money, other property, or services, rather than bought from another shareholder in a secondary sale. And the corporation must have been a domestic C corporation with aggregate gross assets at or below a statutory ceiling at the time the stock was issued and immediately after.

The July 2025 rewrite is what makes stating this rule carefully matter. The One Big Beautiful Bill Act, Public Law 119-21 section 70431, amended section 1202 for stock acquired after July 4, 2025. Two numbers moved and one rule became a schedule. The per-issuer cap on excluded gain rose from the greater of $10 million or 10 times basis to the greater of $15 million or 10 times basis, with the $15 million figure inflation-indexed for tax years beginning after 2026. The corporate aggregate gross-asset ceiling rose from $50 million to $75 million, also indexed after 2026. And the old bright line — 100 percent exclusion after five years or nothing — became a schedule: 50 percent after more than three years, 75 percent after more than four, 100 percent after more than five. Stock acquired on or before July 4, 2025 keeps the pre-amendment rule, so the same shareholder can hold two blocks of the same company's stock that qualify on different terms.

Which businesses qualify is a list of exclusions rather than an inclusion. Section 1202(e)(3) bars any trade or business involving the performance of services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. It also bars banking, insurance, financing, leasing, investing, and similar businesses, farming, extraction industries eligible for percentage depletion, and hospitality businesses such as hotels, motels, and restaurants. What remains is broadly the taxable operating economy: manufacturing, most technology and software, retail, distribution, and the like.

The active-business requirement is a continuous test rather than a snapshot. Under section 1202(c)(2)(A) the corporation must use at least 80 percent of the value of its assets in the active conduct of one or more qualified trades or businesses during substantially all of the shareholder's holding period. A period of holding cash for operating purposes counts; a corporation that turns into a passive holding vehicle does not.

The exclusion has an alternative-minimum-tax and net-investment-income side. The excluded gain is also excluded from the alternative minimum tax and from the 3.8 percent net investment income tax under section 1411. That combination is what makes a full 100 percent exclusion approach a genuine zero for a federal-only calculation. State tax treatment is separate: several states, most visibly California, do not conform to the federal exclusion, so the federal analysis and the state analysis produce different answers on the same sale.

Section 1045 is the safety valve when the holding period is short. A noncorporate holder who has held qualified small business stock for more than six months may roll the proceeds of a sale into new qualified small business stock within sixty days and defer the gain, reducing the basis in the replacement stock by the deferred amount. The rollover preserves the shareholder's original holding period for the section 1202 clock, so it is the standard response to an exit before the first tiered threshold.

Section 1202 asks four questions on a sale. Is the seller a noncorporate taxpayer? Is the stock in a domestic C corporation and was it acquired at original issuance? Did the corporation meet the active-business and gross-asset tests through the holding period? And has the required holding period run? A yes to all four produces an exclusion, and the applicable percentage and cap depend on when the stock was acquired and how long it has been held.

A hypothetical illustration on the post-2025 schedule. Amaya founded a manufacturing C corporation in September 2026 and received 8 million shares of founder stock at $0.001 per share, for $8,000 of basis. In October 2032 the company is acquired and her stock is valued at $28,000,000. She has held for more than five years and the acquisition meets the active-business tests throughout, so the entire gain is potentially eligible for 100 percent exclusion. Her per-issuer cap is the greater of $15 million or 10 times her $8,000 basis, so the cap is $15 million. Of her $27,992,000 gain, $15,000,000 is federally excluded and $12,992,000 remains a long-term capital gain, subject to the ordinary capital-gains rate and the net investment income tax. On a five-year sale at $10,000,000, all of the gain would fall under the $15 million cap and none of it would be federally taxed.

A second illustration on the older rule. Ben received his founder shares in 2022 with a basis of $50,000 in a company then holding $12 million of assets. He sells in 2028 after a full six years. Because the stock was acquired before July 5, 2025 it stays on the pre-amendment rule: 100 percent exclusion after more than five years, and a per-issuer cap of the greater of $10 million or 10 times basis. Ten times his basis is $500,000, so the cap is $10 million. If his gain is $9 million, the whole gain is excluded; if his gain is $14 million, $10 million is excluded and $4 million is a taxable long-term capital gain.

Pros

• The exclusion reaches the alternative minimum tax and net investment income tax as well as the regular capital-gains tax, so at 100 percent it approaches a full federal zero on eligible gain.
• The tiered schedule for post-2025 stock rewards partial holding periods rather than requiring an all-or-nothing five years, which makes an earlier exit less punishing.
• Section 1045 preserves the benefit through a qualified reinvestment within 60 days, so a shareholder forced to sell early does not automatically lose everything.
• The per-issuer cap is stated in the shareholder's favor as the greater of a dollar amount or a multiple of basis, so a small early investment that grows dramatically retains meaningful headroom.

Cons

• The exclusion is a tax rule stapled onto a corporate form, so treating a business as a passthrough for other reasons and then hoping for section 1202 will not work: the corporation must have been a C corporation throughout.
• The excluded industries reach a large share of professional and financial services, so the businesses closest to most readers are the ones the statute excludes.
• Several states, most visibly California, do not conform to the federal exclusion, so the state tax bill on the same sale can be substantial.
• Any decision that changes the character of the stock, including a stock-for-stock reorganization, can end the section 1202 status of what the shareholder holds, and the rules interact with sections 368 and 351 in ways that reward careful drafting rather than reliance.