QSBS and Section 1202: The Tax Exclusion Every Founder Should Know
Rohan Miller
Head of Tax Strategy
IRC Section 1202 allows a 100% exclusion of capital gains on qualified small business stock held for more than five years, up to $10 million or 10x your basis.
What Section 1202 Provides
If you hold qualified small business stock (QSBS) acquired after September 27, 2010, and you hold it for more than five years, you can exclude from federal income tax 100% of the capital gain on the sale of that stock. The exclusion is capped at the greater of $10 million or 10 times your adjusted basis in the stock. For a founder who purchased shares for $1,000, the exclusion cap is $10 million (since 10x basis would only be $10,000). This exclusion also eliminates the 3.8% net investment income tax on the excluded gain. On a $10 million exit, the federal tax savings compared to long-term capital gains rates can exceed $2.3 million.
The Qualification Requirements
Five requirements must be met. First, the stock must be in a domestic C-corporation. S-corps, LLCs, and partnerships do not qualify. Second, the corporation must be a qualified small business, meaning its aggregate gross assets have never exceeded $50 million at any time before and immediately after the stock issuance. Gross assets include cash received from the stock issuance itself. Third, the stock must be acquired at original issuance, directly from the corporation in exchange for money, property, or services. Stock purchased on the secondary market does not qualify. Fourth, the corporation must be engaged in an active trade or business. At least 80% of assets must be used in the active conduct of one or more qualified trades or businesses. Fifth, certain industries are excluded: professional services (health, law, accounting, consulting, financial services), banking, insurance, farming, mining, and hospitality (hotels and restaurants).
The $50 Million Asset Test
The $50 million gross asset test is measured at the time the stock is issued. This means early-stage stock is most likely to qualify. Once a company raises enough capital that its gross assets (cash, equipment, IP, and everything else) exceed $50 million, any stock issued after that point does not qualify for QSBS treatment. Stock issued before the threshold was crossed retains its QSBS status. This creates a planning opportunity: if your company is approaching $50 million in assets, consider whether there are equity grants or option exercises that should be accelerated. Note that gross assets are measured using tax basis, not fair market value, which can be favorable for companies with appreciated assets.
Stacking the Exclusion
The $10 million exclusion is per taxpayer per issuer. A married couple filing jointly can each claim a $10 million exclusion, for a combined $20 million. If QSBS is gifted to family members, each recipient gets their own $10 million exclusion while inheriting the donor's holding period and basis. Some founders use this strategy to gift shares to children or trusts, multiplying the available exclusion. There is also a rollover provision under Section 1045 that allows you to defer QSBS gain by reinvesting the proceeds into another QSBS within 60 days, though the replacement stock must also be held for five years to qualify for the full exclusion.
State Tax Treatment Varies
Not all states follow the federal QSBS exclusion. California, one of the most important states for startups, does not conform to Section 1202. California taxes QSBS gains at the regular capital gains rate, which is the same as the ordinary income rate of up to 13.3%. New York partially conforms, with some limitations. States like Washington, Texas, Florida, and Nevada have no state income tax, so the federal exclusion is the only one that matters. If you are a California founder expecting a large QSBS-eligible exit, consider whether establishing domicile in a no-income-tax state before the sale is a realistic option. The California Franchise Tax Board aggressively audits residency changes that occur close to liquidity events.
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