Qualified Small Business Stock (QSBS) and Section 1202

Section 1202 lets owners of qualifying small business stock exclude some or all of the gain from federal income tax when they sell. For founders, early employees and startup investors, it can be one of the most valuable tax rules available. The One Big Beautiful Bill Act, signed July 4, 2025, expanded it for stock issued after that date. This guide explains the old and new rules, who qualifies and what to document.

Older rules and new rules

Gross assets means cash plus the adjusted basis of other property, tested before and immediately after the stock is issued. The cap is cut in half for a married person filing separately. Gain excluded in earlier years from the same issuer counts against the cap.

What qualifies as QSBS

• The taxpayer is not a C corporation. Individuals, trusts, estates and owners of pass-through entities can qualify, and a pass-through owner must have held the interest when the entity bought the stock.
• The stock is issued by a domestic C corporation. S corporation stock does not qualify, and neither do LLC interests taxed as partnerships. You must acquire it at original issue, for money, other property (not stock) or services.
• Active business: at least 80% of assets (by value) must be used in an active qualified business during substantially all of your holding period. Excluded fields include health, law, engineering, architecture, accounting, consulting, athletics, financial services, banking, insurance, farming, hotels and restaurants, and any business whose main asset is employee reputation or skill.
• Redemptions: certain company buybacks from you or related people around the time of issuance can disqualify the stock.
• Gifts and inheritance: the new owner generally keeps the original holding period.

Founders, options and restricted stock

If you start as an LLC or S corporation and convert, QSBS applies only to C corporation stock issued after conversion, so the structure and timing matter. See LLC, S corporation or C corporation.

The holding period depends on how you got the shares. Shares bought at formation start the clock at purchase. Shares from an option exercise start at exercise, not grant. Restricted stock starts at vesting unless you file a timely Section 83(b) election, in which case it generally starts at transfer. Stock bought from another shareholder is not original issue. See stock options, ISOs, NSOs and RSUs.

Rollover, reporting and tax on the rest

If you sell QSBS held more than six months and buy other QSBS within 60 days, you can elect to postpone gain under section 1045. That reduces the basis of the new stock.

You report an exclusion on Form 8949, Part II, with code Q in column (f) and the excluded gain as a negative number in column (g). The taxable part of gain on 50% or 75% stock is generally taxed at up to 28% federally, not the usual 15% or 20% capital gain rates.

Example (hypothetical): A founder buys 1,000,000 shares for $10,000 when a C corporation is formed in January 2026. If she sells in 2031 for a $5,000,000 gain, after more than five years, the gain is under the $15,000,000 cap and the federal regular tax on it can be $0. If she instead sold after four years, 75% ($3,750,000) would be excluded and the other $1,250,000 would be taxed at up to 28%, or up to $350,000.

Illinois and other states

For tax years ending on or after December 31, 2026, the Illinois Department of Revenue says individuals, trusts, estates and partnerships must add back federally excluded QSBS gain to Illinois base income. In the example above, the $3,750,000 excluded gain would face Illinois income tax at 4.95%, or about $185,600. Other states differ, so check state rules before planning a sale.

Common mistakes

• Assuming an LLC or S corporation qualifies
• Missing the gross assets limit before a large funding round
• Counting the holding period from grant, not exercise or vesting
• Forgetting an 83(b) election on restricted stock
• Choosing a business in an excluded field
• Not keeping issuance documents, valuations and company representations
• Ignoring state tax

How we can help

We can review whether your stock may qualify, map holding periods, model federal and Illinois tax on a sale and report the exclusion correctly. See equity planning and management, startups and founders and C corporation taxes. Corporate structure and stock issuance are also matters for your attorney.

Frequently asked questions

General information only, not tax, legal or accounting advice for your situation. Rules, limits and deadlines change; confirm the current rules with the official source or a qualified professional before you act. Reading this page does not create a professional relationship with CPA Tax Payroll and Accounting Corp.