Under Section 1202 of the Internal Revenue Code, a taxpayer who holds qualifying stock in a small C corporation can exclude a large portion, and in many cases all, of the capital gain when the stock is sold. On a successful exit, the difference can be millions of dollars kept rather than paid to the IRS.

The benefit is also one of the most misunderstood provisions in the tax code, and one the IRS examines closely. Qualifying for the QSBS exclusion depends on a series of technical tests, several of which are easy to fail without realizing it.

This guide explains how the Section 1202 exclusion works, what changed in 2025, and where taxpayers get into trouble. It is written from the perspective of a firm that handles the harder end of the problem: defending these positions when the IRS pushes back.

What is Qualified Small Business Stock?

Qualified Small Business Stock is stock in a domestic C corporation that meets the requirements of Section 1202. When the requirements are satisfied and the stock is held long enough, the shareholder can exclude eligible gain from federal income tax on a sale or exchange. The policy goal is to encourage investment in small, active businesses by rewarding people who put capital into them early and hold for the long term.

Three ideas sit at the center of the QSBS rules. First, the company has to be the right kind of company, small and actively operating a qualified business. Second, you have to acquire the stock the right way, at original issuance, in exchange for money, property, or services. Third, you have to hold it long enough. Miss any one of these and the exclusion can disappear entirely.

The five tests to qualify for the Section 1202 exclusion

1. It must be C corporation stock

The issuer must be a domestic C corporation, both when the stock is issued and, generally, throughout substantially all of the taxpayer’s holding period. Stock in an S corporation, a partnership, or an LLC taxed as a partnership does not qualify. This is why the choice of entity at formation is so important, and why some companies convert to C corporation status with QSBS in mind.

2. The company must be a “qualified small business”

At all times before and immediately after the stock is issued, the corporation’s aggregate gross assets must not exceed a statutory ceiling. For stock issued on or before July 4, 2025, that ceiling is $50 million. For stock acquired after July 4, 2025, the ceiling is $75 million. “Aggregate gross assets” generally means cash plus the adjusted basis of other property, with contributed property counted at fair market value. A company that has already grown past the ceiling can no longer issue QSBS, though stock issued earlier, while the company was under the limit, can remain qualified.

3. It must be acquired at original issuance

You generally must acquire the stock directly from the corporation, in exchange for money, other property (not including stock), or services. Buying shares from another shareholder on the secondary market usually does not produce QSBS in your hands. There are important exceptions for stock received by gift, at death, or from a partnership distribution, where holding periods and QSBS character can carry over.

4. The company must run an active qualified trade or business

During substantially all of the holding period, at least 80% of the value of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses.

Certain fields are specifically excluded, including services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage, along with banking and other financial businesses, farming, mineral extraction, and the operation of hotels, motels, or restaurants. Any business whose principal asset is the reputation or skill of one or more employees is also excluded.

Whether a given company clears this test is one of the most frequently litigated QSBS questions, and a common focus of IRS audits.

5. You must meet the holding period

Historically, the stock had to be held for more than five years to claim any exclusion. The 2025 legislation introduced a tiered holding period for newly acquired stock, discussed below. The holding period generally starts the day after the stock is issued.

How much gain can you exclude?

The share of gain you can exclude depends on when you acquired the stock. Congress has increased the exclusion over time, so the acquisition date matters a great deal:

Any portion of the gain that is not excluded is generally taxed as capital gain at a maximum rate of 28%, rather than the usual 15% or 20% long-term rates. For stock eligible for the 50% or 75% exclusion, a portion of the excluded gain has historically been treated as an alternative minimum tax preference item; stock eligible for the full 100% exclusion generally is not. These interactions are technical, and worth confirming with counsel before you rely on a specific number.

The per-issuer cap

The exclusion is not unlimited. For each company whose stock you hold, the amount of gain you can exclude in a given year is capped at the greater of two figures: a dollar limit, or ten times your aggregate adjusted basis in the QSBS of that company that you sold during the year.

The dollar limit was $10 million for many years and was raised to $15 million for stock acquired after July 4, 2025, with inflation adjustments scheduled to begin after 2026. Because the cap is applied per issuer, sophisticated planning sometimes involves multiplying the cap across family members or trusts, a strategy that carries its own audit risk and is covered in a separate article in this series.

The 2025 changes to Section 1202

The One Big Beautiful Bill Act, enacted in 2025, expanded the QSBS benefit for stock acquired after July 4, 2025 in three main ways. It introduced the tiered holding period so that shareholders no longer have to wait a full five years for any benefit; it raised the per-issuer dollar cap from $10 million to $15 million; and it raised the aggregate gross assets ceiling from $50 million to $75 million, letting somewhat larger companies still issue QSBS. Stock acquired on or before July 4, 2025 keeps the older rules.

We cover the details, and the old-stock-versus-new-stock question, in our dedicated article on the 2025 QSBS changes.

Deferring gain with a Section 1045 rollover

What if you need to sell before your holding period is complete? Section 1045 offers a partial answer. If you have held QSBS for more than six months and sell it, you can generally defer the gain by reinvesting the proceeds into new QSBS within 60 days, carrying your holding period forward. A rollover does not make the gain disappear, but it can preserve the path to a future exclusion. The mechanics are strict, and missing the reinvestment window forfeits the benefit.

Common traps that destroy QSBS status

Redemptions

Section 1202 contains anti-abuse rules that can disqualify stock if the company buys back its own shares around the time of issuance. In general terms, “significant” redemptions from any shareholder within a one-year window before or after issuance, measured against roughly 5% of the company’s value, can taint newly issued stock, and redemptions from the shareholder or related parties within a two-year window can do the same.

These rules catch well-meaning companies that repurchase shares from departing founders or employees without realizing the effect on everyone else’s QSBS.

Entity missteps

Because only C corporation stock qualifies, businesses formed as LLCs or S corporations often have no QSBS unless and until they convert, and the holding period generally starts fresh at conversion. The gross assets ceiling is tested at issuance, so a company that waits too long to issue equity may lose the chance.

California does not follow the federal rule

This is a critical point for our clients. California does not conform to Section 1202. A California resident can exclude 100% of a gain for federal purposes and still owe full California tax on the same gain. For founders considering a move before a liquidity event, the interaction with California residency rules is significant, and it is a frequent trigger for Franchise Tax Board scrutiny. We address this in detail in our article on California and QSBS.

What happens if the IRS challenges your QSBS?

A QSBS exclusion is claimed on your return, but claiming it is not the end of the story. The IRS can examine whether the company was truly a qualified small business, whether the active-business and qualified-trade tests were met, whether the stock was acquired at original issuance, and whether the holding period and dollar caps were respected. Because the dollars at stake are usually large, these examinations are thorough, and a disallowed exclusion can turn into a substantial assessment of tax, interest, and penalties.

This is where careful documentation and experienced representation matter, and we cover it in depth in our guide to how QSBS claims are audited and defended. If you are facing questions about a Section 1202 position, our team handles IRS tax audits, and where a matter cannot be resolved at exam or appeals, U.S. Tax Court litigation. We also assist with related tax problems and, for crypto and blockchain companies, cryptocurrency accounting and audits.

Frequently asked questions about QSBS

Disclaimer. This article is for general information only and is not legal or tax advice. Reading it does not create an attorney-client relationship. Tax results depend on your specific facts. Past results do not guarantee future outcomes. Consult a qualified attorney about your situation before acting.