Section 1202 of the Internal Revenue Code lets a shareholder exclude some or all of the federal capital gain on qualified small business stock (QSBS): stock in a domestic C corporation, acquired at original issuance, and held through a statutory holding period. As of 2026, stock issued after July 4, 2025 can qualify for a 50 percent exclusion after three years, 75 percent after four, and 100 percent after five, capped per issuer at the greater of $15 million or ten times the shareholder’s basis. The catch for most private company owners: S corporation and LLC equity never qualifies, so capturing the benefit usually requires a C corporation restructuring plus years of additional holding before a sale.
Two sets of rules now apply
The tax law signed July 4, 2025 (the One Big Beautiful Bill Act) rewrote the headline numbers, but only for newly issued stock. That created two parallel regimes, and which one governs depends entirely on when the shares were issued.
| Feature | Stock issued on or before July 4, 2025 | Stock issued after July 4, 2025 |
|---|---|---|
| Gross asset ceiling | $50 million | $75 million, indexed for inflation starting in 2027 |
| Per-issuer cap | Greater of $10 million or 10x basis | Greater of $15 million (indexed starting in 2027) or 10x basis |
| Holding period | More than 5 years for any exclusion | 50% at 3 years, 75% at 4 years, 100% at 5 years |
| Exclusion percentage | 100% for stock acquired after September 27, 2010; older acquisitions got 50% or 75% | Tiered by holding period, as above |
Everything below reflects federal law as of 2026. State income tax treatment varies and needs its own analysis, because not every state follows the federal exclusion.
The five core requirements
1. Domestic C corporation
The issuer must be a domestic C corporation when the stock is issued, and it must remain a C corporation for substantially all of the shareholder’s holding period. Stock issued while a company is an S corporation can never become QSBS, and revoking the S election later does not cure shares that are already outstanding. Only stock issued after the company is taxed as a C corporation has a chance to qualify.
2. Original issuance
The shareholder must acquire the stock directly from the corporation, in exchange for money, property other than stock, or as compensation for services. Shares bought from another stockholder do not qualify no matter how long they are held. This is one reason QSBS rarely survives a typical buyout: a buyer of secondary shares starts with nothing.
3. The gross asset test
The corporation’s aggregate gross assets (cash plus the adjusted tax basis of its other property) must not have exceeded the ceiling at any time before the stock is issued or immediately afterward. For stock issued after July 4, 2025 the ceiling is $75 million; for earlier issuances it was $50 million. Property contributed to the corporation counts at its fair market value at contribution, which matters enormously when an existing business converts. Growth after issuance is fine: a company can later be worth far more than the ceiling without tainting stock that already qualified.
4. Active qualified business
During substantially all of the holding period, at least 80 percent of the corporation’s assets by value must be used in the active conduct of one or more qualified trades or businesses. The statute excludes a long list of fields: services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage, plus any business whose principal asset is the reputation or skill of one or more employees. Banking, insurance, financing, leasing, and investing businesses are out, as are farming, businesses eligible for percentage depletion, and hotels, motels, and restaurants. Operating companies outside those fields, such as manufacturers, distributors, and software firms, are generally on the qualified side of the line.
5. The holding period
For stock issued on or before July 4, 2025, nothing is excluded unless the shareholder holds for more than five years. For stock issued after that date, the exclusion phases in: 50 percent of eligible gain at three years, 75 percent at four, and 100 percent at five. On the partial tiers, the gain that is not excluded is taxed at a 28 percent capital gain rate rather than the usual 15 or 20 percent, which trims the net benefit of selling early.
How much gain the caps actually shelter
The exclusion is limited, per issuing corporation, to the greater of a flat dollar cap or ten times the shareholder’s aggregate adjusted basis in the stock sold. For stock acquired after July 4, 2025 the flat cap is $15 million, indexed for inflation starting in 2027. For older stock it remains $10 million. The 10x basis alternative is unchanged under both regimes and is often the larger number when a real operating business incorporates.
A round-number example. Suppose an LLC operating a business worth $8 million incorporates as a C corporation and the owner receives stock in exchange for the assets. Basis for the cap is measured by the $8 million fair market value at contribution, so the 10x limb could shelter up to $80 million of future gain, far above the flat cap. But the $8 million of value that existed at conversion is built-in gain and never becomes excludable; only appreciation after the conversion date can qualify. If the company sells six years later for $20 million, roughly $12 million of post-conversion gain is potentially excludable while the original $8 million is not.
One quirk on legacy stock: under current IRS instructions, when only a 50 or 75 percent exclusion applies, 7 percent of the excluded amount counts as an alternative minimum tax preference item, while the 100 percent exclusion carries no AMT add-back.
Common disqualifiers
- Wrong entity. S corporation stock, LLC membership interests, and partnership interests are not QSBS. This alone rules out a large share of closely held companies as currently structured.
- Secondary purchases. Stock bought from a founder, an employee, or another investor fails the original issuance test.
- Excluded industries. Professional service practices, financial businesses, hospitality, and farming sit outside the statute regardless of size.
- Redemptions. Corporate buybacks around an issuance can taint it. A series of redemptions exceeding 5 percent of the value of the corporation’s stock can disqualify stock issued during a two-year period beginning one year before the redemptions, and buybacks from the shareholder or related persons face even tighter scrutiny.
- Asset drift. A corporation that accumulates cash, portfolio investments, or passive real estate can fail the 80 percent active business test during the holding period.
- Losing C status. Electing S status after issuance can break the requirement that the issuer remain a C corporation for substantially all of the holding period.
Why most lower-middle-market owners do not qualify today
A large share of private companies in the $1 million to $50 million EBITDA range were organized years ago as S corporations or LLCs, structures chosen to avoid entity-level tax. That history is decisive here. Existing S corporation shares can never be QSBS, and no election or amendment fixes them retroactively.
Recognized paths do exist to create QSBS from an existing pass-through, and they are the reason tax counsel gets involved early. An S corporation can contribute its operating assets to a newly formed C corporation subsidiary in a tax-free exchange under Section 351, with the parent holding the new stock. An LLC taxed as a partnership can incorporate and issue stock to its members. In every version, the QSBS clock starts at the conversion, and only appreciation above the fair market value on that date can ever be excluded.
That timing is the practical wall. An owner planning to go to market within the next year or two gains nothing from a conversion, because even the new 50 percent tier requires three full years of holding, and the value already built into the business stays taxable in any event. The arithmetic only starts to get interesting for owners who are realistically four or more years from a sale, expect substantial appreciation from here, and can tolerate C corporation treatment of operating income in the meantime. Whether that trade is worth making is a fact-specific modeling exercise for a CPA and tax attorney to run, and nothing in this article should be read as a recommendation either way.
Where your advisors fit
Section 1202 sits at the intersection of entity taxation, corporate law, and personal wealth planning, and it rewards early coordination. A CPA can model the entity-level tax cost of C corporation status against the projected exclusion. A tax or corporate attorney papers any conversion, watches the redemption and active business rules, and documents eligibility as of each issuance date. A wealth advisor folds the expected after-tax proceeds into the owner’s broader plan. Sell-side platforms such as Bankerly.ai prepare the transaction itself; structural tax decisions of this kind belong with the owner’s own professional advisors, ideally years before a process begins.
This article is educational only. It is not tax, legal, or investment advice, and it does not recommend any structure or strategy. Federal figures reflect the law in effect as of 2026 and may change; state treatment varies. Owners should consult their own qualified tax, legal, and financial advisors before acting on anything described here.
Sources
- IRS: Instructions for Schedule D (Form 1040), Exclusion of Gain on Qualified Small Business (QSB) Stock
- Holland & Knight: One Big Beautiful Bill Act Increases Tax Benefits for Qualified Small Business Stock
- Holland & Knight: Converting from an S Corporation to Qualified Small Business Stock
- The Tax Adviser (AICPA): QSBS Gets a Makeover: What Tax Pros Need to Know About Sec. 1202’s New Look
- Grant Thornton: Explaining Enhanced Section 1202 Benefits
- Taft Law: The ABCs of I.R.C. Section 1202 Qualified Small Business Stock
Frequently asked questions
- How much gain can you exclude under Section 1202 in 2026?
- For QSBS acquired after July 4, 2025, each shareholder can exclude gain per issuer up to the greater of $15 million (indexed for inflation starting in 2027) or ten times the adjusted basis of the stock sold. Stock acquired on or before that date keeps the older cap: the greater of $10 million or ten times basis. The exclusion percentage depends on the holding period.
- Does an S corporation qualify for QSBS?
- No. Stock issued while a company is an S corporation can never be qualified small business stock, because the issuer must be a C corporation at the time of issuance. Revoking the S election does not fix shares already outstanding, though stock issued after a valid conversion to C status can qualify if all other requirements are met.
- How long do you have to hold QSBS to get the exclusion?
- It depends on when the stock was issued. Stock issued on or before July 4, 2025 must be held more than five years for any exclusion. Stock issued after that date phases in: 50 percent of eligible gain is excludable at three years, 75 percent at four, and 100 percent at five. Gain not excluded on the partial tiers is taxed at a 28 percent rate.
- What businesses do not qualify for Section 1202?
- The statute excludes services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage, plus any business whose principal asset is employee reputation or skill. Banking, insurance, financing, leasing, investing, farming, percentage-depletion businesses, and hotels, motels, and restaurants are also excluded. Operating companies outside these fields, such as manufacturing or software, are generally eligible.
- Can an LLC or S corporation convert to a C corporation to get QSBS?
- Structures exist, such as an S corporation contributing assets to a new C corporation subsidiary under Section 351, but the benefit only reaches future growth. Contributed assets count at fair market value, built-in gain at conversion is never excludable, and the holding period starts at the exchange. Owners typically need several years between conversion and sale, so this is a question for tax counsel well ahead of a process.
Considering a sale in the next few years? See what a prepared process looks like.
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