Section 1202 (QSBS Exclusion)
Internal Revenue Code Section 1202 provides an exclusion of up to 100% of capital gains on the sale of qualified small business stock (QSBS) held for at least 5 years. Maximum exclusion: greater of $10 million or 10x basis. Requirements: (i) C corporation issuer with assets ≤$50M (since 2026 amendments) at issuance, (ii) active business in qualified industry, (iii) original issuance, (iv) 5-year holding period. Among the most powerful tax provisions for U.S. startups and early-stage investors.
Internal Revenue Code Section 1202 provides an exclusion of up to 100% of capital gains on the sale of qualified small business stock (QSBS) held for at least 5 years. The exclusion is among the most powerful tax provisions for U.S. startups and early-stage investors, properly structured QSBS investments can generate millions of dollars of tax-free gain on exit. Section 1202 has been amended multiple times to expand its scope, most recently with the One Big Beautiful Bill Act (OBBBA) reforms expanding asset thresholds and gain exclusion limits.
The exclusion percentages
Section 1202 exclusion percentage depends on stock acquisition date: (1) before Feb. 18, 2009, 50% exclusion; (2) Feb. 18, 2009 - Sept. 27, 2010, 75% exclusion; (3) after Sept. 27, 2010, 100% exclusion (the standard for current investments). The 100% exclusion makes post-2010 QSBS particularly valuable, qualifying gain is entirely excluded from federal income tax (with parallel exclusion from federal Net Investment Income Tax and AMT for 100% category). Pre-2010 stock has reduced exclusions and partial AMT preference treatment.
The dollar cap, $10M or 10x basis
The maximum gain excludable per issuer per taxpayer is the greater of: (1) $10 million; (2) 10x adjusted basis. Example: investor purchases QSBS for $200K; can exclude up to $10M gain (the greater amount); for $500K basis, can exclude up to $10M (still); for $2M basis, can exclude up to $20M (10x); for $5M basis, can exclude up to $50M (10x). Higher-basis investors benefit substantially from the 10x multiplier. Multiple QSBS investments in different issuers each have their own $10M/10x cap, the cap is per-issuer.
Qualified small business, asset test
Section 1202(d) requires the issuer to be a "qualified small business", historically defined as C corporation with aggregate gross assets of $50 million or less at all times during qualifying period (immediately before and after stock issuance). The 2025 OBBBA reforms increased the asset threshold to $75 million for stock issued after the effective date, expanding QSBS eligibility for slightly larger companies. The asset test is at issuance, not at sale; companies that grow substantially after QSBS issuance retain QSBS qualification.
Active business requirement
The issuer must conduct a "qualified trade or business", generally any business EXCEPT: (1) professional services, health, law, engineering, accounting, actuarial, performing arts, consulting, athletics, financial services, brokerage; (2) banking, insurance, financing, leasing, investing; (3) farming; (4) extraction of natural resources, oil, gas, mining; (5) hotels, restaurants, similar businesses. Most technology companies, manufacturers, retailers, and many service businesses qualify. The exclusions reflect Congressional judgment about which industries deserve QSBS preferential treatment.
Original issuance requirement
QSBS must be acquired by the taxpayer at original issuance, not from a prior holder. Acquisition methods: (1) direct from issuer, most common; (2) tax-free exchanges, typically from another QSBS issuer in §351 or §368 transactions; (3) gift, recipient inherits original issuance status; (4) death, heir inherits original issuance status. Secondary purchases of QSBS (from a prior holder) do NOT qualify, buyer's gain is not QSBS-eligible. This requirement makes QSBS planning particularly important at financing rounds.
5-year holding period
QSBS must be held for at least 5 years before sale to qualify for the exclusion. Sales before 5 years: (1) regular capital gain, no QSBS exclusion; (2) §1045 rollover, sale plus reinvestment in new QSBS within 60 days defers gain and tacks holding period. The 5-year requirement aligns QSBS with long-term investment horizons. Holding period typically begins: SAFE, at conversion to stock; convertible note, at investment (debt-to-stock exchange tacks holding period); preferred stock, at issuance.
Section 1045 rollover
Section 1045 permits gain deferral on QSBS sales held more than 6 months but less than 5 years if proceeds are reinvested in new QSBS within 60 days. Mechanics: (1) sale of QSBS with gain; (2) reinvestment within 60 days into different QSBS issuer; (3) gain deferred rather than recognized; (4) basis carried over to new QSBS; (5) holding period tacks from original investment. § 1045 is valuable for managing QSBS portfolios and resetting QSBS positions; sophisticated QSBS investors use it actively.
Stack structures and family planning
Sophisticated QSBS planning multiplies $10M cap across multiple taxpayers: (1) spousal stack, joint filers have one $10M cap, but spouse can have separate $10M cap if originally issued to spouse; (2) trust stack, non-grantor trusts can each have separate $10M cap; family planning with non-grantor trusts can multiply the exclusion; (3) charitable planning, donations of QSBS to charity provide deductions and avoid recognition. Stack structures require careful tax planning but can substantially expand QSBS benefit.
For Texas startups and investors, QSBS planning is high-value. Best practice for issuers: (1) maintain C corporation status from inception (LLC must convert to C corp; consider timing carefully, conversion before substantial value creation preserves QSBS); (2) document QSBS qualification at each issuance, corporate records confirming asset levels, active business, original issuance; (3) coordinate equity issuances to maximize QSBS-qualifying timing; (4) avoid disqualifying redemptions in 4-year window before/after issuance; (5) provide investors with QSBS qualification analysis at investment. For investors: (1) verify QSBS qualification at investment, request issuer representations and analysis; (2) document basis carefully, tax records, subscription documents; (3) plan 5-year holding period from investment; (4) consider §1045 rollover for shorter-hold positions; (5) consider stack structures for high-value positions; (6) maintain QSBS records through holding period. For founders: (1) understand that LLC-to-C-corp conversion timing affects QSBS, generally must convert before substantial value creation; (2) preserve QSBS through subsequent rounds, most rounds maintain QSBS; (3) coordinate exit timing with 5-year requirement. Common pitfall: companies operating as LLC for years before C-corp conversion lose QSBS for value creation during LLC period, early planning preserves substantial future tax savings.
Companion article: Selling Your Business