Section 1202 Gain Exclusion: QSBS Qualification, Cap, and Rollover

The Section 1202 gain exclusion lets a non-corporate investor exclude some or all of the capital gain from selling qualified small business stock (QSBS) in a domestic C corporation, provided the stock and the issuing company meet a long list of requirements. The One Big Beautiful Bill Act, signed on July 4, 2025, expanded the benefit in three important ways: the per-issuer dollar cap rose to $15 million for newly issued stock, the corporate gross assets ceiling rose to $75 million, and a tiered holding period now allows partial exclusions starting at three years. Stock acquired on or before July 4, 2025, still runs on the older rules, so the acquisition date decides which set applies.

How Much of the Gain You Can Exclude

The exclusion percentage depends on when you acquired the stock and, for newer stock, how long you held it.

For QSBS acquired after September 27, 2010, and on or before July 4, 2025, the exclusion is 100% once you have held the shares more than five years. Sell earlier and no exclusion applies. Stock acquired between February 18, 2009, and September 27, 2010, qualifies for a 75% exclusion; stock acquired on or before February 17, 2009, qualifies for 50%.¹

For QSBS acquired after July 4, 2025, a tiered schedule replaces the five-year cliff:

Held more than 3 years: 50% of the gain is excluded
Held more than 4 years: 75% of the gain is excluded
Held 5 years or more: 100% of the gain is excluded

A forced sale at year four now still preserves three-quarters of the tax benefit rather than none of it.¹

One catch on the older partial rates: only the 100% exclusion is fully sheltered from the Alternative Minimum Tax. Under the 50% or 75% rates, 7% of the excluded gain is treated as an AMT preference item, which can raise your alternative minimum tax.

The Per-Issuer Dollar Cap

The exclusion is limited on a per-taxpayer, per-issuer basis. For any single company’s stock, you can exclude the greater of two amounts:

A flat dollar cap — $10 million for stock acquired on or before July 4, 2025, or $15 million for stock acquired after that date, with inflation adjustments starting for tax years after 2026 — reduced by any gain you have already excluded from that same issuer in prior years
10 times your aggregate adjusted basis in the QSBS you sold during the year

You use whichever number is larger.¹ The 10x-basis alternative matters when you invested a substantial amount. A $5 million investment yields a $50 million cap on that measure, well above the flat dollar limit.

Two features of the cap are worth understanding. It is per issuer, so investments in several qualifying companies each get their own separate limit. And it is per taxpayer, so spouses who each independently own QSBS in the same company each get a full cap. A married couple filing jointly could exclude up to $30 million from a single issuer’s post-July 4, 2025, stock ($15 million each), or up to $20 million from older stock. Gain above the cap flows to Schedule D as taxable capital gain.

Holding Period Rules

Your holding period starts the day after the stock is issued. For stock acquired through exercise of a compensatory option, that means the day after exercise, not the grant date.

Some transfers preserve the holding period. A gift of QSBS carries the donor’s holding period to the recipient. Stock transferred at death carries the decedent’s holding period to the heir. When a partnership distributes QSBS to a partner who was in the partnership when the stock was acquired, the partner’s holding period includes the partnership’s holding period.

Hedging can freeze it. Opening a short position, buying a put on substantially identical property, or entering any transaction that substantially reduces your risk of loss blocks the exclusion unless you had already met the holding period before the hedge was in place.²

Whether Your Stock Actually Qualifies as QSBS

The exclusion only exists if the stock meets every element of the QSBS definition. Any single failure disqualifies the shares.

Issuer and Original Issuance

The issuer must be a domestic C corporation, and it must maintain that status during substantially all of your holding period. S corporations, partnerships, LLCs taxed as partnerships, and foreign entities never qualify.¹ Practitioners generally read “substantially all” as roughly 85% to 95% of the holding period, so even a brief conversion to S status creates real audit risk.

You must acquire the stock at original issuance, directly from the corporation or through an underwriter, in exchange for cash, property (other than stock), or services. Secondary-market purchases do not qualify in the buyer’s hands even if the seller held QSBS. Founders at incorporation, employees exercising options, and primary-round investors are the typical qualifying holders.

The Gross Assets Ceiling

The corporation’s aggregate gross assets — cash plus the adjusted basis of other property — must have stayed below the statutory ceiling at all times before issuance and immediately after your stock was issued. That ceiling is $50 million for stock issued on or before July 4, 2025, and $75 million for stock issued after that date, with inflation adjustments starting for tax years after 2026.¹ The test is applied only at each issuance. If the company grows past the threshold later, your stock keeps its status; the company simply cannot issue new qualifying stock going forward.

Active Business Test

Throughout your holding period, at least 80% of the corporation’s assets, by value, must be used in one or more qualified trades or businesses.¹ This is ongoing, not a one-time check. A company that drifts toward passive investments or excluded activities can retroactively cost you the exclusion.

Several industries are excluded even when actively conducted: 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, investing, and farming are also excluded. A corporation also fails the test for any period in which more than 10% of its total asset value is real property not used in a qualified trade or business.²

Cash and other assets held as reasonably required working capital count as used in the active business for the 80% test. Assets held for investment count too if they are reasonably expected to be used within two years to fund research or increased working capital. Once the corporation has existed for two years, no more than 50% of its assets can rely on this working capital safe harbor.

Redemptions That Silently Kill QSBS Status

Corporate buybacks in the wrong window can strip QSBS status. Two separate tests apply, and failing either one disqualifies your stock.

The first looks at redemptions from you or a related person. If the corporation repurchases any of its stock from you or a related party during the four-year period beginning two years before your stock was issued, your stock is disqualified. A de minimis exception applies only if both the total paid exceeds $10,000 and more than 2% of the stock held by you and related persons is repurchased.³

The second looks at all shareholders. During the two-year period beginning one year before your issuance, the corporation cannot repurchase stock exceeding 5% of the aggregate value of all its outstanding stock at the start of that two-year window. A parallel de minimis exception applies.¹ These rules trip up companies where early investors are bought out around the same time new funding closes.

Who Can Claim It

Only non-corporate taxpayers — individuals, certain trusts, and estates — can claim the exclusion. C corporations cannot.¹

QSBS held through a partnership or S corporation flows through to you, but only if you were a partner or shareholder when the entity acquired the stock and held your interest continuously through the sale. Your share of the excludable gain cannot exceed what would have been allocated to you based on your interest at the time of acquisition.⁴

Selling Before Five Years: The Section 1045 Rollover

If you have to sell before hitting the required holding period, Section 1045 lets you defer the gain by reinvesting in replacement QSBS. Requirements:

You held the original stock more than six months
You purchase replacement QSBS within 60 days of the sale
The replacement stock is acquired at original issuance and meets all QSBS requirements at that time

Your basis in the original stock carries over to the replacement, reduced by the deferred gain. Buy the original shares for $200,000, sell for $1 million, roll the full $1 million into new QSBS, and your basis in the new stock is $200,000. That embedded gain is taxed when you eventually sell in a taxable transaction. Your original holding period tacks onto the replacement, so time already served counts toward the new five-year (or three-year) requirement.⁵

The rollover is not automatic. You must elect it on a timely filed return for the year of sale, treating the transaction as a non-taxable exchange and attaching a statement with the sale date, replacement acquisition date, adjusted basis of the stock sold, and gain deferred. Miss the election and the deferral is gone.

Multiplying the Cap Through Gifts and Non-Grantor Trusts

Because the cap is per taxpayer and QSBS can be gifted with a carryover of both basis and holding period, some holders gift shares to family members or non-grantor trusts before a sale, giving each recipient its own per-issuer cap. In principle, a founder holding $60 million of unrealized gain could distribute shares across several non-grantor trusts and family members, each with a separate $15 million exclusion.

The guardrails are real. Gifts must occur well before any binding commitment to sell; a transfer after a signed letter of intent invites the IRS to invoke the assignment-of-income doctrine and treat the sale as yours. The recipient trust must be a non-grantor trust — a grantor trust does nothing because the grantor is still the owner for income tax purposes. Multiple trusts by the same grantor with substantially the same primary beneficiary can be collapsed into one taxpayer if a principal purpose was tax avoidance, and spouses count as one grantor for this rule, so mirror-image trusts for the same child do not multiply the cap.

How to Report the Exclusion on Your Return

Report the sale on Form 8949 the way you would any capital asset sale: description, acquisition date, sale date, proceeds, and cost basis. Then in column (f), enter code “Q” for a Section 1202 exclusion, and enter the excludable gain as a negative number in parentheses in column (g).⁶ For a full 100% exclusion, the negative adjustment equals the entire gain, zeroing out the recognized amount. For a 50% or 75% partial exclusion, the negative is only that percentage of the gain. Totals flow to Schedule D, and any gain above your cap is taxed as capital gain.

The negative adjustment cannot exceed the lesser of the realized gain or the applicable per-issuer cap. With $18 million of gain and a $15 million cap, the column (g) entry is negative $15 million and $3 million remains taxable.

For a Section 1045 rollover, use code “R” in column (f) and enter the deferred gain as a negative in column (g). Attach the election statement.

If your QSBS is held through a partnership, the entity reports your share of the eligible gain on Schedule K-1 (Form 1065) in Box 11 with Code O, along with the issuer’s name, your share of basis and sales price, and the acquisition and sale dates.⁴ You compute the exclusion on your own Form 8949 and Schedule D; the partnership passes information through and does not claim the exclusion itself.

Documentation You Need to Keep

The IRS puts the burden of proof on the taxpayer claiming the exclusion, and the records must cover the timeline from the corporation’s formation through the moment immediately after your stock was issued, and then through your holding period. At minimum, keep:

Balance sheets or financial statements showing gross assets never exceeded the applicable ceiling from formation through immediately after your issuance
Articles of incorporation, tax elections, and returns confirming continuous C corporation status
Stock purchase agreements, board resolutions, or option exercise records proving original issuance
Periodic asset breakdowns showing at least 80% of assets were used in a qualified trade or business
Clear records of issuance (or exercise) and sale dates

In Ju v. Commissioner, the Tax Court rejected a QSBS claim because the taxpayer’s financial records covered only 2009 through 2011 while the stock had been issued in 2003, leaving the gross assets test unproven at the critical date. If you are receiving shares years after the company was formed, ask for a corporate certification of QSBS eligibility at the time of issuance and keep it permanently. Investor rights agreements can include covenants requiring the company to run periodic QSBS analyses and share the results; that language becomes valuable years later.

State Tax Treatment Does Not Follow the Federal Rules

The federal exclusion does not decide what happens on your state return. California does not conform to Section 1202 at all, so the full gain is taxable at up to 13.3% even when it is 100% excluded federally. Pennsylvania, Mississippi, and Alabama also reject the federal exclusion. Most other states conform in whole or in part, but conformity rules shift, so confirm your state’s current position before assuming the whole gain escapes tax. The state bill on a large QSBS sale in a non-conforming state can reach seven figures.

1
Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock
2
Office of the Law Revision Counsel. 26 US Code 1202 – Partial Exclusion for Gain From Certain Small Business Stock
3
eCFR. 26 CFR 1.1202-2 – Qualified Small Business Stock; Effect of Redemptions
4
Internal Revenue Service. Partners Instructions for Schedule K-1 (Form 1065)
5
Office of the Law Revision Counsel. 26 USC 1045 – Rollover of Gain From Qualified Small Business Stock to Another Qualified Small Business Stock
6
Internal Revenue Service. Instructions for Form 8949 (2025) Sales and Other Dispositions of Capital Assets