Qualified Small Business Stock Section 1202 Exclusion (2026)

Section 1202 allows a non-corporate shareholder to exclude up to 100% of gain on the sale of qualified small business stock, capped at the greater of $10,000,000 or ten times basis. That is a complete exclusion from federal tax, not a deferral.

It is one of the most valuable provisions in the code and among the least used, because it requires a C corporation, a five-year hold, and decisions made at formation that most founders make without knowing the provision exists.

The Core Requirements

The stock must be issued by a domestic C corporation. S corporation stock never qualifies, and stock acquired while the company was an S corporation does not qualify even after a later conversion. Only stock issued after the conversion can qualify.

The stock must be acquired at original issuance from the corporation, in exchange for money, property other than stock, or services. Purchasing shares from an existing shareholder does not qualify, which is a common and expensive surprise for early employees buying from founders.

The corporation's aggregate gross assets must not have exceeded $50,000,000 at any time before and immediately after issuance. Legislation enacted in 2025 raised this threshold to $75,000,000 for stock issued after the effective date, with the per-issuer gain cap increasing correspondingly to $15,000,000. Which threshold applies depends on when the stock was issued, so the analysis is issuance-date specific.

At least 80% of assets by value must be used in the active conduct of a qualified trade or business throughout substantially all of the holding period.

The holding period is five years for the full exclusion. The 2025 legislation added a tiered exclusion for stock issued after the effective date, allowing 50% exclusion at three years and 75% at four years, with 100% at five.

The Excluded Businesses

IRC Sec. 1202(e)(3) excludes a list of businesses, and it overlaps substantially with the Sec. 199A specified service list but is not identical.

Excluded are businesses involving services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services, where the principal asset is the reputation or skill of employees. Also excluded are banking, insurance, financing, leasing, and investing businesses, farming, businesses involving oil, gas, or mineral extraction eligible for percentage depletion, and hotels, motels, restaurants, and similar businesses.

Note that engineering and architecture are excluded here while they are permitted under Sec. 199A. The lists are different and must be checked separately.

Technology companies, manufacturers, consumer products, software, and most product businesses qualify. Service firms generally do not.

Stacking and Packing

The per-taxpayer cap applies per issuer. Gifting stock to family members, or to non-grantor trusts for their benefit, multiplies the exclusion because each recipient has their own $10,000,000 or $15,000,000 cap.

Under IRC Sec. 1202(h), a recipient by gift takes the transferor's holding period and basis and is treated as having acquired the stock in the same manner. This is the mechanism that makes stacking work.

A founder with $60,000,000 of anticipated gain who gifts stock to four non-grantor trusts for children well before an exit can potentially exclude far more than the individual cap. The trusts must be genuinely non-grantor for this to work, since a grantor trust's income is taxed to the grantor and does not create a separate cap.

Packing refers to increasing basis to raise the ten-times-basis alternative cap. A shareholder contributing $4,000,000 of property to the corporation at issuance has a $40,000,000 alternative cap rather than the $10,000,000 floor. Basis for this purpose is generally the amount paid, and contributed property is valued at fair market value at contribution under IRC Sec. 1202(i).

The Redemption Traps

Two anti-abuse rules disqualify stock based on the corporation's redemption activity, and they catch ordinary transactions regularly.

Under IRC Sec. 1202(c)(3)(A), stock is not QSBS if the corporation purchased any of its stock from the taxpayer or a related person within a four-year window beginning two years before issuance.

Under IRC Sec. 1202(c)(3)(B), stock is not QSBS if the corporation made significant redemptions, exceeding 5% of aggregate stock value, within a two-year window beginning one year before issuance.

A company that buys back shares from a departing founder and then issues new shares to an incoming investor within a year may have inadvertently disqualified the new shares. De minimis exceptions exist under the regulations, and redemptions from terminating employees have a specific exception, but the rules are unforgiving and should be checked before any buyback.

Section 1045 Rollover

Where stock is sold before the five-year holding period is satisfied, IRC Sec. 1045 permits a rollover of gain into replacement QSBS purchased within 60 days. The holding period tacks.

This preserves the exclusion for a founder whose company is acquired at year three. Reinvesting the proceeds into another qualifying company continues the clock rather than resetting it.

The election is made on a timely filed return and requires the replacement stock to itself be QSBS, which means the acquisition target must satisfy all the same requirements.

State Conformity Is Not Universal

The exclusion is federal. States conform inconsistently. California does not conform and taxes QSBS gain in full. Pennsylvania, Mississippi, and Alabama also do not conform.

For a founder in California with $10,000,000 of excluded federal gain, the state tax at 13.3% is approximately $1,330,000 on gain that is entirely tax free federally.

This drives real planning. Establishing residency in a conforming or no-tax state well before an exit, or holding stock in a non-grantor trust sited in a favorable state, can preserve the state-level benefit. Both require lead time and genuine substance, and states with aggressive residency audit programs will examine the facts closely.

Worked Example: Founder Exit

A founder incorporates a software company as a C corporation in 2021, contributing $180,000 of cash and property at issuance for 4,000,000 shares. Company gross assets never exceed $28,000,000.

In 2023 the founder gifts 800,000 shares to each of two non-grantor trusts for their children, sited in a no-income-tax state with an independent trustee.

In 2027 the company is acquired for $96,000,000. The founder's remaining 2,400,000 shares produce $57,600,000 of gain and each trust's 800,000 shares produce $19,200,000 of gain.

The five-year holding period is satisfied. The founder excludes $10,000,000. Each trust excludes $10,000,000, for $20,000,000 across the two.

Total excluded gain is $30,000,000, against $27,600,000 of the founder's gain and $18,400,000 across the trusts remaining taxable at long-term capital gain rates.

Federal tax saved through the exclusion, at 23.8% including net investment income tax, is approximately $7,140,000. The gifting decision made four years before the exit accounts for $4,760,000 of that.

Frequently Asked Questions

Does S corporation stock qualify for Section 1202?

No. QSBS must be issued by a domestic C corporation. Stock held while the company was an S corporation never qualifies, even after conversion. Only shares issued after the conversion to C corporation status can qualify, and the five-year clock starts then.

How much gain can I exclude?

The greater of $10,000,000 per issuer or ten times your basis in the stock. Legislation enacted in 2025 raised the cap to $15,000,000 for stock issued after the effective date, along with raising the gross asset threshold from $50 million to $75 million.

Can I multiply the exclusion by gifting stock?

Yes. The cap applies per taxpayer per issuer, and under IRC Sec. 1202(h) a donee takes your holding period and is treated as acquiring the stock as you did. Gifts to non-grantor trusts for family members each carry their own cap. The trusts must be genuinely non-grantor.

What if I sell before five years?

IRC Sec. 1045 allows a rollover of gain into replacement QSBS purchased within 60 days, with the holding period tacking. For stock issued after the 2025 effective date, a tiered exclusion also applies: 50% at three years and 75% at four years.

Do states honor the Section 1202 exclusion?

Not all of them. California does not conform and taxes the gain in full, as do Pennsylvania, Mississippi, and Alabama. For a California founder with $10 million excluded federally, state tax can still exceed $1.3 million. Residency and trust siting planning requires years of lead time.

Qualified Small Business Stock: The Section 1202 Exclusion Most Owners Never Claim