For founders and early investors, few tax rules matter more at a sale than section 1202. When shares count as qualified small business stock, often shortened to QSBS, some or all of the gain can be excluded from federal income tax, within limits that can reach millions of dollars of gain from one company. The benefit is real, and so are its conditions. Most of them come down to facts the company and its shareholders already have, if someone gathers them before a buyer asks.
What makes shares qualify
The rules look at three things: the shares, the holder and the company. The shares generally have to come straight from the company when first issued, in exchange for money, property or services, instead of being bought from another shareholder. The exclusion is available to eligible noncorporate taxpayers who satisfy the holding-period rules. The company has to be a C corporation that met a size test when the shares were issued and used its assets in an active business for substantially all of the time they were held.
Businesses in some fields do not qualify, including health, law, accounting, consulting, financial services, farming, and hotels and restaurants. Shares received as a gift or an inheritance generally keep the original holder’s history, so family transfers need records from the original purchase as well.
One July 4, 2025 cutoff: acquisition versus issuance
The 2025 tax law made the exclusion more generous, and it applied the July 4, 2025 cutoff to two different events. Shares acquired after July 4, 2025, can earn a partial exclusion after only three years and carry a higher limit on the gain eligible for it, while the higher company size limit applies to shares issued after that date. The table below sets out the schedule.
Picture a founder whose shares date from the company’s formation in 2019 and an employee who exercised options in 2026. They hold stock in the same company under different rules: the founder under the earlier schedule, the employee under the new tiers, each measured against the size test that applied when their shares were issued.
| Shares acquired | Federal exclusion if every condition is met |
|---|---|
| After July 4, 2025 | 50% after 3 years, 75% after 4 years, 100% after 5 years, applied to eligible gain. Eligible-gain limit per taxpayer, per issuer: the greater of $15 million or 10 times basis. |
| September 28, 2010, through July 4, 2025 | 100% after more than 5 years, applied to eligible gain. Eligible-gain limit per taxpayer, per issuer: the greater of $10 million or 10 times basis. |
The percentage applies to eligible gain within the limit. Eligible gain from the same issuer in earlier years reduces the dollar limit, and the $15 million and $75 million amounts are adjusted for inflation after 2026. The company size test is separate: gross assets up to $75 million for shares issued after July 4, 2025, and $50 million for earlier shares. Earlier stock follows older percentages. California does not follow the federal exclusion. Source: 26 U.S.C. § 1202, as amended by Public Law 119-21.
Why the records decide it
The exclusion is claimed on the shareholder’s return, but much of the support sits with the company: capitalization tables, board consents, option and purchase records, balance sheets from the dates shares were issued, and a history of what the business did. Company buybacks of stock around an issuance date can also affect whether shares qualify. Gathering all of this can take weeks once a sale is on the calendar, and far less while the people who remember the history are close at hand.
California does not follow the federal exclusion, so California residents generally owe state tax on the gain even when the federal exclusion applies.
Where we help
We test the share history against the rules and show what the exclusion could mean for a sale: which shares look eligible, which need more support, and what the federal and state tax would be under each outcome. When the answer is that the shares do not qualify, that is worth knowing before a price is agreed as well. Company counsel confirms the corporate records and handles any legal opinion the deal requires.
Sources
Tell us about the shares.
Tell us how the shares were acquired and when a sale might happen. We can talk through the questions that matter and what it would take to answer them.
Contact our team