For many entrepreneurs, the greatest financial reward comes not from annual profits, but from the eventual sale of the business they spent years building.
One of the most powerful tax incentives available to founders and early investors has long been the Qualified Small Business Stock (“QSBS”) exclusion under Section 1202 of the Internal Revenue Code.
The recently enacted One Big Beautiful Bill Act (“OBBBA”) significantly expands the benefits available under Section 1202, making QSBS planning more valuable than ever for startups, founders, and investors. While many of the core requirements remain unchanged, the new law increases the potential tax savings, broadens eligibility for qualifying companies, and creates additional planning opportunities that did not previously exist.
For business owners considering forming a new company, raising outside capital, or planning an eventual exit, understanding Section 1202 is a must.
What Is Qualified Small Business Stock?
Congress originally enacted Section 1202 to encourage investment in innovative small businesses by rewarding investors who commit long-term capital to growing companies.
But the benefits are not limited to investors and in many cases, are just as valuable to founders and early employees receiving stock compensation. Under Section 1202, any eligible shareholder in a qualifying company can exclude some or all of the capital gain realized when selling their stock.
If all requirements are satisfied, the gain excluded from federal income tax can be substantial. Depending on the shareholder’s basis and the applicable exclusion limits, millions of dollars of gain may escape federal capital gains tax.
What Must a Company Do to Qualify?
Several requirements must be satisfied, both when the stock is issued and for the period that the shareholder owns the stock.
1. The Company Must Be a Domestic C Corporation
Only stock issued by a domestic C corporation qualifies.
This means:
- S corporations do not qualify.
- Foreign corporations do not qualify.
- Limited liability companies (LLCs) taxed as partnerships do not qualify (but you can convert!)
Further, stock in a C corporation is not treated as QSBS unless the corporation has been a C corporation during substantially all, typically 85% to 95%, of the taxpayer’s holding period. Because many startups begin life as LLCs, assessing whether a conversion to a C corporation makes sense is important. There are many reasons a company may wish to convert from an LLC to a C corporation but, as we will discuss, the changes to Section 1202 now make that a more intriguing conversation.
2. The Stock Must Be Original Issue Stock
Generally, the shareholder must acquire the stock directly from the corporation in exchange for:
- Cash;
- Property (other than stock); or
- Services provided to the corporation.
In other words, the shareholder needs to acquire their stock from the company and not from a third-party, such as purchasing stock from another shareholder.
3. The Corporation Must Meet the Gross Asset Test
The corporation’s aggregate gross assets generally cannot exceed the statutory threshold immediately before and immediately after issuing the stock.
First, prior to the OBBBA, this threshold was $50 million. Now, for qualifying stock issued after July 4, 2025, the threshold has increased to $75 million. The new threshold will also be indexed for inflation in future years beginning in 2027. This expands the number of companies that may qualify and increases the window during which growing companies may be able to issue QSBS.
What this effectively means is that the total assets owned by the company at the time it issues the relevant stock cannot be more than $75 million. For most startups and early-stage companies, this is rarely an issue. For more established companies, a closer review of its assets and their value is needed before determining if the issued stock is QSBS.
4. The Corporation Must Conduct a Qualified Trade or Business
To meet this requirement, at least 80% of the corporation’s assets must be used in an active qualified trade or business. This means a company needs to put its assets to work in a real business. The corporation must have satisfied this active business requirement for substantially all of the shareholder’s holding period, typically between 85% and 95% of the total holding period. Again, for startups and early-stage companies, this is rarely an issue. But established companies that have accumulated passive assets, such as free cash or real estate unrelated to the core business, need to structure carefully their asset mix.
Also, certain businesses are excluded and cannot meet this requirement even if they meet the asset test. This includes many professional service businesses such as:
- Law firms
- Accounting firms
- Medical practices
- Consulting businesses
- Financial services
- Banking
- Insurance
- Investing
- Farming
- Hotels and restaurants
5. The Shareholder Must Satisfy the Holding Period Requirements
This is where the OBBBA has changed the game. Historically, Section 1202 required shareholders to hold their stock for more than five (5) years before they qualified for tax exclusion. This is a long time and hard to plan around. But now, OBBBA fundamentally changes this rule for newly issued QSBS.
What Changed Under the One Big Beautiful Bill?
There are three major changes for QSBS issued after July 4, 2025:
1. Tax Exclusions Are Now Available Sooner
One of the biggest criticisms of the old law was the “five-year cliff.” Shareholders who sold after four (4) years and eleven months received no Section 1202 benefit. This was harsh, especially given the enormous benefit provided to QSBS.
The new law introduces a phased-in exclusion schedule:
- After 3 years: 50% gain exclusion
- After 4 years: 75% gain exclusion
- After 5 years: 100% gain exclusion
This provides founders and investors with considerably more flexibility when evaluating acquisition offers or other liquidity events before reaching the traditional five-year mark.
2. Larger Gain Exclusion
Previously, Section 1202 permitted exclusion of up to the greater of:
- $10 million of gain; or
- Ten times the taxpayer’s basis.
For newly issued QSBS, the fixed exclusion amount has increased to $15 million, while the “10× basis” limitation remains unchanged. The new $15 million amount will also be adjusted for inflation over time.
3. More Companies Can Issue QSBS
As mentioned above, the increase in the gross asset limitation from $50 million to $75 million is a major change for growing companies.
Many venture-backed startups previously lost the ability to issue new QSBS after surpassing the $50 million threshold. The higher limit allows companies to continue issuing qualifying stock deeper into their growth cycle, benefiting founders, employees, and later-stage investors.
Important Effective Date
These changes are great but they are not retroactive. They apply only to Qualified Small Business Stock issued after July 4, 2025.
Stock issued before that date generally remains subject to the prior Section 1202 rules, including the five-year holding period before any exclusion becomes available.
Why This Matters for Startup Companies
The changes to QSBS brought about by the OBBBA rules substantially change the calculus for many of the decisions facing early-stage companies.
Choosing the Right Entity
For many founders, forming an LLC makes a lot of sense because of its flexibility and pass-through taxation. This is particularly true for startups that do not know if they will seek investment from venture capital firms or other institutional investors.
However, companies expecting rapid growth, institutional investment, or an eventual acquisition may now wish to revisit whether a C corporation offers greater long-term value because of the enhanced QSBS benefits.
The answer depends on many factors, including expected profitability, funding strategy, and anticipated exit timeline.
Timing Equity Issuances
Since QSBS generally applies only to original issuances of stock, the timing of founder stock, employee equity grants, and investment rounds can materially affect future tax benefits.
Early planning can preserve opportunities that may not be available later. It was always true that granting stock earlier was generally better given the “five-year cliff” of the original Section 1202. But that time period was often too far away to make it a major factor for planning purposes. With substantial benefits kicking in after 3 years, the planning horizon is no longer so daunting.
Capital Raising
Venture capital funds and angel investors have always viewed QSBS favorably. Many of them require their portfolio companies to certify continued compliance.
The expanded benefits may make qualifying startups even more attractive investment opportunities because investors may realize significantly larger after-tax returns. It also expands the universe of qualifying startups and lengthens the window for issuing qualified stock. This provides investors more tax-advantaged opportunities and gives growing companies greater flexibility on when they seek outside capital.
Exit Planning
Historically, founders sometimes delayed a sale simply to satisfy the five-year holding period. The contrast was stark – sell your business after four years and not realize any tax exclusion or sell your business after five years and realize a substantial exclusion (possibly up to the entire amount of gain).
The new graduated exclusions provide additional flexibility by offering meaningful tax benefits after three and four years, potentially allowing founders to accept attractive acquisition offers without completely foregoing the valuable tax exclusions.
What About Existing Businesses?
For new businesses, planning around all of the new Section 1202 benefits is obvious. They should be part of your conversations and decisions from day one.
But what about existing businesses? A company that anticipates significant future appreciation should consider whether their current structure supports future QSBS eligibility. For example, if formed as an LLC, should the business convert to a C corporation?
Founders should also periodically evaluate:
- Whether future stock issuances will qualify;
- Whether company asset levels remain within applicable limits;
- Whether business activities continue to satisfy the active business requirements;
- Whether corporate actions could inadvertently jeopardize QSBS status; and
- How future financing rounds may affect eligibility.
Because Section 1202 planning often intersects with estate planning, mergers and acquisitions, executive compensation, and business succession planning, these issues are best addressed well before a liquidity event is on the horizon. Also, many of the issues described above can disqualify stock from Section 1202 eligibility even after it has been issued. Planning doesn’t stop when the stock is first issued.
Final Thoughts
The One Big Beautiful Bill Act represents the most significant expansion of Qualified Small Business Stock benefits in years. By increasing the gain exclusion, expanding the size of eligible companies, and introducing phased-in benefits, Congress has made Section 1202 an even more powerful tax planning tool for entrepreneurs and investors.
For North Carolina business owners, these changes create a valuable opportunity to revisit entity selection, capitalization strategy, and long-term exit planning. Decisions made during the earliest stages of a company’s development can determine whether founders and investors ultimately qualify for millions of dollars in federal capital gains tax savings.
Although Section 1202 offers extraordinary benefits, it is also highly technical. Careful coordination among corporate counsel, tax advisors, and accountants is essential to preserve eligibility throughout the life of the business. For startups and growth companies, proactive planning today may produce significant tax savings when the company is eventually sold.
