The Qualified Small Business Stock [QSBS] gain exclusion is one of those rare tax breaks that delivers everything it promises: it helps investors avoid capital gains tax on the sale of qualified small business stock, with no downside. And it just got even better. Thanks to the One Big Beautiful Bill Act (OBBBA), more taxpayers can now qualify — and the amount they can exclude may be larger than ever.

 Today we’re taking a deep dive into how it works. We’ll answer:

• What is the Section 1202 QSBS gain exclusion?
• How do you qualify for the exclusion?
• How much gain is excluded?
• Who is eligible for the gain exclusion?
• How did the OBBBA change Section 1202?

What is the Section 1202 QSBS gain exclusion?

The Qualified Small Business Stock [QSBS] gain exclusion is a tax provision under Section 1202 of the Internal Revenue Code, which is why you’ll sometimes hear it called the “Section 1202 gain exclusion.” Congress enacted it in 1993 to encourage investment in small businesses. The incentive is powerful: if certain conditions are met, eligible investors can exclude up to 100% of the taxable gain recognized from the sale of qualified small business stock.

How does it work?

For an investor to qualify for the Section 1202 gain exclusion, both the investor and the issuing corporation must meet several requirements:

The investor must be an eligible shareholder.

Individuals, trusts, and estates qualify. Partnerships and S corporations may also qualify, although certain requirements must be met for pass-through entities to claim the benefits of Section 1202. C corporations cannot be eligible shareholders.

The stock must be original issuance stock.

The investor must have acquired the stock directly from the corporation, not by purchasing it from another shareholder. A few things to remember:

• The stock doesn’t have to be issued as part of the company’s initial incorporation; secondary stock issuances may also qualify.
• Stock that is awarded in exchange for non-cash property, from the conversion of debt, from the exercise of stock options, or in lieu of cash compensation also qualifies.
• If original issuance stock is gifted or transferred at death, the new owners may still qualify for Section 1202.

The investor must meet the required holding period.

Typically, the investor will be eligible for the largest exemption if they hold their small business stock for at least 5 years. But thanks to the OBBBA, they may receive partial exclusions if they hold the stock for three or four years.

The holding period typically begins on the day the stock was issued, but gifted or inherited shares, converted stock, and stock distributed from a partnership may carry over the original shareholder’s holding period.

The issuing corporation must be a qualified small business.

To be considered a qualified small business, the issuing corporation must satisfy all the following:

• C corporation tax status: The issuing corporation must be a domestic C corporation or an LLC that has elected to be taxed as a C corporation.
• Active business: At least 80% of the business’s assets must have been used to conduct an active trade or business for substantially all of the shareholder’s holding period.
• Qualified trade or business: The corporation must be performing a “qualified” trade or business, which excludes businesses where the principal asset of the business is the reputation or skill of its employees, like many businesses in the following fields:
  • Health
  • Law
  • Engineering
  • Architecture
  • Accounting
  • Actuarial services
  • Financial services
  • Brokerage services
  • Performing arts
  • Consulting
  • Athletics
• Gross assets limit: The corporation’s tax basis of its assets cannot have at any time throughout the year exceeded a predetermined limit. Until recently, this limit was $50 million, but the OBBBA raised it to $75 million for stock issued July 4, 2025, or later.
• No significant redemptions: Any “significant” stock buybacks in the year preceding or following the stock issuance could disqualify the stock sale from Section 1202 treatment — or two years for buybacks between related parties.

How much gain is excluded?

Qualified investors will be able to exclude 50%, 75%, or 100% of the gain they would have otherwise recognized — depending on when the stock was acquired and how long they held it.

But the amount of gain used in the calculation is limited. Until recently, this gain was capped at the greater of 10 times the taxpayer’s basis in the stock or $10 million. But the OBBBA boosted this dollar cap to $15 million for stock purchased July 4, 2025, or later.

How did the OBBBA change Section 1202?

The OBBBA made three major updates to Section 1202. But keep in mind that these changes are only relevant for QSBS that is purchased July 4, 2025, or later.

The gross assets limit increased from $50 million to $75 million.

A corporation can now have up to $75 million in aggregate gross assets and still issue qualified small business stock.

CRI’s perspective: This higher threshold allows for more growth-stage companies to qualify as “small,” expanding the number of investors who can benefit from Section 1202.

Partial exclusions are now available for stock held less than five years.

Past law required a full five-year holding period to claim any QSBS exclusion. The OBBBA adds:

• 50% exclusion for stock held at least 3 years
• 75% exclusion for stock held at least 4 years
• 100% exclusion for stock held at least 5 years (unchanged)

CRI perspective: This gives investors more flexibility in planning exit strategies. Even those who invest in QSBS for only a short time can receive partial tax exclusions under Section 1202.

Exclusion cap increased from $10 million to $15 million.

For QSBS acquired on or after July 4, 2025, taxpayers can exclude the greater of $15 million or 10 times the taxpayer’s basis in the stock. This $15 million cap is adjusted for inflation going forward.

If taxpayers sell stock that they acquired prior to July 4, 2025, the $10 million cap remains.

CRI perspective: This higher exclusion could allow investors to exclude an additional $5 million in gains from taxation, making Section 1202 even more valuable.

What if I don’t qualify for Section 1202?

The benefits of Section 1202 are obvious: excluding up to 100% of capital gains is a powerful incentive. But not all of our clients qualify for Section 1202 treatment. In that case, we often rely on a different tax strategy: a Section 1045 election.

A Section 1045 election lets you defer capital gains realized on the sale of QSBS held for at least 6 months if you use the sale proceeds to purchase another QSBS within 60 days. While it’s not as powerful as Section 1202, deferring gain can be a very useful tax planning strategy. And the great news is that it’s easier to make a Section 1045 election than it is to qualify for Section 1202.

While nearly all the requirements of Section 1045 are the same as Section 1202, there are a few key differences. For purposes of Section 1045, you only need to hold the stock for 6 months (versus 3, 4, or 5 for Section 1202), and the active business requirement only needs to be satisfied for the first 6 months of your holding period.

We often use Section 1045 when:

1. You hold your QSBS for less than the Section 1202 required holding period.
   If you hold stock for less than five years (or less than 3 years for QSBS issued on or after January 4, 2025), you wouldn’t qualify for the Section 1202 exclusion, and the deferral under Section 1045 would be your next best option,
2. The amount of gain exceeds Section 1202 limits.
   If your gain exceeds $10 million (or $15 million for QSBS issued on or after January 4, 2025), you’d be taxed on that excess gain, and you might prefer to defer 100% of the gain instead.

Whatever method you and your tax advisor choose, we encourage you to keep good records. Taxpayers bear the burden of proof for substantiating their eligibility with both Section 1202 and 1045. A few records you’ll want to collect are:

• Records of property contributions
• Equity grant agreements
• Sale or exchange agreements
• Corporate and personal tax returns
• Corporate financial statements
• QSBS issuer certificates
• Third-party attestations
• Written tax advice

Have you considered Section 1202?

The QSBS gain exclusion is a permanent addition to the tax code, so it’s a strategy you can revisit again and again. With the OBBBA expanding who qualifies and how much gain can be excluded, Section 1202 is an even more powerful tool than it has ever been.

If you’d like to explore whether you can benefit from the gain exclusion — or if your company can solicit investment from investors wanting to take advantage of Section 1202 — connect with your CRI advisor. We’ll see if you qualify, and if you do, we’ll help you maintain the substantiation that’s required to prove eligibility.