QSBS §1202: The Federal Exclusion on Your Founder Exit, and What California Still Taxes

Go deeper: excluding gain on qualified small business stock under Sections 1202 and 1045 on Big Sale Tax.

The most under-used founder exit benefit

IRC §1202, the Qualified Small Business Stock (QSBS) exclusion, lets a qualifying founder exclude up to $10 million OR 10× their basis (whichever is greater) of capital gain on the sale of C-corp founder stock acquired on or before July 4, 2025 from federal income tax after a 5+ year hold. Codified since 1993, expanded to 100% exclusion in 2010.

2025 update (P.L. 119-21, signed July 4, 2025): for stock acquired after July 4, 2025, the per-issuer cap rises to $15 million (indexed for inflation after 2026), the exclusion phases in at 50% after 3 years, 75% after 4 years and 100% after 5 years, and the company gross-assets limit rises to $75M. Stock acquired on or before July 4, 2025 keeps the old rules: $10M cap, 5-year hold, $50M limit.

For a California founder selling a successful startup exit, this can remove millions of gain from the federal return, and it’s a statutory exclusion in the Internal Revenue Code that doesn’t require any structure, trust, or annuity.

Who qualifies: the 5 §1202 tests

1. C-corporation. The company must be a domestic C-corp (NOT an S-corp or LLC). If your startup is an S-corp or LLC at exit, §1202 doesn’t apply.
2. Founder/employee stock, not options. The stock must be ORIGINAL ISSUE acquired directly from the company (founder stock, ISO/NSO exercise BEFORE exit, regulated private placement). Stock bought from another shareholder doesn’t qualify.
3. Held long enough. Stock acquired on or before July 4, 2025 needs a continuous 5-year hold from issuance; sold sooner, it gets no §1202 exclusion (but see §1045 rollover below). For stock acquired after July 4, 2025, a 3-year hold earns a 50% exclusion, 4 years 75%, and 5 years 100%.
4. Company under the gross-assets limit. At the time the stock was issued, the company’s aggregate gross assets must not have exceeded $50M ($75M for stock issued after July 4, 2025, indexed for inflation after 2026). Many pre-seed, seed and Series A startups fit under it.
5. Active business in qualified industry. Company must use 80%+ of assets in a qualified trade or business. Excluded: financial services, professional services (law/accounting/consulting), real estate, farming, mining, hospitality.

The math: $10M or $15M cap, OR 10× basis (whichever is greater)

The exclusion limit is the GREATER of:

• $10 million per issuer per taxpayer (lifetime) for stock acquired on or before July 4, 2025, or $15 million for stock acquired after July 4, 2025 (indexed for inflation after 2026), OR
• 10× the aggregate adjusted basis of QSBS stock sold in that tax year

For a founder who got 1M shares at $0.0001 basis ($100 total cost), the 10× cap = $1,000. So the dollar cap controls: for older stock, $10M of gain is excluded and normal capital-gains tax applies above that; for stock acquired after July 4, 2025, the cap is $15M.

Example: California founder, $15M exit (stock acquired before July 5, 2025)

Item	Amount
Sale of founder stock	$15,000,000
Cost basis (original purchase)	$100
Capital gain	$14,999,900
§1202 exclusion (federal, capped at $10M)	−$10,000,000
Remaining taxable gain	$4,999,900
Federal tax on remaining (20% + NIIT 3.8%)	−$1,189,976
California state tax (~13.3% on FULL $15M gain, CA does NOT conform to §1202)	−$1,994,987
Net to founder	$11,815,037

In this example, the federal §1202 exclusion removes about $2.38M of federal tax (the federal tax that would otherwise apply to the first $10M). California still taxes the full gain at ordinary rates. California does NOT conform to §1202 for individual sellers.

Under the new rules, the same $15M gain on stock acquired after July 4, 2025 could be fully excluded federally after a 5-year hold (the earliest such sales are in July 2030). The California tax would still apply.

California-specific gotcha: no state conformity

California, Pennsylvania, Mississippi and Alabama do not conform to the federal §1202 exclusion. A California founder still owes CA marginal income tax on the FULL gain, even the portion excluded on the federal return.

For a $15M California exit, that means $1.99M in CA tax even with the full $10M federal exclusion. This is where stacking §1202 with the SIS makes sense: it spreads the California portion across multiple years.

The §1202 + SIS stacking play

Most §1202-qualifying founders can:

1. Claim the federal §1202 exclusion in Year 1 (up to the $10M or $15M cap, excluded from federal income tax)
2. Structure the residual gain as an SIS to spread the California state tax across 10-30 years at low CA marginal rates
3. Take a cash carve-out at closing for immediate needs (downpayment on a house, paying off debt, etc.)

For a founder with $15M of qualified gain who has no immediate cash need, one structure to model is: claim the $10M §1202 exclusion + structure the remaining $5M as a 20-year SIS + a ~$1M cash carve-out for liquidity, which in this illustration comes to roughly $13M net (vs ~$11.8M from a straight cash sale at California rates). Your figures depend on your income, state and the payment terms.

The §1045 rollover (when you can’t hold 5 years)

If you didn’t hold the QSBS for the period §1202 requires (5 years for stock acquired on or before July 4, 2025; at least 3 years for a partial exclusion on newer stock), you can use IRC §1045 to roll over the gain into REPLACEMENT QSBS within 60 days of sale. The new QSBS inherits your holding period from the old. After 5 total years (counting both the old and new holding periods), you can sell with the §1202 exclusion.

Common use case: company gets acquired at year 4. Roll the gain into a new QSBS investment, hold for 1+ more year, sell with the full exclusion.

The §1244 ordinary-loss flip side

If your QSBS-eligible startup FAILS (worth $0 at exit), §1244 lets you claim up to $50K single / $100K MFJ as an ORDINARY LOSS (rather than capital loss limited to $3K/yr). Combine with regular capital-loss treatment for the rest. It is the downside counterpart to §1202’s upside.

The 5 things every QSBS-eligible founder should do BEFORE the exit

1. Verify the C-corp election was in place for the entire holding period. If the company converted from LLC to C-corp at year 2 and you sell at year 5, you only have 3 years of QSBS holding, which doesn’t qualify for full §1202.
2. Get a §1202 qualification letter from the company. The company should certify in writing that gross assets were under the limit ($50M, or $75M for stock issued after July 4, 2025) when YOUR stock was issued. Memorialize at the time of stock issuance, not at sale.
3. Track basis carefully. Founder stock often has near-zero basis but employee stock from ISO exercises has the strike price as basis. Keep records.
4. Coordinate with your CPA on the year of sale. §1202 interacts with AMT (alternative minimum tax): 7% of the excluded gain is an AMT preference item for stock acquired before Sept 28, 2010; a 100% exclusion on later stock carries none. Ask your CPA how AMT applies to a 50% or 75% partial exclusion on stock issued after July 4, 2025.
5. For gain above the cap ($10M or $15M), plan the structure BEFORE closing. The residual gain above the §1202 cap can be SIS-structured. But the SIS assignment paperwork must be in place before escrow opens. See the SIS timing rules.