Qualified Small Business Stock (§1202)

It is also narrow, full of disqualifiers, and — for anyone selling from California — only half as good as it looks.

The tests, all of which must hold

The company. A domestic C corporation. Not an S corp, not an LLC, not a partnership — though stock issued when a company converts to a C corp can qualify from the conversion date forward.

Gross assets. Aggregate gross assets of $50,000,000 or less at all times before and immediately after the stock was issued. For stock issued after July 4, 2025, that ceiling was raised to $75,000,000.

Original issuance. You must have acquired the stock directly from the company for cash, property, or services. Buying shares from another shareholder does not qualify, no matter how small the company is.

Active business. At least 80% of assets used in a qualified active trade or business.

Holding period. More than five years. For stock issued after July 4, 2025, a tiered exclusion applies: 50% at three years, 75% at four, 100% at five.

The industries that are excluded

This is where most sellers fall out, and the list is broader than people expect. §1202 excludes any business whose principal asset is the reputation or skill of its employees, plus several named sectors:

Health · law · engineering · architecture · accounting · actuarial science · performing arts · consulting · athletics · financial services · brokerage services · banking, insurance, financing, leasing, investing · farming · mining and natural resources · hotels, motels and restaurants

A medical practice, a law firm, an accounting firm, an insurance agency, a restaurant group — none of them qualify, regardless of structure or size. Software, manufacturing, consumer products, biotech and most technology businesses generally do.

The cap

Excluded gain per issuer is the greater of $10,000,000 or 10× your aggregate adjusted basis in the stock. For stock issued after July 4, 2025, the fixed figure is $15,000,000 and indexed going forward.

The 10× basis prong is the one people forget. Put $3,000,000 into a company and your cap is $30,000,000, not $10,000,000. Found it with a nominal contribution and your cap is the fixed amount.

California does not conform

This matters more than anything above if you live in Los Angeles, Orange County or San Diego.

California repealed its QSBS provisions and does not conform to §1202. Your federal tax on qualifying gain may be zero. Your California tax is computed as if §1202 did not exist — at rates up to 13.3%, the highest state rate in the country.

Sellers who plan around a zero-tax exit are frequently working from federal-only math. On a $10,000,000 qualifying gain, the California bill on its own can exceed $1,300,000. That is not a rounding error and it does not disappear because the federal side is clean.

What to do with the gain that doesn't qualify

Most real exits are not cleanly inside or outside §1202. They are partly inside:

• Gain above the per-issuer cap
• Shares bought from other holders rather than issued to you
• Shares held under five years — where §1045 lets you roll proceeds into replacement QSBS within 60 days, if you have somewhere to put it
• A company that fails the active-business or asset tests for part of the holding period
• Every dollar of California tax, qualifying or not

That leftover gain is ordinary capital gain, taxed in one year, at the top rate, plus the surtax, plus the state. It is exactly the position an installment sale under §453 addresses — spreading recognition across years instead of stacking it into one. QSBS handles what it can; §453 handles the remainder.

Run the non-qualifying portion through the capital gains exit calculator to see what that layer actually costs before you assume the exit is tax-free.

Frequently asked

Q: Does QSBS apply to an LLC? A: Not as an LLC. Stock issued after converting to a C corporation can qualify from the conversion forward, but the pre-conversion appreciation does not.

Q: Can I stack the cap across family members? A: Each taxpayer has their own per-issuer limit, and gifts of QSBS carry over the original holding period and character. Multiplying the cap through gifts to family members or non-grantor trusts is an established technique, but it requires real transfers made well before a sale is in sight.

Q: Is excluded QSBS gain subject to the 3.8% surtax? A: No. Gain excluded under §1202 is also excluded from net investment income.

Q: Does my state conform? A: Most do. California, and at times Pennsylvania, Mississippi, Alabama and New Jersey, have not. Check your state before relying on a zero-tax number.

Q: What if I sell at four years? A: For stock issued before July 5, 2025, you get nothing under §1202 — but §1045 lets you roll the proceeds into new qualifying stock within 60 days and keep the clock running. For stock issued after that date, 75% is excluded at four years.