Section 1202: Qualified Small Business Stock (QSBS) Tax Guide

Section 1202-Qualified Small Business Stock (QSBS) Guide _ Millan + Co., CPAs

December 1, 2025 8am Ryan Millan, CPA

Qualified Small Business Stock (QSBS) can turn a taxable eight-figure exit into a nearly tax-free one if it’s structured correctly from day one. It also became more advantageous under the One Big Beautiful Bill Act (OBBBA), and state-level rules now matter more than ever.

Updated for 2026, this guide explains how Section 1202 Qualified Small Business Stock (QSBS) works, who qualifies, which service businesses do not, and how federal and state-level rules affect founders, investors and business owners.

What is Qualified Small Business Stock (QSBS) under Section 1202?

Qualified Small Business Stock (QSBS) is stock in a domestic C corporation that meets the detailed requirements of Internal Revenue Code §1202. For eligible non-corporate shareholders (individuals, certain trusts, estates), a qualifying sale can exclude up to 100 % of the gain from federal income tax, within strict dollar and holding-period limits.

At a high level, stock may be QSBS if:

1) The issuer is a domestic C corporation (not an S-corp or partnership).
2) The corporation’s aggregate gross assets do not exceed $75 million at and before the issuance of the stock for post-OBBBA shares (up from $50 million; indexed for inflation after 2026).
3) You acquire the shares at original issuance (directly from the company) in exchange for money, property (other than stock), or services.
4) During substantially all of your holding period, at least 80 % of the company’s assets by value are used in an active qualified trade or business (not a disqualified “service” or passive/financial business).

QSBS is available only to non-corporate taxpayers (individuals, certain trusts and estates). Corporations cannot claim the §1202 exclusion.

How much gain can QSBS exclude after the One Big Beautiful Bill Act?

Under current §1202 (as amended by the OBBBA), gain from QSBS can be excluded as follows for post-OBBBA QSBS (stock acquired after the new “applicable date,” July 4, 2025):

Held at least 3 years: 50 % exclusion
Held at least 4 years: 75 % exclusion
Held 5+ years: 100 % exclusion

There is also a per-issuer cap on the amount of gain you can exclude:

For QSBS acquired on or before the OBBBA applicable date:
– Greater of $10 million or 10× your basis in that issuer’s stock (lifetime, per taxpayer, per issuer).

For QSBS acquired after the applicable date:
– Greater of $15 million (indexed for inflation beginning in 2027) or 10× your basis per taxpayer, per issuer.

Properly structured, that means a founder, early employee, or investor can potentially shelter $15 million+ of gain per company at the federal level under current law.

Note: For QSBS acquired before OBBBA, the prior rule (generally 100 % exclusion after five years for post-2010 shares) continues to apply. (irs.gov)

QSBS eligibility checklist: shareholder and company

From a practical “CPA checklist” perspective, a QSBS review usually runs through:

Shareholder-side requirements

You are a non-corporate taxpayer (individual, partnership-look-through, S-corp shareholder, or certain trusts/estates).

You acquired the stock at original issuance (not purchased on a secondary market, from another shareholder, or via most conversions of preferred to common that don’t track back to original issuance).

You have held the stock for at least 3, 4, or 5 years depending on the level of exclusion sought.

You respect the per-issuer cap ($10 million / $15 million or 10× basis).

Company-side requirements

The company is a domestic C corporation (an LLC that has elected to be taxed as a C corporation under the “check-the-box” rules can still qualify).

Gross assets (including cash and contributed property at FMV) do not exceed $75 million at and immediately after the issuance for post-OBBBA QSBS.

During substantially all of the holding period:

At least 80 % of the assets by value are used in one or more qualified trades or businesses, and
The corporation is not an ineligible entity (e.g., RIC, REIT, REMIC, cooperative).

The company avoids disqualifying stock redemptions (buybacks) within a window stretching from one year before issuance to several years after, above certain thresholds.

If any of these prongs fail, the stock generally does not qualify as QSBS.

Service businesses that do not qualify for QSBS

Section 1202 is explicit that “qualified trade or business” excludes a long list of service and asset-heavy activities.

The following categories do not qualify as QSBS trades or businesses:

Health services

Examples: physician practices, dental groups, physical therapy clinics, mental health practices, many telehealth platforms where the revenue is professional services rather than tech SaaS.

Law

Examples: law firms, solo practitioners, litigation boutiques, in-house counsel services provided through a personal PC entity.

Engineering and architecture

Examples: civil engineering firms, structural engineering consultants, architecture studios that primarily sell professional design services.

Accounting and actuarial science

Examples: public accounting firms (audit, tax, advisory), enrolled agent practices, actuarial consulting shops.

Performing arts

Examples: production companies built primarily around the performances of specific artists or entertainers.

Consulting

Examples: strategy and management consulting, IT consulting, marketing consulting, HR advisory, coaching when the core “asset” is your expertise.

Athletics

Examples: sports agencies centered on a star athlete, training businesses selling the personal services of a particular coach or athlete.

Financial services and brokerage services

Examples: investment advisory firms, wealth managers, broker-dealers, M&A brokers, private equity fund managers (their management company), many family offices.

Any trade or business where the principal asset is the reputation or skill of one or more employees

This catch-all can pull in influencer-driven brands, personal-brand consulting practices, keynote speaking businesses, and similar “one-expert” firms, even if they sell courses or intellectual property (IP).

In addition, §1202 also excludes the following non-service sectors:

Banking, insurance, financing, leasing, investing, or similar financial businesses
Farming and timber businesses
Natural resource extraction and production (e.g., oil & gas, mining)
Hotel, motel, restaurant, or similar businesses (including many hospitality and food-service operations)

These exclusions are broad and fact-intensive. A company that looks like “software” on the surface can inadvertently fall into consulting or financial-services categories depending on how it earns revenue and markets itself.

Examples of businesses that often can qualify for QSBS

While every fact pattern is unique, trades and businesses that often do qualify for QSBS include:

Product-based technology and SaaS platforms where value lies in proprietary software or IP, not in custom consulting hours (e.g., standardized SaaS with limited implementation support).
Manufacturing and distribution companies (industrial products, consumer goods, food products made and sold at wholesale).
E-commerce companies selling physical products they design, source, or brand, where professional services are incidental.
Med-device or biotech R&D entities focused on products, not on providing medical services to patients.
Clean-tech, robotics, and hardware companies with significant investment in tangible and intangible capital.

The distinction is usually “products and scalable IP” vs. “personal services or finance.” Again, the 80 % active-business test and service-business exclusions are highly nuanced; detailed modeling is usually required.

State-level QSBS treatment: why your state of residence matters

QSBS is a federal provision, but states are free to conform, partially conform, or decouple from §1202. That means a sale can be tax-free federally yet still fully taxable at the state level.

Current landscape (simplified, based on 2025 analyses): (ITEP)

States that do not allow the QSBS exclusion at all (decoupled)

As of late 2025, key examples include: Alabama, California, Mississippi, Pennsylvania.
These states tax QSBS gains like any other capital gain, even when federal tax is zero.

States with partial QSBS benefits

Hawaii allows only a 50 % exclusion, even when federal law allows 100 %.
Some states (e.g., Massachusetts, historically Wisconsin) have or had partial conformity or special limitations, so the effective state benefit can be much smaller than the federal benefit.

States newly moving toward conformity

New Jersey enacted legislation in 2025 to adopt QSBS rules beginning with tax years starting on or after January 1, 2026, aligning with federal §1202 (including OBBBA enhancements).

States with no individual income tax

States like Texas, Florida, Nevada, South Dakota, Tennessee, Wyoming, and others do not tax individual income; the QSBS question is essentially federal only for their residents.
Washington has no broad income tax, but it does impose a capital gains excise tax that includes a QSBS-style exclusion—planning is required for high-income residents.

Key takeaway: For founders, employees, and investors in high-tax, non-conforming states, QSBS may eliminate federal tax but still leave a significant state bill. For residents of Texas and other no-tax states, a well-structured QSBS exit can be truly tax-free on the gain.

Does it matter where you incorporate?

Clients often ask if they should form the corporation in a QSBS-friendly state to get the state benefit.

Two important clarifications:

QSBS status itself is federal. It does not depend on the state of incorporation; a Delaware, Texas, or Nevada C-corp can all issue QSBS if they meet §1202 requirements.
State taxes follow where you are taxed as a person, not where the company is formed.

A California founder with a Delaware C-corp is generally taxed by California on their capital gains, including QSBS, even if the company has no California operations.

So “incorporate in a conforming state” does not by itself protect you from non-conforming state taxes. More impactful levers include:

Your state of residence when the sale occurs; and

Whether the gain is realized by non-grantor trusts or other entities resident in tax-favored jurisdictions.

Advanced QSBS tax planning ideas (high-level)

Nothing here is a recommendation—just a roadmap of issues sophisticated founders and investors are exploring with their advisors:

Entity selection and timing

Early-stage businesses often start as LLCs taxed as partnerships (to pass through early losses), then convert to a C-corp before significant value creation to turn on QSBS eligibility.
The conversion must be structured carefully to preserve original-issuance treatment and start the holding-period clock.

Trust-based “stacking” and situs planning

Because the §1202 cap is “per taxpayer, per issuer,” some families use multiple non-grantor trusts to multiply QSBS exclusions and/or locate them in no-tax states (e.g., Nevada, South Dakota, Wyoming, Texas).
States are increasingly scrutinizing “in-name-only” out-of-state trusts, so substance (trustee, administration, decision-making, beneficiaries) matters.

Redemption and recapitalization planning

Stock redemptions (company buybacks) within certain windows around the issuance can blow QSBS status for the entire round.
Capital raises, secondary sales, and restructurings should be reviewed for §1202 redemption issues.

Given the dollars at stake, these strategies should involve coordinated work between your CPA, corporate counsel, and (often) an estate-planning attorney.

Common QSBS pitfalls practitioners flag

Advisors who work regularly with QSBS frequently see:

Assuming all “startups” qualify. Many venture-backed companies are in disqualified sectors -especially fin-tech, health-tech with heavy clinical services, and consulting-driven SaaS.
Losing QSBS status at the last minute. An ill-timed stock buyback or recap can trigger a redemption taint that disqualifies an entire issuance.
Documentation gaps. Five or ten years later, no one can find clean records on:

Date of original issuance
Asset values at issuance (to prove the $75 million cap)
How assets were used (to defend the 80 % active-business test)

Ignoring state rules. Founders in California, Pennsylvania, Mississippi, Alabama and similar states are often surprised when they owe double-digit state tax on a federally tax-free exit. (ITEP)

FAQs: Qualified Small Business Stock (QSBS)

Who can claim the QSBS exclusion?

Generally, non-corporate taxpayers—individuals, partners (through a partnership), S-corp shareholders, and certain trusts and estates—can claim §1202 benefits if they hold QSBS directly or indirectly and meet the holding-period and per-issuer limits. Corporations themselves cannot. (CBIZ)

Do LLCs ever qualify for QSBS?

An LLC taxed as a partnership cannot issue QSBS. However, if an LLC elects to be taxed as a C corporation, or converts into a C-corp in a qualifying transaction, stock of the resulting C-corp can be QSBS if all other §1202 conditions are satisfied.

Can a CPA firm, law firm, or consulting firm ever issue QSBS?

Almost never. Trades or businesses involving health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial and brokerage services, and any trade where the principal asset is reputation or skill are expressly excluded.

Does QSBS apply to foreign corporations?

No. The issuer must be a domestic C corporation to qualify.

How does QSBS interact with the 3.8 % Net Investment Income Tax (NIIT) and AMT?

For qualifying QSBS with a 100 % exclusion, the excluded gain is generally not subject to regular tax, NIIT, or AMT, although older 50 %/75 % exclusion regimes had complex AMT preference adjustments. Current post-OBBBA rules effectively allow a full federal exclusion if the stock and holding period qualify. (irs.gov)

Can I “stack” QSBS exclusions using family members or trusts?

Yes, subject to complex rules. Because the cap is per taxpayer, per issuer, some families spread QSBS among spouses, adult children, and non-grantor trusts to multiply exclusions. The IRS and states scrutinize these structures, so anyone considering stacking needs tailored legal and tax advice. (Kiplinger)

Is QSBS at risk of repeal or state-level cutbacks?

At the federal level, QSBS has just been expanded under OBBBA. But it is politically controversial; recent Treasury and think-tank research highlight its cost and distribution to very high-income households. At the state level, there is a clear trend toward decoupling or limiting QSBS, especially in high-tax states.

If I move from California to Texas before selling, does that eliminate state tax on my QSBS gain?

Possibly -but not automatically. States apply source-of-income and residency rules; California, for example, has detailed rules for taxing built-in gains that accrued while you were a resident. Whether a move before exit eliminates state tax depends on timing, how the stock was acquired, and how each state’s law applies. This is a classic situation for pre-transaction planning with a CPA and tax attorney.

How Millan + Co. CPAs can help with QSBS planning

QSBS can be a “magic” exclusion for founders, search-fund operators, and early-stage investors—but only if it’s planned up front and continually monitored.

Millan + Co. can help you:

Evaluate whether your current or proposed entity can qualify as a §1202 “qualified small business.”
Model federal and state-level outcomes, including for Texas-based residents vs. high-tax states and international owners.
Coordinate with your attorneys on formation, conversions, and trust design, so QSBS, §1202, and §1045 (rollover) rules are considered together.
Integrate QSBS into broader tax planning, family office, and estate planning strategies.

If you’re contemplating forming a C corporation, raising capital, or selling an existing business interest, it’s often far more efficient to design for QSBS now rather than try to retrofit it right before an exit.

Our firm’s mission is to simplify complex tax matters while delivering the highest level of client service and insight.

Your journey toward financial clarity starts with a conversation.

Millan + Co., CPAs - Related Resources

External Resources

Legal Information Institute

Phoenix Strategy Group

Davis Wright Tremaine