At a Glance
The One Big Beautiful Bill Act (OBBB) expands Internal Revenue Code Section 1202, which can let eligible individuals exclude some or all gain when they sell qualified small business stock (QSBS). For QSBS acquired after July 4, 2025, investors can reach exclusions sooner, more companies can qualify because the gross assets limit is $75 million, and eligible shareholders can exclude more gain because the per issuer cap is generally $15 million.
The One Big Beautiful Bill Act (OBBB), enacted on July 4, 2025, made significant changes to Internal Revenue Code 1202 for qualified small business stock. While this provision has been available for more than thirty years, the attractiveness of the code has become increasingly favorable over time, enticing many entities to convert to corporations in hopes of taking advantage of the benefit.
Background
Sec.1202(a) of the Internal Revenue Code provides that a noncorporate shareholder can exclude up to 100 percent of the gain from the sale of qualified small business (QSB) stock. Sec.1202 was added to the Code as part of the Revenue Reconciliation Act of 1993, with the stated goal of providing targeted relief for investors who risk their funds in new ventures and small businesses. Under the original version of the provision, gain from the sale of QSB stock acquired on or after August 10, 1993, was eligible for a 50 percent exclusion. The 50 percent exclusion was increased to 75 percent for stock acquired from February 18, 2009, to September 27, 2010, and then again to 100 percent for stock acquired on or after September 28, 2010. The 100 percent exclusion, unlike many other tax breaks, is now permanent. However, the percentage exclusion still defaults back to the original purchase date of the stock.
Under OBBB the 100 percent exclusion remains. However, there is now an opportunity to claim a lower percentage under less strict requirements, which may allow even more investors to reap the benefits of Sec.1202.
Requirements
There are several requirements to meet the eligibility of Sec.1202. These requirements must all be met and often trip investors up when planning for the gain exclusion. OBBB loosened some requirements and has now made it simpler for corporate shareholders to take advantage of this benefit.
1. The stock must be domestic C corporation stock. This does not mean that the entity must have been a C corporation since inception. It is possible to convert from an LLC to a C corporation and still take advantage of Sec.1202 as long as other requirements are met. OBBB did not change this.
2. Only non-corporate shareholders such as individuals, trusts and estates are eligible to take the exclusion. Partnerships and S corporations may qualify depending on their ultimate ownership. Having corporate shareholders does not nullify the ability of the Sec. 1202 exclusion for all investors. It would still apply to eligible shareholders. OBBB did not change this.
3. The stock must be originally issued by the company in exchange for money, property other than stock or services provided to the issuing corporation. This is either through purchase directly from the company or stock option exercises or issuances. Purchase from other shareholders does not qualify. While there are exceptions to this for gift, inheritance and distributions from a partnership, the original issuance requirement is often the first requirement that nullifies a potential Sec.1202 exclusion. OBBB did not change this.
Also, it is important to be wary of any corporate liquidations and redemptions. There are special rules around corporate redemptions to safeguard from corporations evading the requirement that QSB stock be newly issued stock by redeeming non-QSB stock from a shareholder only to reissue it as QSB stock. Certain redemptions within a two-year period before or after issuance, particularly those involving related parties, may disqualify stock under Sec.1202(c)(3).
4. Under OBBB stock must be held at least three years from the original date of issuance. This is one of the most significant changes to Sec.1202. Prior to OBBB there was a strict five-year holding period. It was five years or nothing. Under OBBB investors may now claim a 50 percent exclusion for stock held for at least three years, 75 percent exclusion for stock held for at least four years and 100 percent exclusion for stock held for at least five years, for any QSBS acquired after July 4, 2025. This makes QSBS even more attractive by allowing investors to realize tax benefits sooner.
When a shareholder contributes cash or property to a corporation in exchange for stock, the issuance date is the date of the contribution. When stock is received by a shareholder upon the exercise of an option, warrant or convertible debt, the issuance date is the date of the exercise or conversion. An unexercised option or warrant is never considered QSB stock, even if the underlying stock would meet the definition of QSB stock in the hands of the option holder. When convertible QSB stock is converted into other stock of the same corporation, the stock received in the conversion is treated as QSB stock, and the date of issuance is the date the convertible stock was originally acquired by the shareholder.
5. The corporation must have aggregate gross assets of not more than $50 million at all times before and immediately after the issuance of the stock. Gross assets are defined as cash plus the adjusted tax basis of all other property held by the corporation. Liabilities are not netted against assets. Also note this is tax basis and not the fair market value. This often results in a lower asset value, especially for companies with appreciated intangibles or Goodwill. There are rules for contributed property; such that contributed property is treated as having a value equal to the fair market value at the time of contribution. Not carryover tax basis.
Under OBBB the asset threshold has been increased from $50 million to $75 million, for any QSBS acquired after July 4, 2025. This change allows larger startups to qualify for QSBS benefits, expanding the range of companies that may take advantage of this benefit.
Be advised, however, that the gross assets test is applied at each stock issuance. Earlier stock issuances prior to the asset threshold may still qualify even if later issuances fail.
6. The company must use at least 80 percent of its assets, measured by value, in the active conduct of one or more “qualified trades or businesses”. Most operating businesses qualify unless specifically excluded, such as those involving the performance of services, financial and investment activities, and many others as defined in Sec.1202(e)(3). Qualifying assets are generally inventory, equipment and machinery, cash held for working capital or research and development needs. Intangibles and other assets used in operations, such as software, also generally qualify. Non-qualified assets may include investment securities, real estate held for investment and not used in the business, or other portfolio holdings. OBBB did not change this.
How Much Gain Can Be Excluded
Say you have successfully met all the requirements of Sec.1202. How much gain can you exclude? There are two limitations on the amount of gain that a shareholder may exclude: a cumulative limitation and an annual limitation, both of which apply on a corporation-by-corporation and a shareholder-by-shareholder basis. Each year that a shareholder sells QSB stock, the total gain that may be considered under Sec.1202 for each issuing corporation is limited to the greater of:
- $15 million reduced by the aggregate amount of eligible gain taken into account under Sec. 1202 for prior tax years attributable to stock in the corporation (the “cumulative limitation”), or
- Ten times the aggregate adjusted basis of QSB stock issued by the corporation and sold during the tax year (the “annual limitation”).
OBBB raised the cap for any QSBS acquired after July 4, 2025. Prior to OBBB, the cap was generally the greater of either $10 million or 10 times the basis of the stock sold. The “ten times aggregate” basis remains the same. This higher exclusion cap allows investors to exclude even more gain from taxes, making investments in qualified small businesses even more attractive.
Note that the $15 million is a cumulative lifetime cap per taxpayer, per issuing corporation. You cannot “refresh” the $15 million exclusion each year by spreading a sale of the same issuer’s stock over multiple years. However, you can subsequently claim an additional $15 million on QSBS in a different corporation.
Potential Trip-Up
Let’s say you have met all the requirements for Sec.1202, you are ready to sell your company, and you are certain you will pay no capital gains on the sale. The one thing you may not have considered all along: is your potential Buyer willing to purchase the stock of your company? Or will they only want the assets?
Sec.1202 only works in a stock sale. Most buyers want assets because they do not want to take on any potential liabilities and history that your company will bring. Plus, they desire the ability to gain a step-up in basis on the acquisition which creates a very favorable tax deduction. If you get to the end and sell and it is not a stock sale, not only have you lost the benefit of the Sec.1202 gain exclusion, but now you have placed yourself into a potential double tax situation. Selling a C corporation can result in either the best-case or worst-case scenario.
For example, assume you sell your business for $10 million and have no basis in the company.
Best case scenario in a stock sale you have a long-term capital gain of $10 million, all eligible under the Sec.1202 exclusion, and you pay no taxes.
Worst case scenario, it becomes an asset sale. The company pays 21 percent tax on the sale, or $2.1 million leaving $7.9 million of profit distributed out to the owners. That $7.9 million is taxed again at the 20 percent capital gain rate plus the 3.8 percent Net Investment Tax for total taxes on the sale of over $3.98 million and a total effective tax rate of 39.8 percent.
Sec. 1202 Planning and Tips
1. Be careful of contributing assets into the business or issuing additional capital. This could cause the gross asset test to fail. For example, say you currently have $65 million of assets in the business. If you issue additional shares and receive $10 million in cash, you now exceed the $75 million threshold.
2. Document all stock issuances. This will not only track the basis of the stock for gain purposes but will also track the asset values and holding periods necessary to ensure applicability to each shareholder. Use outside advisors if necessary to ensure you are staying in compliance for Sec.1202 purposes.
3. Be mindful of how you obtain your C corporation stock. Don’t assume that just because the company itself is a qualified small business, you will be eligible for the Sec.1202 exclusion.
4. Be wary of stock redemptions. Owners may be issued stock from the company with a promise of receiving future Sec.1202 treatment. However, if issued stock was previously redeemed back to the company and did not sit within the company for a required period, the stock may be ineligible for Sec.1202 treatment to the new owner.
5. Consider stock ownership from the onset of the company. Each shareholder is entitled to an exclusion up to $15 million or 10 times basis. Married spouses are considered two separate taxpayers if they each directly own shares of stock. This means that jointly they could realize a gain excluding up to $30 million or 10 times their individual basis. If one spouse does not own stock, merely filing joint does not double the exclusion.
However, gifted stock does retain its QSBS characteristics. If one spouse gifts the other spouse stock prior to the sale, the holding period is retained, and the doubling of the exclusion may still be possible. The gift must just occur before there is a binding sale agreement or otherwise IRS may not allow the transaction. The same gifting would apply to certain trusts.
6. Be confident you can sell your business in a stock sale. If you end up only being able to sell assets you may have been better off keeping the business in a pass though entity for tax purposes.
7. If you sell otherwise qualified small stock but are unable to meet the required Sec.1202 holding period, consider Sec.1045.
Sec.1045 allows taxpayers to defer the gain by reinvesting the proceeds in new QSBS within 60 days, effectively preserving the opportunity to later qualify for the Sec.1202 exclusion.
8. Both the $15 million per-issuer cap and the $75 million aggregate gross assets limitation may be indexed for inflation for tax years beginning after 2026. This will provide even more benefit going forward.
9. Note that not all states conform to Sec.1202. You may be able to exclude your QSBS gain for federal tax purposes, but not state. Consider residency changes well in advance of a sale if your state is one that does not conform.
In Conclusion
The Sec.1202 qualified small business stock exclusion is by far one of the most advantageous tax provisions in the Internal Revenue Code. However, with all the requirements and pitfalls that may arise, careful planning and analysis must be performed from the onset of the corporation to ensure proper compliance and eligibility along the way. OBBB broadened the eligibility and benefits to Sec.1202 even more but be advised that those changes only apply to any QSBS acquired after the July 4, 2025, enactment date. Old rules still apply to old stock.
Windham Brannon’s Tax Practice professionals can provide the right guidance and assist you in determining how Sec.1202 might apply to you. The changes described above are based on recently enacted (or proposed, if applicable) legislation commonly referred to as the ‘One Big Beautiful Bill Act.’ Taxpayers should confirm applicability and final guidance before relying on these provisions. For questions or more information, contact your Windham Brannon advisor today, or reach out to Nicole Suk.
FAQ
- What changed under OBBB for QSBS? For QSBS acquired after July 4, 2025, exclusions can start earlier, the gross assets limit is $75 million, and the per issuer cap is generally $15 million.
- Does the new law apply to stock I already own? No. The expanded benefits apply only to QSBS acquired after July 4, 2025.
- What can cause QSBS treatment to be lost? Common issues include failing original issuance rules, disqualifying redemptions, missing the gross assets test at issuance, or operating in an excluded business. Sec. 1202 generally requires a stock sale.
- What if I need liquidity before the holding period? Sec. 1045 may allow gain deferral if proceeds are reinvested in new QSBS within 60 days.
