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Qualified small business stock

The Section 1202 exclusion (Qualified Small Business Stock or QSBS) is a tax benefit allowing investors to exclude a large portion of gains from the sale of qualifying small business stock—up to 50% (or 75%-100% depending on when acquired)—if the stock is held for at least five years. This can reduce effective tax rates from 20% long-term capital gains rates to 10% or less. QSBS is a major incentive for early-stage investors and startup employees.

For the statutory basis, see Section 1202 stock. For real estate gains, see qualified opportunity zone investor.

How QSBS works

If you buy stock in a qualifying startup for $100,000 and sell it five years later for $1 million, your capital gain is $900,000.

Without Section 1202, you owe long-term capital gains tax: 20% × $900,000 = $180,000.

With QSBS, if the stock qualifies, you can exclude 100% of the gain: $900,000 × 100% = $900,000 excluded. Your federal tax is $0.

The exclusion can be enormous for successful startup investments.

Exclusion percentages by acquisition date

  • Stock acquired before 2001: 50% exclusion
  • Stock acquired 2001-2010: 50% exclusion
  • Stock acquired 2010-2014: 50% exclusion
  • Stock acquired 2014-2027: 100% exclusion (50% for high earners phasing to 100%)
  • Stock acquired 2027 onward: 0% exclusion (expires)

The percentages reflect policy shifts. Under current law, stock acquired between 2015 and 2027 receives a 100% exclusion, making this period unusually favorable for startup investing.

Qualification requirements

To qualify for QSBS treatment:

C-corporation. The company must be a C-corporation, not an S-corp, partnership, or LLC. (If the LLC is taxed as a C-corp, it may qualify.)

Asset requirement. The corporation must use at least 80% of its assets in active business (not passive investments or real estate).

Gross asset limit. The corporation cannot have more than $50 million in assets (measured at the time you acquire the stock).

Holding period. You must hold the stock for at least five years from the acquisition date.

Initial issuance. The stock must be originally issued to you (not purchased secondhand), and you must have paid fair market value for it.

Why the exclusion exists

The Section 1202 exclusion is meant to encourage investment in small businesses and startups. Early-stage investors take large risks; Congress rewards patient capital with preferential tax treatment.

The $10 million per-company limit

You can exclude gains up to $10 million (or 10× your cost basis, whichever is larger) per company. If you invested $1 million in a startup and it sells for $50 million, you exclude only $10 million of the gain (roughly), not the full amount.

This limit prevents the exclusion from being a complete loophole for mega-successful companies.

No alternative minimum tax

Unusually, the Section 1202 exclusion is not an alternative minimum tax preference. This means you can claim the exclusion even if you are subject to AMT.

Reporting the exclusion

You report QSBS gains on Form 8949 and Schedule D. You calculate the excluded portion separately and report it as a separate line item. Tax software should handle this if you indicate that the stock qualifies under Section 1202.

Documentation and proof

To claim the exclusion, you must be prepared to document:

  • The acquisition date and price
  • The sale date and price
  • That the company was a qualifying C-corporation at the time of purchase
  • That the company met the asset test
  • That you held the stock for 5+ years

Keep your stock certificates, investment confirmations, and records of the company’s size and business.

State taxes

The federal Section 1202 exclusion does not apply to state income tax. You still owe state capital gains tax on the full amount (in states that have it). Some states (like California) have enacted their own QSBS exclusions, but they are not automatic.

Limitation: “Small business” only

The $50 million asset limit means that large, mature companies do not qualify. If you hold stock in a large public company acquired in an IPO when the company had under $50 million in assets, you do not receive the exclusion.

This is deliberate: Congress wants to encourage investment in young, small companies, not large ones.

See also

Wider context