QSBS and §1202: the founder’s most under-used exemption

What Section 1202 does. Qualified Small Business Stock is the one provision in the code that can make a founder's exit federally tax-free. Sell stock that qualifies, after holding it long enough, and a large share of the gain is excluded from capital gains tax and from the 3.8% net investment income tax. For stock issued before July 5, 2025, the exclusion is 100% of the gain up to the greater of $10 million or ten times your basis, after a five-year holding period. For stock issued after July 4, 2025, the July 2025 tax law made the rules more generous: the per-issuer cap rose to $15 million, indexed for inflation, and a tiered exclusion now begins earlier, 50% after three years, 75% after four and 100% after five.

Who can use it. The company must be a domestic C corporation at the time the stock is issued, its gross assets must not have exceeded $50 million before and immediately after the issuance ($75 million for stock issued after July 4, 2025), and at least 80% of its assets must be used in an active qualified trade or business. You must acquire the stock at original issuance, for money, property or services, not by buying it from another shareholder. Most technology, manufacturing, product and construction-adjacent businesses qualify. Most professional service firms do not: health, law, accounting, consulting, financial services, hospitality and any business whose principal asset is the reputation of its employees are excluded, and so are real estate holding companies.

Where developers and business owners fit. A developer's rental portfolio will not qualify; the real estate exclusion is explicit. But the operating businesses around a development practice often can: a construction company, a building products or prefabrication business, a property technology venture, a manufacturing operation. The question we ask is whether a business that is currently an LLC taxed as a partnership or S corporation, and that could plausibly be sold for a large multiple, should be converted to a C corporation now so that the five-year clock starts. Conversions have their own rules: the stock is treated as issued on the conversion date and the gross asset test is measured then, so the timing has to be deliberate.

The structure is the whole strategy. QSBS is lost far more often to structure than to eligibility. Founders redeem shares and fail the redemption tests. Companies buy back stock within the two-year window around an issuance. Stock is gifted or sold inside the family without preserving the holding period. Options are exercised late, restarting the clock. Each of these is avoidable when the cap table, the shareholder agreements and the exit plan are designed with Section 1202 in view from the first round of funding. A ten-minute decision at formation is regularly worth seven figures at exit.

Stacking. The cap applies per taxpayer per issuer. Gifting qualified stock to a non-grantor trust for a spouse or children before a sale can, when done correctly, give each trust its own exclusion, because the donee takes the donor's holding period and the stock keeps its qualified status. This is legitimate and it is scrutinized, so the trusts must be real, independently trusteed and funded well before a letter of intent exists. It is also one of the reasons an exit should be planned three to five years out, not the quarter before the sale.

Rollovers when the clock is short. If you sell before the holding period is met, Section 1045 allows you to roll the proceeds into new qualified small business stock within 60 days and defer the gain, carrying the original holding period forward. It is a narrow window and it requires having the replacement investment identified in advance, but for a founder selling early it can preserve an exclusion that would otherwise be lost.

What to do next. If you own or are forming an operating business that could sell for eight figures, the entity decision belongs in your tax plan now, not at the exit. Apply for tax planning and we will review the company's eligibility, the conversion arithmetic and your family structure together. If the question is narrower, bring it to a Strategy Session and leave with an answer.