QSBS §1202: Qualified Small Business Stock

TaxKiln framework

QSBS §1202 Five-Test Exclusion Framework

TaxKiln's five-test analytical structure for §1202 Qualified Small Business Stock gain exclusion: (1) C-corp issuer status; (2) gross-asset cap at issuance ($75M under OBBBA, up from $50M); (3) qualified-trade test (non-SSTB); (4) original-issuance acquisition; (5) holding-period gate — OBBBA tiered exclusion at 50% / 75% / 100% for 3 / 4 / 5+ year holds. Caps gain at the greater of $15M (OBBBA-raised) or 10× basis per issuer.

The OBBBA QSBS overhaul

Before OBBBA, §1202 was an all-or-nothing rule: 5 years of holding → 100% exclusion (for stock acquired after 9/27/2010); less than 5 years → no exclusion. The $50M gross-asset cap and $10M per-issuer dollar cap had been static since 1993 — making the exclusion increasingly stale relative to startup valuations. OBBBA modernised three parameters simultaneously, effective for stock acquired after the enactment date: 1. Tiered holding period: 3 years (50%), 4 years (75%), 5+ years (100%) exclusion 2. Gross-asset ceiling raised from $50M to $75M (indexed going forward) 3. Per-issuer dollar cap raised from $10M to $15M (indexed) Stock issued before OBBBA enactment remains under the prior rules — basis-stacking strategies that worked before still work for that vintage.

The five tests (Five-Test Framework)

ALL FIVE must be met for any exclusion: **Test 1 — C-corp issuer**: Issuer must be a domestic C corporation at issuance and continuously throughout substantially all the holding period. LLC and S-corp stock fails. Conversion from LLC to C-corp creates fresh QSBS-eligible stock from the conversion date. **Test 2 — Gross-asset cap**: Aggregate adjusted gross assets ≤ $75M immediately before AND immediately after issuance. **Test 3 — Active business / qualified trade**: ≥80% of assets used in a qualified trade. Excluded trades (SSTB-style): health, law, accounting, consulting, performing arts, financial services, brokerage, banking, insurance, leasing, hospitality (restaurants, hotels), farming, extraction. **Test 4 — Original issuance**: Stock acquired at original issuance directly from the corporation (or by gift/inheritance from someone who did). Secondary-market purchases fail. **Test 5 — Holding period**: At least 3 years (for 50%) through 5+ years (for 100%) of qualifying holding under OBBBA's tiered structure.

The per-issuer cap mechanics

The exclusion is the greater of $15M OR 10× the taxpayer's adjusted basis in the QSBS of that issuer. For founders with low basis (often $1,000–$100,000), the $15M cap binds. For investors with substantial basis (Series B/C/D rounds at $5M+ checks), 10× basis quickly exceeds $15M. Key planning consequence: the cap is PER ISSUER, PER TAXPAYER. Spouses each get their own cap. Non-grantor trusts (with separate taxpayer status) each get their own cap. Pre-IPO QSBS stacking — gifting stock to multiple non-grantor trusts before exit — is a standard exclusion-multiplication strategy, subject to gift tax and step-transaction risk.

Section 1045 rollover

If QSBS is sold before the 3-year tier (so the exclusion is 0%), gain can be deferred under IRC §1045 by rolling proceeds into other QSBS within 60 days. The replacement stock inherits the original's holding period for §1202 purposes — preserving the path to a later 100% exclusion. Useful when forced exits (acquihires, recap events) occur before any §1202 tier is reached.

AMT and NIIT treatment

Under TCJA (carried forward in OBBBA), excluded §1202 gain on stock acquired after 9/27/2010 is NOT an AMT preference item. It is also excluded from the §1411 Net Investment Income Tax base. The combined effect: 100% exclusion = fully tax-free at federal level (regular tax + AMT + NIIT). State conformity varies — California does NOT conform to §1202 and taxes the gain in full. Founders contemplating exit often relocate to a non-income-tax state before sale (TX, FL, NV, WA, TN) to capture full federal exclusion without state offset.

Worked example: Tomás Hernández, founder of Tradewind Robotics, Inc. (Delaware C-corp)

Tomás founded Tradewind on 6/1/2022 for $10,000 of common stock. Gross assets at issuance: $1.2M. He sells 100% of his common in October 2027 for $24,000,000. Tradewind operates in qualified manufacturing — non-SSTB.

Five-test review: 1. C-corp: ✓ Delaware C-corp throughout. 2. Gross-asset cap: ✓ $1.2M at issuance (under both $50M old and $75M new caps). 3. Qualified trade: ✓ manufacturing. 4. Original issuance: ✓ founder stock. 5. Holding period: 6/1/2022 → 10/2027 = 5+ years. Stock issued 6/2022 — PRE-OBBBA, so under prior 5-year all-or-nothing rule: 100% exclusion applies. Gain: 24,000,000 − 10,000 = 23,990,000. Per-issuer cap (pre-OBBBA $10M, since stock pre-dates OBBBA): greater of $10M or 10× basis (10 × 10,000 = 100,000) = $10,000,000 cap. Excluded gain: 10,000,000. Taxable gain: 23,990,000 − 10,000,000 = 13,990,000 (LTCG at 20% + state). If Tomás had issued Tradewind stock POST-OBBBA: cap would be $15M, excluded gain 15,000,000, taxable 8,990,000 — saving ~$1M of federal tax. Federal tax on excluded portion: $0 (no regular tax, no AMT, no NIIT). State: depends on residency at sale.

Statute references

• Qualified Small Business Stock exclusion — IRC §1202
• Section 1045 QSBS rollover — IRC §1045
• OBBBA modernisation of §1202 — OBBBA §70431 (gross-asset cap, holding tiers, dollar cap)
• Definition of qualified trade — IRC §1202(e)(3)
• Original-issuance requirement — IRC §1202(c)(1)(B)

Related pages

• Capital Gains Tax Guide →
• LLC vs S-Corp Election Guide →
• NIIT Calculator →