Qualified Small Business Stock (QSBS) under IRC Section 1202 allows eligible investors and founders to exclude up to 100% of capital gains, up to $10 million per taxpayer, from the sale of qualifying small business C-corporation stock. To qualify, the stock must have been issued by a C-corporation with gross assets under $50 million at the time of issuance, held for at least five years, and acquired at original issue. If you qualify, QSBS is one of the most powerful tax exclusions available to business founders.
Section 1202 was designed to incentivize investment in small businesses by offering a substantial tax exclusion on gains at exit. For business founders who hold qualifying stock, the exclusion can be worth millions, and unlike most tax strategies, it doesn't defer the gain, it eliminates it entirely (for federal tax purposes).
The requirements are strict. The issuing company must be a C-corporation. S-corporations, LLCs, and partnerships don't qualify. The company's aggregate gross assets must not have exceeded $50 million at any time from inception through the time the stock was issued. The stock must have been acquired at original issue (not purchased on the secondary market). And the stock must have been held for at least five continuous years before the sale.
The exclusion applies per taxpayer, not per company. A married couple filing jointly gets two $10 million exclusions, $20 million of gains excluded if both spouses own qualifying stock. The stock can also be gifted to family members or held in certain trusts, potentially multiplying the exclusion across multiple taxpayers.
Importantly, QSBS exclusion applies at the federal level. Illinois, like most states, conforms to the federal exclusion, but a handful of states don't, meaning the gain may still be taxable at the state level even if federally excluded. Verify your state's conformity with QSBS before relying on the exclusion.
Key facts
- Section 1202 exclusion: 100% of gain excluded from federal tax (for stock acquired after September 27, 2010 and held 5+ years)
- Maximum exclusion: $10 million per taxpayer ($20 million per married couple if both own qualifying stock)
- Qualifying entity: C-corporation only. S-corps, LLCs, and partnerships don't qualify
- Gross assets test: company must have had $50 million or less in gross assets at time of stock issuance
- Holding period: minimum 5 years of continuous ownership before sale
- Illinois generally conforms to Section 1202, verify state conformity for your specific situation
My business is an S-corporation, can I convert to C-corp to qualify for QSBS?
Converting from an S-corp to a C-corp is possible and restarts the clock for QSBS purposes, but you must then hold the newly converted shares for at least five years. The conversion also has its own tax consequences (S-corp built-in gains tax may apply). If you're planning a sale in the near term, conversion likely doesn't provide sufficient runway. If you're 5+ years from an exit, it may be worth evaluating.
What is a Section 1045 rollover and how does it relate to QSBS?
A Section 1045 rollover allows you to defer gains from a QSBS sale by reinvesting the proceeds in new QSBS within 60 days. This is useful if you want to defer rather than exclude (perhaps because your holding period didn't meet the 5-year threshold), or if you want to restart the QSBS clock in a new qualifying company.
