# What is QSBS (Section 1202) and does my company qualify?

By James Ustby, CFP®, APMA®. Published 2026-10-20. Canonical URL: https://jamesustby.com/articles/qsbs-section-1202-qualify

> QSBS is C corporation stock whose sale can be partly or fully free of federal tax, often on up to $15,000,000 of gain. Entity type and timing decide it.

## Key takeaways

- Qualified small business stock (QSBS) is stock in a C corporation that, if every test in Section 1202 is met, can let a shareholder exclude part or all of the federal gain when the stock is sold.
- For stock acquired after July 4, 2025, the exclusion is 50 percent after 3 years, 75 percent after 4 years and 100 percent after 5 years, on up to the greater of $15,000,000 or 10 times basis per company.
- For stock acquired on or before July 4, 2025, the old rules still apply: more than 5 years of holding, a cap of the greater of $10,000,000 or 10 times basis, and a $50,000,000 gross asset test at issuance.
- Only C corporation stock can qualify. S corporation shares and LLC interests do not, and many service businesses are excluded by statute.
- In our hypothetical $21,000,000 stock sale, federal tax runs from $4,760,000 with no exclusion to $1,190,000 with the full 5 year exclusion.

## The short answer

QSBS, short for qualified small business stock, is stock in a C corporation that meets the tests in Section 1202 of the tax code. When those tests are met, a shareholder can exclude part or all of the federal gain on a sale, up to the greater of $15,000,000 or 10 times basis per company for stock acquired after July 4, 2025.

Whether your company qualifies turns on four things: the entity type, the size of the company when the stock was issued, what the company does, and how long you hold the shares.

## What is QSBS and what does Section 1202 exclude?

Section 1202 lets a shareholder other than a corporation leave some or all of the gain on qualifying stock out of gross income. Public Law 119-21, signed on July 4, 2025, changed the rule for stock acquired after that date, so the answer depends on when you got your shares.

| Rule | Stock acquired on or before July 4, 2025 | Stock acquired after July 4, 2025 |
|---|---|---|
| Holding period | More than 5 years | At least 3 years |
| Share of eligible gain excluded | 100 percent if acquired after September 27, 2010 (50 or 75 percent for older stock) | 50 percent at 3 years, 75 percent at 4 years, 100 percent at 5 years or more |
| Per company cap on eligible gain | Greater of $10,000,000 or 10 times basis | Greater of $15,000,000 or 10 times basis, indexed for inflation after 2026 |
| Company gross assets at issuance | Not over $50,000,000 (stock issued on or before July 4, 2025) | Not over $75,000,000 (stock issued after July 4, 2025), indexed after 2026 |
| Alternative minimum tax | Excluded gain is not a preference item for stock acquired after September 27, 2010 | Excluded gain is not a preference item |

When the exclusion is 50 or 75 percent, the part of the eligible gain that is not excluded is "section 1202 gain" under Section 1(h), taxed at up to 28 percent, not 20 percent. Gain above the cap is ordinary long term capital gain. The 10 times basis test ignores basis added after the stock was issued.

The IRS summarizes the new tiers in its business tax provisions script for the 2025 law, and Publication 550 explains reporting the exclusion on Form 8949 with code "Q".

## Does my company qualify as a qualified small business?

Section 1202 sets tests for the company, for how you got the stock, and for what the company does while you hold it.

1. **C corporation.** The issuer must be a domestic C corporation when the stock is issued and during substantially all of your holding period.
2. **Gross assets.** The company's cash plus the adjusted basis of its other property cannot have exceeded the limit at any time before the issuance or immediately after it. A parent and its more than 50 percent owned subsidiaries count as one company.
3. **Original issue.** You generally must get the stock directly from the company, in exchange for money, property other than stock, or services. Shares bought from another shareholder generally do not qualify, though shares received by gift or at death keep their status and holding period.
4. **Active business.** During substantially all of your holding period, at least 80 percent of the company's assets, by value, must be used in a qualified trade or business. Limits apply to investment real estate and to stock in other companies.
5. **Not an excluded field.** Health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage, and any business whose principal asset is the reputation or skill of its employees are excluded. So are banking, insurance, financing, leasing, investing, farming, certain mining and extraction businesses, and hotels, motels and restaurants.
6. **No disqualifying redemptions.** Stock can be disqualified if the company bought back shares from you or a related person in the 4 year window starting 2 years before your stock was issued, or bought back more than 5 percent of its stock in the 2 year window starting 1 year before.

A manufacturer or a software company can often pass the business test. A medical practice, a law firm or a consulting firm generally cannot.

## What if my company is an S corporation or an LLC?

This is where many owners stop. S corporation shares are not QSBS, and neither are interests in an LLC taxed as a partnership. Section 1202 looks at the company when the stock is issued, so revoking an S election later does not turn shares issued during the S years into QSBS.

When an LLC or an S corporation business becomes a C corporation, the new stock is treated as acquired on the date of the exchange, with a basis of at least the fair market value of the property contributed. In plain terms, the growth before the conversion generally does not qualify, the 3 or 5 year clock starts at conversion, and the company's gross assets are measured at fair market value at that point. A business already worth more than $75,000,000 would generally fail the test.

Entity type also shapes the sale itself. Section 1202 applies to the shareholder's gain on stock. In an asset sale, a C corporation still pays its own 21 percent tax on the gain inside the company, and Section 1202 does not reach that tax. Our breakdown of [asset sale vs stock sale taxes](https://jamesustby.com/articles/asset-sale-vs-stock-sale-tax) shows how large that corporate layer can be, which is one reason QSBS holders tend to focus on selling stock.

Whether a conversion fits a given company is a facts question for a CPA and an attorney, and a C corporation brings costs of its own, including tax on dividends.

## Priya's sale at 3, 4 and 5 years: a hypothetical example

Here is a hypothetical example. It is an illustration, not a projection, and your numbers can differ.

Example: Priya, 48, married filing jointly, forms a software company in Durham as a C corporation in September 2025 and buys all of the founding shares for $1,000,000 in cash. The company stays well under $75,000,000 of gross assets, meets the active business test throughout and makes no redemptions. A buyer later offers $21,000,000 for her stock, a $20,000,000 gain. Her $800,000 of other taxable income puts all of the taxable gain above $613,700, where the 2026 20 percent rate starts for joint filers. We hold 2026 rates and the $15,000,000 cap flat (the cap can be indexed higher after 2026) and leave out state tax.

Her cap is the greater of $15,000,000 or 10 times her $1,000,000 basis ($10,000,000), so $15,000,000 of her gain is eligible. The other $5,000,000 is taxed as ordinary long term capital gain in every column.

| Line | No exclusion | Sold after 3 years (50 percent) | Sold after 4 years (75 percent) | Sold after 5 years (100 percent) |
|---|---|---|---|---|
| Total gain | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 |
| Eligible gain under the cap | $0 | $15,000,000 | $15,000,000 | $15,000,000 |
| Excluded from income | $0 | $7,500,000 | $11,250,000 | $15,000,000 |
| Taxed at 28 percent (section 1202 gain) | $0 | $7,500,000 | $3,750,000 | $0 |
| Taxed at 20 percent | $20,000,000 | $5,000,000 | $5,000,000 | $5,000,000 |
| Capital gains tax | $4,000,000 | $3,100,000 | $2,050,000 | $1,000,000 |
| 3.8 percent tax on gain not excluded | $760,000 | $475,000 | $332,500 | $190,000 |
| Total federal tax | $4,760,000 | $3,575,000 | $2,382,500 | $1,190,000 |
| Federal tax as a share of the gain | 23.8 percent | About 17.9 percent | About 11.9 percent | 5.95 percent |

How the 3 year column works: half of the $15,000,000 eligible gain, $7,500,000, is excluded. The other $7,500,000 is section 1202 gain taxed at 28 percent, or $2,100,000. The $5,000,000 above the cap is taxed at 20 percent, or $1,000,000. The 3.8 percent tax applies to the $12,500,000 that stays in income, or $475,000.

In this example, waiting from year 3 to year 5 changes her federal tax by $2,385,000 on the same price. The cap matters too: with a $2,000,000 basis, 10 times basis would be $20,000,000, and her whole gain could be eligible. The "no exclusion" column is roughly what an S corporation or LLC owner with the same gain faces, though an S corporation owner who works in the business may owe less of the 3.8 percent tax.

You can test other prices and bases in the [business sale calculator](https://jamesustby.com/business-sale-calculator).

## What can break QSBS before a sale?

Most lost exclusions come from facts that changed quietly over the years.

- **Selling too soon.** New stock sold before 3 years, or older stock sold at 5 years or less, gets no exclusion. Section 1045 can let a holder of QSBS held more than 6 months defer gain by buying other QSBS within 60 days.
- **A change in the business.** A shift into consulting, or a build-up of investment assets, can fail the active business test.
- **Redemptions.** A buyback from a founder or a large repurchase near an issuance can disqualify stock.
- **Hedging.** A short sale or similar position against the stock can block the exclusion.
- **State tax.** Not every state follows the federal exclusion, and a state can follow an older version of the federal code, so the state answer needs its own check.

Because these tests look back over the whole holding period, records matter: the balance sheet at each issuance, the business run each year and every repurchase. Our [exit planning timeline](https://jamesustby.com/articles/exit-planning-business-owner-start) covers why multiyear clocks like this one push planning years ahead of a sale.

## The bottom line

QSBS can remove much of the federal tax on a sale, but only for C corporation stock that passes every test in Section 1202. For stock acquired after July 4, 2025, the exclusion now starts at 3 years and reaches 100 percent at 5, with a cap of the greater of $15,000,000 or 10 times basis. Older stock still follows the 5 year, $10,000,000 rules. S corporation and LLC owners generally start from zero, and a conversion restarts the clock. In our hypothetical $21,000,000 sale, the federal tax ran from $4,760,000 to $1,190,000 depending only on the holding period.

Do you know what kind of entity issued your shares, on what date, and whether every year since would pass the Section 1202 tests?

For owner-focused planning next to a sale timeline, browse the [business owner lessons](https://jamesustby.com/owners) or start with the free [Retirement Reality Report](https://jamesustby.com/reality-report).

## Questions people ask next

### Can S corporation stock be QSBS?

No. Section 1202 requires stock in a C corporation, both when the stock is issued and during substantially all of the time it is held. An S corporation or an LLC that later becomes a C corporation can issue new stock that may qualify, but generally only the growth after that point can count, and the holding period starts then.

### Does the 3 year rule apply to stock I received before July 5, 2025?

No. The 50 percent and 75 percent tiers apply only to stock acquired after July 4, 2025. Stock acquired from September 28, 2010 through July 4, 2025 still needs to be held more than 5 years, and then the exclusion is generally 100 percent of eligible gain.

### Which businesses cannot qualify?

Section 1202 excludes businesses in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage, and any business whose principal asset is the reputation or skill of its employees. It also excludes banking, insurance, financing, leasing, investing, farming, certain mining and extraction, and hotels, motels and restaurants.

### Does excluded QSBS gain avoid the 3.8 percent tax?

Generally, yes. The net investment income tax applies to net gain to the extent it is taken into account in computing taxable income, and excluded gain is not included in gross income. Any part of the gain that is not excluded is generally subject to the tax for an owner above the income threshold.

## Sources

- [26 U.S. Code Section 1202, Partial exclusion for gain from certain small business stock (Cornell Law School, Legal Information Institute)](https://www.law.cornell.edu/uscode/text/26/1202)
- [26 U.S.C. Section 1202 (Office of the Law Revision Counsel, U.S. House of Representatives)](https://uscode.house.gov/us/usc/119-121/t26/s1202/)
- [Public Law 119-21 (July 4, 2025), Section 70431, Expansion of qualified small business stock gain exclusion (GPO text via Congress.gov)](https://www.congress.gov/119/plaws/publ21/PLAW-119publ21.htm)
- [IRS, Understanding the Working Families Tax Cuts: Business Tax Provisions (video text script, Section 1202)](https://www.irs.gov/newsroom/understanding-the-working-families-tax-cuts-business-tax-provisions-youtube-video-text-script)
- [IRS, Publication 550, Investment Income and Expenses (Gains on Qualified Small Business Stock)](https://www.irs.gov/publications/p550)
- [IRS, Revenue Procedure 2025-32, 2026 inflation adjusted amounts (capital gains rate thresholds)](https://www.irs.gov/pub/irs-drop/rp-25-32.pdf)
- [IRS, Net Investment Income Tax](https://www.irs.gov/individuals/net-investment-income-tax)
- [26 U.S. Code Section 1, Tax imposed (28 percent rate gain and section 1202 gain, Section 1(h)) (Cornell Law School, Legal Information Institute)](https://www.law.cornell.edu/uscode/text/26/1)
- [26 U.S. Code Section 57, Items of tax preference (Cornell Law School, Legal Information Institute)](https://www.law.cornell.edu/uscode/text/26/57)
- [26 U.S. Code Section 1411, Imposition of net investment income tax (Cornell Law School, Legal Information Institute)](https://www.law.cornell.edu/uscode/text/26/1411)
- [26 U.S. Code Section 1045, Rollover of gain from qualified small business stock to another qualified small business stock (Cornell Law School, Legal Information Institute)](https://www.law.cornell.edu/uscode/text/26/1045)

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Author: James Ustby, CFP®, APMA®, Wealth Advisor, LPL Financial, Durham and Chapel Hill, North Carolina. This material is for general information only and is not intended to provide specific advice or recommendations for any individual. Examples are hypothetical and for illustration only. Securities and advisory services offered through LPL Financial, a registered investment advisor. Member FINRA / SIPC. Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP® and CERTIFIED FINANCIAL PLANNER® in the United States to Certified Financial Planner Board of Standards, Inc., which authorizes individuals who successfully complete the organization’s initial and ongoing certification requirements to use the certification marks.