Qualified Small Business Stock (QSBS) and Section 1202: Tax benefits explained

If you’re an investor in, employee of or a founder of a small business and are selling some of the stock you hold in that business, it’s likely that one of your main goals is to keep as much money from the transaction as possible. But taxes can take a big chunk out of the sale proceeds — up to almost a quarter of the taxable gain recognized on the sale.

Fortunately, there’s a provision in the tax code that can eliminate federal capital gains taxes on the sale of qualified small business stock (QSBS). Section 1202 of the Internal Revenue Code allows small business shareholders to avoid paying federal taxes on up to 100% of the capital gains recognized on the sale of QSBS.

What is qualified small business stock (QSBS)?

Qualified small business stock (QSBS) refers to shares of stock in a small business that qualify for preferential tax treatment. The stock must meet several criteria to qualify for the QSBS exemption:

• The issuer must be a C corporation based in the U.S.
• The business’s assets cannot exceed $75 million (adjusted annually for inflation beginning in 2027).
• The business must be active, not a holding company.
• The business must be in the manufacturing, retail, technology or wholesaling industry.
• The business stock must be acquired in exchange for money or property or as compensation for services provided to the business.
• The business stock must be held for at least three years for partial benefit and five years for full benefit.

What is Section 1202?

Congress enacted Section 1202 of the tax code in 1993 to encourage investment in small businesses. Section 1202 permits noncorporate shareholders to exclude a significant portion of the capital gain they receive from selling QSBS if they have held the stock for at least five years.

Section 1202 applies to up to $15 million in capital gains from QSBS you acquired after July 4, 2025. If you acquired the QSBS on or before July 4, 2025, it applies to up to $10 million in capital gains (see table below).

The savings can be substantial, as it includes the capital gains tax rate of up to 20% plus the 3.8% net investment income tax (NIIT) for federal tax purposes and possibly more depending on the state of residence. Note that not all states conform to the federal rules regarding QSBS.

Does your business qualify for QSBS tax benefits?

Not all small businesses are qualified for the QSBS exemption. Here are some of the QSBS exemption requirements for small business stock:

• Only domestic C corporations qualify for the QSBS exclusion.
  • S corporations don’t qualify, although LLCs that have elected to be taxed as C corps may qualify.
  • If your company stock was initially issued as non-qualifying stock for QSBS (such as S corp stock), it may be possible to convert the business entity to C corp, provided certain conditions are met.  
  • The exclusion will primarily apply to manufacturing, retail, wholesale, technology, equipment sales firms and auto dealerships.
• If the original issue of stock occurred after Aug. 10, 1993 but before July 4, 2025, the issuing corporation must have had assets (on the date of issue and immediately after) valued at $50 million or less.
• If the original issue of stock occurred after July 4, 2025, the issuing corporation must have assets (on the date of issue and immediately after) valued at $75 million or less.
• The corporation must use at least 80% of the fair market value of its assets on the active conduct of a qualified trade or business. The IRS sets the definition of a qualified business. 
• Significant redemptions of stock cannot be made in the year proceeding or following a stock issuance.

Who can claim the QSBS Section 1202 exclusion?

Any shareholder who owns qualified small business stock may benefit from the Section 1202 exclusion, including investors, employees (if they’re U.S. residents), and trusts and estates. In closely held businesses, stock owners are often family members or family trusts. Qualifications for claiming the exclusion include:

• Shareholders must be non-corporate, including individuals, trusts and estates.
• The stock must have been held for more than three years before it’s sold to receive partial benefit, and five years to receive full benefit, starting on the date it was issued.
• The stock must have been purchased from the corporation, not from another shareholder. However, it can be obtained through an inheritance or as a gift from someone who acquired the stock when it was originally issued.

How much is the QSBS Section 1202 exemption?

The QSBS exemption allows different amounts of capital gains to be excluded from capital gains tax and net income investment tax (NIIT), depending on when the stock was originally issued and how long you have held it.

The One Big Beautiful Bill Act, signed into law on July 4, 2025, included several enhancements to the QSBS:

Higher capital gain exclusion.

The maximum capital gain exclusion increased from $10 million to $15 million for QSBS acquired after July 4, 2025. This amount will be adjusted annually for inflation beginning in 2027.

Tiered capital gain exclusion for assets under the QSBS exemption.

A three-tiered capital gain exclusion now applies to QSBS assets acquired after July 4, 2025.

• A 50% exclusion for assets held between three and four years, resulting in a 11.9% maximum effective federal tax rate.
• A 75% exclusion for assets held between four and five years, resulting in a 5.95% maximum effective federal tax rate.
• A 100% exclusion for assets held at least five years, resulting in a 0% effective federal tax rate.

Note that QSBS assets acquired before July 4, 2025, must be held for at least five years for any capital gain to be excluded. These assets will be subject to the previous $10 million exclusion cap even if they are sold after July 4, 2025.

Higher corporate-level gross asset threshold.

The corporate-level gross asset threshold increased from $50 million to $75 million. This amount will be adjusted annually for inflation beginning in 2027.

How much could you save in capital gains taxes using the QSBS exemption?

If you qualify for the QSBS exemption, your tax savings could be substantial. Consider the following example:

Chris invests in a business with a cutting-edge new technology that has major disruption potential and could enable the business to dominate its industry. He invests $1 million in the business and receives qualified small business stock in return. The business is successful over the next decade, and 10 years later, Chris sells his QSBS for $10 million. Since the stock meets the Section 1202 qualification criteria, Chris can pocket the entire $9 million profit federal tax-free.

When is the QSBS exemption appropriate?

If you’re considering selling qualified small business stock under Section 1202, work closely with your tax and financial professionals to create a projection of the ultimate result.

First, it’s important to know when you acquired the stock and how long you’ve held it. Then, look at the sale price and what the QSBS gain would be versus a standard stock sale, asset sale, or other form of business transition, such as gifting stock. With that information, you can estimate the potential tax deduction and maximize your return on investment.

Learn how U.S. Bank wealth advisors and teams can help you balance the needs of your business while working toward your personal wealth goals.