One of the last best tax breaks for some business owners is the exclusion of gain on the sale of qualified small business stock (QSBS). Some businesses can issue stock that entitles owners to eventually obtain fully or partially tax-free income when they sell their stock. Yes, as much as 100% of gain on the sale of QSBS (also called Section 1202 stock after the section in the Tax Code governing it) may be excludable from gross income. There are very strict rules for this tax break…and some recent changes of note.
Recent changes to note:
The corporation must be a domestic C corporation
The corporation must be a regular domestic corporation, meaning a C corporation. It can’t be a foreign corporation. It can’t be an S corporation. If an S corporation terminates its S election, its prior S stock does not become QSBS.
The corporation must be a certain type of business
Basically, the corporation cannot be one involving personal services (e.g., those performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services); banking, insurance, financing, leasing, or investing; farming; mining; or operating a hotel, motel, or restaurant.
Examples of industries for which QSBS can be issued: manufacturing, retailing, technology, and wholesaling.
Active business. The corporation can’t be a mere holding company; it must be engaged in an active business within a permissible industry. At least 80% of the value of the corporation’s assets are used in the active conduct of one or more qualified businesses.
The stock usually must be acquired from the corporation
Shareholders must acquire their stock for cash, property, or as payment for services from the corporation (those acquiring QSBS as a gift or inheritance can still get the tax break). At year end, if your corporation is a qualified small business, you can give bonuses to employees (including owner-employees) in the form of stock. The stock given as a year-end bonus is includible in gross income as long as there are no restrictions on it, so employees pay income tax on it (and the value of the stock at issuance is subject to employment taxes). But future appreciation can be transformed into tax-free income.
The corporation must be of a certain size
As of the date the stock was issued and immediately after issuance of the stock, the corporation must have total gross assets below a threshold amount. For stock issued before July 5, 2025, the threshold was $50 million. For stock issued after July 4, 2025, the threshold is $75 million. The threshold amount will be indexed for inflation after 2026.
Gross assets include those of any predecessor of the corporation. All corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.
The exclusion may be limited
The amount of gain excludable depends on when the stock was acquired and how long the shares are held.
For stock issued before July 5, 2025, and held more than 5 years:
- 100% exclusion applies for stock acquired after September 27, 2010.
- 75% exclusion applies for stock acquired after February 17, 2009.
- 50% exclusion applies for stock issued before February 19, 2009.
For stock issued after July 4, 2025:
- 100% exclusion for stock held at least 5 years or more
- 75% exclusion for stock held at least 4 years but less than 5 years
- 50% exclusion for stock held at least 3 years but less than 4 years
Check state rules. The exclusions described here apply for federal income tax purposes. Different rules may apply for state income tax purposes. Several states have decoupled from some or all of the rules, which means they don’t follow the federal rules. For example, on April 10, 2026, Maine’s decoupling was signed into law. But New Jersey, which had been decoupled, adopted the federal exclusion for its state income tax effective for 2026. Find a complete list of states that do not honor the federal exclusion here (the list could change).
The amount of gain excludable is capped
The exclusion cannot be more than a certain amount.
- For stock issued before July 5, 2025: the greater of $10 million ($5 million for married persons filing separately) minus any gains excluded in prior years, or 10 times the shareholder’s basis in QSBS if this is less.
- For stock issued after July 4, 2025: the greater of $15 million ($7.5 million for married persons filing separately) minus any gains excluded in prior years, or 10 times the shareholder’s basis in QSBS if this is less. The $15 million exclusion limit will be indexed for inflation after 2026.
Tax savings from the exclusion. If the $10 million exclusion applies, it saves about $2.38 million in federal income taxes. If the $15 million exclusion applies, the savings are about $3.57 million.
The excluded gain impacts other tax rules
The excluded gain has consequences beyond tax-free income.
- The portion of the gain not excluded is taxed at a capital gain rate of 28% (not the usual 15% or 20% on most other long-term capital gains).
- The excluded gain is not treated as investment income for purposes of the net investment income (NII) tax.
- The excluded gain is not treated as investment income in figuring the limit on the itemized deduction for investment interest.
- The excluded gain cannot be used to offset capital losses.
- The exclusion is ignored in figuring a net operating loss deduction.
Final thought
While the potential benefit of tax- free or partially tax-free income is significant, there are a lot of rules to handle. Work with your CPA or other tax adviser to do things right.
Additional related information can be found in this list of blogs.
