Understanding QSBS: How to Qualify for Section 1202 Tax-Free Gains

Top 3 Takeaways from the OBBBA (July 4, 2025):

1. Broader Eligibility: QSBS asset limit increased from $50M → $75M, allowing more businesses to qualify.
2. Shorter Holding Periods: Partial exclusions now start at 3 years (50%), 4 years (75%), and 5 years (100%).
3. Higher, Inflation-Indexed Limits: Exclusion cap raised to $15M (or 10× basis) and both caps will adjust for inflation starting 2027.

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The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, included multiple tax provisions anticipated to have significant impacts for businesses and individuals. In some cases, sunsetting provisions were made permanent, while in others, new provisions have been introduced that may change the strategies businesses follow to gain the greatest tax advantage.

One such change is to Section 1202, expanding the available benefits for Qualified Small Business Stock (QSBS). While alterations to the required holding period as well as to the gross asset threshold and single issuer exclusion hold promise for increased availability of tax savings on the sale of QSBS, whether the pursuit of this strategy is the best path for a closely held business should not be considered in isolation. Examining the changes to the Internal Revenue Code as well as other possible implications for setting up a business as a C Corporation with the guidance of tax law experts can help ensure that the choice of business entity produces the optimal financial results.

Changes to QSBS Under the OBBBA

Government policy regarding QSBS is intended to encourage investment in smaller, innovative companies by providing significant capital gains tax exclusions to individuals who sell their stock in qualifying companies after a required holding period. This can include not only investors, but founders and key employees, who may be issued stock in a startup in lieu of a higher salary or other benefits. However, the significant tax advantages provided were counterbalanced by requirements necessary to achieve the full benefit.

While many similar restrictions remain after the passage of the OBBBA, some have been expanded and loosened. Specifically, key provisions have been altered as follows:

Notably, certain eligibility requirements have not changed. The small business issuing the stock must be a domestic eligible C corporation at the time the stock is issued, and it must be issued to a noncorporate stockholder (individual or pass-through entity). The stock must be acquired directly from the small business at the time it is issued in exchange for money, other property, or services. The business must also be engaged in a qualified trade or business and using 80% (by value) of its assets in the active conduct of that trade for substantially all the time the stockholder holds the QSBS in question. A closely held business and the individual stockholders must adhere to these requirements to ensure that its stock will qualify for QSBS treatment at the time of any sale. 

Is a C Corp the Right Entity Choice for a Closely Held Business?

The prospect of large tax-exempt sale of QSBS may tempt business owners to organize as a C corporation, but it is not necessarily the best financial choice in every situation. Among the issues to consider: Owners who must pay themselves significant compensation or dividends from the business lose the advantage of the low corporate tax rate, as compensation is taxed at a higher rate and dividends are subject to double taxation. If they are able to limit these types of payouts, they must be able to gainfully put the cash flow back into growing the business to avoid the threat of additional taxes meant to penalize C corporations that unnecessarily avoid distributing earnings to owners. Finally, when it comes time to sell, buyers may demand a discount on QSBS, as opposed to an asset purchase, because stock does not trigger an inside step-up basis for the buyer that allows the amortization of the purchase price of the business.

This does not mean that a closely held business should always organize as a pass-through entity, or that it is impossible to take advantage of a QSBS sale. Rather, it means that the choice to pursue a business plan that relies on qualifying for Section 1202 treatment should be undertaken with detailed planning and careful examination of the potential risks, including possible undesirable tax outcomes.

Expert Law Firm for Domestic and International Tax Advisory

Updated tax provisions can significantly change the equation when it comes to maximizing the value of a business venture. The business law and tax advisory experts at Bridge Law LLP can help you devise the right structure and tax-efficient strategies to help you accomplish your goals. To schedule your consultation, contact us here today.