Significant changes in the One Big Beautiful Bill Act (“H.R. 1”) have made Section 1202 of the Internal Revenue Code an even more valuable tax break for small business owners and investors. These updates expand who can qualify, shorten the time to claim benefits, and increase the amount of gain that can be excluded.
Qualified Small Business Stock (“QSBS”) Rules Prior to H.R. 1
To take advantage of Section 1202, both the stockholder and the issuing corporation must fulfill a series of requirements.
Stockholder Eligibility Criteria
First, the holder of the stock must be a non‑corporate entity (either an individual, partnership, or trust). Second, the stock must have been held for a minimum of five years to qualify for the exclusion. Third, the stock must also have been acquired in exchange for cash, property, or services, not in exchange for other stock. This rule includes LLC membership interests, which the courts have defined as “stock” for these purposes (for further analysis, see Leto v. United States, No. CV‑20‑02180‑PHX‑DWL (D. Ariz. 2022)).
If the stockholder is a pass‑through entity, such as a limited liability company, partnership, or S-corporation, the exclusion may still apply. In this case, the entity itself must meet the five‑year holding requirement, and the gain must be passed through to a non‑corporate owner who: 1) held an interest in the pass‑through entity at the time it acquired the QSBS, and 2) has continued to hold that interest.
Issuing Corporation Requirements
The corporation issuing the stock must also satisfy several conditions to ensure the stock qualifies for the exclusion.
Before all else, the stock must have been issued after August 10, 1993. The percentage of gain that can be excluded depends on the issuance date: 50% for stock issued between August 11, 1993, and February 17, 2009; 75% for stock issued between February 18, 2009, and September 27, 2010; and a full 100% for stock issued on or after September 28, 2010.
The issuing corporation must also be structured as a C‑corporation with less than $50 million in gross assets at the time of issuance, calculated based on the tax basis of the assets. For LLCs that convert to C‑corporations, this means the conversion must occur before reaching $50 million in gross assets. However, careful planning is required, as certain actions (such as cash contributions in exchange for shares) can inadvertently push gross assets over the limit and disqualify the stock.
Qualifying as a “Qualified Business”
Next, the business itself must also meet the criteria of a “qualified business.” The issuing corporation cannot exceed $50 million in gross assets, which includes cash and the aggregate adjusted tax basis of other property. Additionally, under the “look‑through rule,” if the corporation owns more than 50% of another company, it is considered to own its proportionate share of the subsidiary’s assets, which could potentially push the corporation over the $50 million limit.
To qualify, at least 80% of the corporation’s assets must be used in qualifying activities. Certain service businesses, such as those dependent on the reputation or skill of their employees (including health, law, engineering, and consulting firms) are excluded. A full list of non‑qualifying activities can be found in the IRC.
What’s New?
H.R. 1 resulted in three key changes to the application of Section 1202 on QSBS:
- First, the limitation on the size of the underlying business increases by 50%, heightening the limit from $50 million to $75 million.
- Second, the holding period shifts from an all-or-nothing rule (requiring a full five years before any exclusion applied) to a phased-in schedule that begins at three years and reaches the full benefit at the same five-year mark.
- Third, the flat cap on the tax benefit allowed increases from $10 million to $15 million. The 10x adjusted basis of the QSBS remains unchanged.
Asset Limit Increase
The first change increases the gross asset limit for qualifying businesses from $50 million to $75 million. This limit is measured at the time the QSBS is issued and immediately afterward. As long as the corporation’s gross assets are at or below the $75 million threshold at those points, the stock can still qualify, even if the company’s assets later grow beyond the limit. Beginning in 2027, the $75 million threshold will be indexed for inflation. This change applies only to stock issued after July 4, 2025.
As an example, before H.R. 1, a manufacturing company with $52 million in gross assets couldn’t issue QSBS, the $50 million cap made it ineligible. After H.R. 1 raised the limit to $75 million, a newly incorporated C-corporation with $70 million in gross assets could issue qualifying stock. Investors in that August 2025 raise may now be able to exclude millions in future gains under Section 1202.
Shortened Holding Period
The second change replaces the all-or-nothing five-year holding rule with a phased schedule: 50% of the gain can be excluded after three years, 75% after four years, and the full 100% after five years. Again, this change only applies to those shares acquired after July 4, 2025.
For example, in August 2026, an investor puts $1 million into QSBS from a qualifying tech startup with $60 million in assets. Before H.R. 1, they would need to wait until August 2031 for any exclusion. Under the new phased approach, selling after three years allows a 50% exclusion, after four years 75%, and after five years the full 100%, giving flexibility if an early acquisition offer arises.
Increase on Tax Benefit
The third and final change to Section 1202 QSBS benefit is the increase in the flat cap from $10 million to $15 million. This will only affect those taxpayers where $15 million is greater than 10x that taxpayers’ basis in the stock. To the extent the 10x test exceeds $15 million, this change will not affect the taxpayer. Again, this cap will increase for inflation beginning in 2027 and will affect stock acquired after July 4, 2025.
For example, in late 2025, an investor buys QSBS for $500,000. In 2030, they sell it for $20 million, realizing a $19.5 million gain. Under the old rules, the exclusion would be the greater of $10 million or 10x basis ($5 million), so $10 million. With H.R. 1’s higher flat cap, they can now exclude $15 million, shielding an additional $5 million from tax.
Navigating the Potential Pitfalls
For those who meet these stringent criteria, the tax savings can be substantial. But navigating the rules can be complex, with pitfalls that may cause a business to lose its QSBS status. An LLC that converts to a C‑corporation, for example, must do so before surpassing the $50 million asset threshold. Further, specific transactions, like cash contributions for shares pushing the assets over $50 million, redemptions by the issuing company, or the issuing company holding too much cash, can result in losing the QSBS status.
Conclusion
Section 1202 of the Internal Revenue Code presents a unique opportunity for investors and business owners to exclude millions of dollars from taxable income, but only if they carefully navigate the requirements. For those ready to invest in small businesses, understanding these rules can make a significant difference in your tax bill. Proper planning, awareness, and ultimately, documentation of the criteria are essential to unlocking these savings and maximizing your financial benefits.
