Section 1202 Exclusion: Qualified Small Business Stock

by Michele Pizzey, in

Section 1202 provides a significant US federal tax break for those who invest in certain small domestic businesses. Investors who hold Qualified Small Business Stock (QSBS) for long enough can exclude some, or all, of their gain on sale from US federal income tax.

The rules changed materially on 4 July 2025, when the One Big Beautiful Bill Act (OBBBA, P.L. 119-21) was signed into law. There are now effectively two parallel regimes running side by side, and which one applies depends entirely on when the stock was acquired. Nothing in the OBBBA is retrospective — pre-existing QSBS stays under the old rules for good.

Please note that if you are a UK resident taxpayer the UK gives no corresponding relief for QSBS. A UK-resident shareholder can end up with a 100% US exclusion on gains on QSBS stock, and attract a full UK CGT bill – although it is possible that an element of relief could be obtained under FIG regime or BADR.

 

What the OBBBA changed

Old rules (stock acquired on or before 4 July 2025) New rules (stock acquired after 4 July 2025)
Holding period More than 5 years Tiered from 3 years
Exclusion 100% (for post-27 Sept 2010 stock) 50% at 3 yrs / 75% at 4 yrs / 100% at 5 yrs
Per-issuer cap Greater of $10m or 10× basis Greater of $15m or 10× basis (indexed from 2027)
Issuer gross assets $50m or less $75m or less (indexed from 2027)

OBBBA introduced three changes to the treatment and conditions surrounding QSBS stock.

  • Tiered exclusion – The old all-or-nothing five-year cliff has gone for new stock. A sale at three years now gets a 50% exclusion, at four years 75%, and at five years or more the full 100%. Unlike the historic 50% and 75% tiers, the excluded portion under the new three- and four-year tiers is not an AMT preference item.
  • Higher cap – The flat cap rises from $10m to $15m per issuer, per taxpayer, indexed for inflation for tax years beginning after 2026 (so first adjusted in 2027). The alternative 10× basis limit is unchanged — but because the gross asset ceiling has risen to $75m, the theoretical maximum exclusion rises to $750m.
  • Higher size ceiling – More companies now qualify as a “qualified small business”, and companies can keep issuing QSBS through later funding rounds than before.

There are a number of corporate conditions to be met to be QSBS stock, however these are outside the scope of this article.

 

The 28% trap on the 3- and 4-year tiers

The headline percentages flatter the new tiers. The portion of gain that is not excluded is “section 1202 gain” under §1(h)(4) and is taxed at a maximum 28% rate — not the 20% long-term capital gains rate — and it remains subject to the 3.8% net investment income tax.

So the maximum effective federal rates on gain within the cap are roughly:

  • 3 years (50%): 14% + 1.9% NIIT = 15.9%
  • 4 years (75%): 7% + 0.95% NIIT = 7.95%
  • 5 years (100%): 0%

Compare that with 23.8% on an ordinary long-term gain. The three-year tier saves around eight percentage points, not half the tax bill. Where a sale can realistically be deferred, holding to the five-year mark is usually worth far more than the tier suggests, and a §1045 rollover into replacement QSBS within 60 days can preserve the clock where an early exit is forced.

Gain in excess of the cap is not §1202 gain at all — it falls back to the normal 20% rate plus NIIT.

 

Legacy QSBS: acquired on or before 4 July 2025

The old rules still govern this stock, and the five-year holding period remains an absolute requirement — there is no partial relief at three or four years.

  1. 100% exclusion — stock acquired after 27 September 2010 and on or before 4 July 2025. No AMT preference, no NIIT on the excluded gain.
  2. 75% exclusion — stock acquired after 17 February 2009 and on or before 27 September 2010. 7% of the excluded gain is an AMT preference item; the non-excluded 25% is taxed at 28% plus NIIT.
  3. 50% exclusion — stock acquired after 10 August 1993 and on or before 17 February 2009. Same AMT and 28% treatment as above.
  4. No exclusion — stock acquired before 11 August 1993.

The cap for all legacy stock stays at the greater of $10m or 10× basis, and the issuer must have satisfied the $50m gross asset test.

State taxes

The exclusion is federal only. California does not conform and taxes the whole gain at state rates of up to 13.3%. A small number of other states also decline to follow section 1202, and the list has moved in both directions since the OBBBA — conformity should be confirmed as at the expected completion date rather than assumed.

This is only intended to be a brief overview of section 1202 and each case should be considered independently, based on the taxpayer’s individual circumstances. Tax law is subject to change, and the IRS has not yet issued guidance on the OBBBA amendments. Please get in touch if you would like us to look at a specific position.