Investing in a growing company can be rewarding, and under federal law, it can also bring major tax advantages. Two provisions—Sections 1202 and 1045 of the Internal Revenue Code—were designed to encourage investment in early-stage U.S. C corporations. Section 1202 allows investors to exclude a portion of their capital gains when they sell qualified small business stock (QSBS). Section 1045 lets them roll over those proceeds into new QSBS investments and defer the tax bill.
How the Exclusion Works
For stock issued before July 5, 2025, investors can generally exclude up to $10 million in gains per taxpayer, per company. Under the One Big Beautiful Bill Act (OBBBA), the limit rises to $15 million for stock issued after July 4, 2025. In some cases, there’s also a “10-times basis” cap—meaning the exclusion can equal 10 times what was originally invested in that stock.
Deferring Taxes with a Rollover
If you sell QSBS before meeting the required holding period or your gains exceed the limit, Section 1045 allows you to reinvest the proceeds in another qualified business and defer paying taxes. To qualify, the new investment must meet specific timing and eligibility rules.
Keeping Records Matters
To claim these benefits, documentation is key. Investors must be able to prove eligibility if the IRS ever asks. It’s wise to create and maintain a QSBS file that includes subscription or stock-purchase documents, corporate financial statements, tax returns, and written tax guidance. The file should be started when you first acquire the stock and kept for several years after it’s sold.
Who and What Qualifies
Eligible Companies. Only U.S. C corporations can issue qualified small business stock. Limited liability companies (LLCs) that elect to be taxed as corporations can also qualify, but the business generally needs to remain a C corporation for most of the investor’s holding period.
Eligible Investors. Individuals and trusts can benefit directly. Partnerships and S corporations can hold QSBS and pass the gain to their owners, though the rules are complex. C corporations, nonprofits, and non-U.S. investors don’t qualify because they aren’t subject to U.S. capital-gains tax. For retirement accounts, QSBS isn’t ideal for traditional IRAs, though it may help in limited cases with Roth IRAs.
How the Stock Must Be Acquired. To qualify, the stock must be purchased directly from the corporation—whether for cash, property, or services. Buying shares from another shareholder doesn’t count. Some exceptions apply, such as gifts, inheritances, and certain partnership distributions. In mergers or reorganizations, it may be possible to preserve QSBS status if the transaction meets IRS requirements.
What Counts as Stock. Both voting and nonvoting common or preferred shares can qualify. Convertible debt and stock options don’t qualify until they’re exercised. Restricted stock counts only after it vests, unless the investor files an election under Section 83(b).
Ownership and Trust Planning. In most cases, only the original investor can claim the exclusion. However, gifting QSBS to a trust or family member may allow each recipient to use their own separate exclusion, within IRS guidelines.
Business and Stock Requirements
Size and Structure. To qualify, a company’s total assets must not exceed $50 million before or immediately after the stock is issued, or $75 million for stock issued after July 4, 2025. Once the limit is exceeded, the company can’t issue additional QSBS, though existing shares remain eligible.
Type of Business. At least 80% of the company’s assets must be used in active operations. Certain fields—such as health care, law, accounting, consulting, finance, real estate, and hospitality—are excluded. Start-ups that are still in research and development can qualify if they reasonably expect to operate in a qualifying business.
Active Operation. The company must actively conduct its business, not simply hold investments or passive assets.
Redemptions. Stock buybacks can sometimes affect QSBS eligibility, depending on timing and the percentage redeemed. It’s important to evaluate potential redemptions before or after issuing stock.
Holding Period and Gain Exclusions
For stock issued after July 4, 2025, investors can exclude:
- 50% of the gain after holding the stock for three years
- 75% after four years
- 100% after five years
Stock issued between September 27, 2010, and July 5, 2025, may qualify for a full 100% exclusion. Earlier issuances may qualify for partial exclusions under older rules.
Transactions and Exit Planning
Selling or exchanging QSBS in a taxable transaction—such as a stock sale, qualifying redemption, or liquidation—can trigger the exclusion if all requirements are met. In mergers or acquisitions, rolling QSBS into acquirer stock may preserve benefits, but future exclusions depend on the structure and the status of the new stock.
When the required holding period hasn’t been met, investors can consider a stock-for-stock exchange or a qualified rollover under Section 1045. Careful documentation and planning are essential to avoid losing eligibility.
Plan Ahead to Protect the Benefit
Tax incentives for startup investors are evolving, and proper recordkeeping is essential to preserve these benefits. To learn how the rules apply to your investments, contact your Stephano Slack tax manager or partner at 610-687-1600 or TaxInfo@StephanoSlack.com.
Author: Jennifer Crawford, CPA, is a manager dedicated to helping high-net-worth individuals and small- to middle-market businesses navigate complex tax matters, particularly for family-owned companies. She is known for her strategic insight and hands-on approach to developing customized tax strategies that minimize liabilities and drive results. Reach her at jcrawford@stephanoslack.com.
Disclaimer: This content is for informational purposes only and does not constitute professional advice.
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