Few provisions of the Internal Revenue Code (the "Code") are as generous as the rules under section 1202 governing "qualified small business stock," most commonly known as QSBS. Designed to encourage investment in start-ups, section 1202 permits capital gain exclusion on all or a portion of the sale proceeds of QSBS in C corporations. Most recently, the 2025 tax law, Public Law 119-21, also known as the One Big Beautiful Bill Act (OBBBA), quietly enhanced the already powerful section 1202 by making its tax benefits even more generous. These changes may make C corporations a more attractive entity form for small and mid-size businesses going forward.

The Evolution of QSBS

QSBS was first introduced in 1993 during the Clinton administration. Start-ups faced challenges raising capital because angel investors typically saw lower after-tax returns compared to more liquid, lower-risk investments. To address this, Congress enacted Section 1202 of the Code, allowing investors to exclude 50% of the gain (up to certain limitations) from the sale of stock in a qualifying small C corporation if held for more than five years.

President Obama supercharged the incentive in the wake of the financial crisis. For stock acquired after early 2009, the exclusion jumped to 75 percent, and for stock acquired after Sept. 27, 2010, it became a full 100 percent. At the same time, the gain that is excluded avoids the 3.8 percent net investment income tax (NIIT) and the alternative minimum tax (AMT).

Even with this powerful tax incentive, many did not take full advantage because it required small start-ups to be taxed as C corporations rather than S corporations or partnerships. C corporations are subject to a two-tier tax rate, first at the entity level and then upon distribution to the shareholders, as contrasted with a partnership (or a limited liability company taxed as a partnership), for example, which only has one level of tax at the owner's personal income tax rates. Additionally, the corporate rates ranged between 35–39 percent at the top end, in addition to generally the 23.8 percent tax (inclusive of the NIIT) on the shareholder upon receipt of funds. The net result was that small businesses—or really those individuals setting them up—did not see the value in gambling the short-term immediate savings for the hypothetical, future, not-guaranteed, big-time tax break at the other side of the rainbow.

Starting in 2017, with the lowering of the corporate tax rate to 21 percent, there was a surge of interest in QSBS. Now, by comparison, the combined C corporation rate was only 39.802 percent compared to a top individual rate of 37 percent. This removed a major barrier for businesses. Many now were willing to start as C corporations or convert over to C corporations moving forward.

Most recently, under the OBBBA, stock issued on or after Jul. 5, 2025, will more easily qualify as QSBS because a partial exemption now begins after a 3-year holding period. Additionally, taxpayers will enjoy a $15 million exemption compared to a $10 million exemption on pre–July 5, 2025, on QSBS. This will likely lead to another surge in interest in QSBS. However, taxpayers must be mindful of the pre and post OBBBA tax incentives that will continue to coexist in some instances.

The Benefits of QSBS

The extent of the QSBS benefit depends on two dates: the date of incorporation of the business and the date stock in the business was acquired by the taxpayer. First, one determines the amount of gain eligible for QSBS treatment. If the stock was acquired prior to Jul. 5, 2025, the eligible gain is the greater of $10,000,000 or ten times the basis of the stock. If the stock was acquired on Jul. 5, 2025, or thereafter, the eligible gain is the greater of $15,000,000 (indexed for inflation as of 2027) or ten times the basis of the stock. In either case, it is unusual for founders' shares’ basis to be great enough that the basis multiplier exceeds the specified dollar limit. Second, based on the date of incorporation, the eligible gain is exempt from taxes between 50 percent and 100 percent as follows:

1. If incorporated on or after Aug. 11, 1993, 50 percent of the eligible gain is excluded from federal income taxes.
   
   
2. If incorporated on or after Feb. 18, 2009, 75 percent of the eligible gain is excluded from federal income taxes.
   
   
3. If incorporated on or after Sept. 28, 2010, 100 percent of the eligible gain is excluded from federal income taxes.

All gains that are not eligible for the exemption are taxed at the normal corporate rate, which is currently 21 percent and the shareholder’s appropriate capital gains rate. The only exception is gains on businesses incorporated between August 1993 and September 2010 under the $10,000,000 threshold but not exempt from federal income taxes, which are taxed at 28 percent. Additionally, pre-Sept. 28, 2010, QSBS is subject to the AMT.

Lastly, and not to be taken lightly or forgotten, is the application of state income taxes on QSBS. Some states have similar statutes or track the federal application of QSBS, resulting in zero taxes on the eligible gains. Some states have no state income taxes, and others have no exemption for QSBS and treat it just like any other income generated by the taxpayer.

The Basic Requirements

The interpretive nuances of section 1202 warrant careful review at each stage of the business’s life cycle from formation through sale to guarantee QSBS status. In order to qualify as QSBS, the following basic requirements must be met:

1. The seller must be a noncorporate taxpayer.
2. There must be no disqualifying redemptions.
3. The stock must be held for the applicable holding period.
4. The business must be a qualified small business.

The seller of QSBS cannot be a C corporation. It can, however, be a passthrough entity such as a partnership, limited liability company, or S corporation. In order for the passthrough to qualify, such entity must have held the stock for the applicable holding period, and the taxpayer must have held an interest in the passthrough entity on the date the passthrough acquired the QSBS. A common mistake made by taxpayers is contributing their QSBS into a passthrough, which results in disqualifying the stock as QSBS.

Since the goal of QSBS is to encourage investment, a redemption of stock that is otherwise not de minimis may result in either the taxpayer's stock being disqualified as QSBS or all of the stock in the business being disqualified. A related party redemption affects only the individual taxpayer. This occurs when either the taxpayer or a related party redeems stock over a four-year period beginning two years before the issuance of such stock to the taxpayer. A significant redemption, however, affects all of the stock of the business. This is where 5 percent of the aggregate value of the stock is redeemed over a two-year period beginning one year before the issuance of such redeemed stock.

Stock issued before Jul. 5, 2025, is required to be held a minimum of five years to qualify as QSBS. Stock issued post-Jul. 4, 2025, begins to qualify after a three-year holding period but is limited to a 50 percent exemption on the eligible QSBS gains. Post-Jul. 4 stock held for four years qualifies for a 75 percent exemption, and post-Jul. 4 stock held for five years qualifies for a 100 percent exemption. The holding period is specific to each individual taxpayer and generally cannot be transferred. However, the tacking of the holding period is permitted in certain tax-free exchanges. These include: 1) gifts and bequests, 2) distributions from partnerships to partners, and 3) section 351 tax-free incorporations and section 368 tax-free reorganizations. Additionally, taxpayers are permitted, pursuant to section 1045, to reinvest sales proceeds of an otherwise ineligible QSBS entity into another QSBS entity and continue their original holding period. This rollover must be completed within 60 days of the sale of the original QSBS entity.

Lastly, the business must be a qualified small business. This means the entity is incorporated as a C corporation and must be a C corporation during substantially all of the time held by the taxpayer. The gross assets of the entity cannot exceed $75 million (indexed for inflation as of 2027) through the date of issuance of the stock. Finally, the business has to be an active trade or business.

The Active Business Requirement

The QSBS incentive was designed to encourage innovation and creation, not passive holding vehicles. This is why Congress required that at least 80 percent of the value of the business must be used in the qualified business. The business must also be active during substantially all of the holding period. Unfortunately, there is no guidance on how to calculate the 80 percent test over the holding period nor what the term "substantially all" means. Best practice is that annually the 80 percent test is met. As for the undefined term "substantially all," various sections of the code have defined the section to mean between 80–90 percent. Again, best practice is to stay on the top end of this range. There are special rules for working capital and amounts needed for research and experimentation activities. Additionally, the business cannot hold 10 percent or more of assets that consist of real estate not used in the active business or 10 percent or more of stock in other companies.

Even if a business meets the active business requirement, there are certain corporations and certain trades or businesses that are ineligible for QSBS treatment. Ineligible corporations include domestic international sales corporations, regulated investment companies, real estate mortgage investment conduits, and real estate investment trusts and cooperatives. Ineligible trades or businesses include banking, farming, hotels, restaurants, and professional service fields. Professional service fields include law, health, accounting, and consulting; all these fields are defined by the reputation and skill of the employees.

Private Letter Rulings: Clarifying Section 1202 Uncertainties

Because formal regulations under section 1202 are sparse, taxpayers (and their advisors) often seek private letter rulings (PLRs) for comfort. Recent PLRs illustrate the wide range of businesses that may qualify, as well as the ambiguous boundaries of the statute:

• PLR 201436001 blessed a pharmaceutical services company (despite its ties to health) because it created tangible drug assets rather than providing patient care.
  
• PLR 202114002 concluded that an insurance agency offering value-added administrative services was not a broker, so its stock was QSBS.
  
• PLR 202342014 held that a data-migration firm's embedded advice was incidental; the core was implementing technology, not consulting.
  
• CCA 202204007, by contrast, found that a website matching renters with facility owners was engaged in brokerage, causing it to not be QSBS eligible.

These rulings demonstrate the importance of specific facts and highlight how subtle the distinction can be between an excluded service trade or business and a qualified one. Until comprehensive regulations are issued, investors should perform careful diligence, consider seeking their own ruling when the stakes are high, and document why the company's principal assets are something other than the reputation or skill of its employees.

QSBS Planning

The saying "pigs get fat, hogs get slaughtered" comes to mind when it comes to QSBS planning. Though there are some theories about various methods that allow taxpayers to multiply their QSBS exemption, there really is only one best practice approach—"stacking." The other variations pose a far greater risk to taxpayers, with little to no case law supporting the positions, thereby exposing the taxpayer unnecessarily.

The initial starting point is that each taxpayer who owns QSBS is entitled to the exemption. This means relatives such as children, siblings, and parents. Gifting QSBS to these individuals is one way to multiply the exemption on a per-person basis. Specifically excluded from this category are spouses. Though there is some commentary about the ability of a married couple who file jointly to take two exemptions ($20 million, rather than $10 million), this position is not supported by any case law, and spouses should be considered as the same taxpayer when it comes to QSBS.

Care needs to be taken with the timing of making gifts of QSBS to avoid running up against anti-abuse rules. For example, if QSBS is gifted shortly before a sale of the business occurs, the IRS may invoke the anticipatory assignment of income doctrine to invalidate the QSBS benefits of having the stock held by multiple taxpayers. On the other hand, if QSBS is gifted well ahead of the commencement of any sale discussions (ideally, coterminously with or shortly after the acquisition of the QSBS by the original taxpayer), the gifts are likely to be respected.

Normally, with gifting, it is often recommended—for a slew of reasons—that rather than gifting directly to an individual, taxpayers should gift to a trust for their benefit. This eliminates the risk of giving to children who are too young to manage their money, or relatives who are too immature to manage their money, or may allow the taxpayer to continue to have investment control over the funds long after the QSBS is liquidated. Unfortunately, grantor trusts are not an option since, for income tax purposes, they are considered the same taxpayer as the grantor.

Non-grantor trusts, on the other hand, are separate taxpayers, and they are entitled to their own QSBS exemption. The more non-grantor trusts one can create, the more exemption the taxpayer will have created. This is “stacking.” However, there are limitations to this method. Section 643(f) of the Code prevents the abuse of a taxpayer creating an endless number of trusts that are substantially similar. Trusts that run afoul of section 643(f) are deemed the same trust for income tax purposes, thereby negating any further QSBS exemptions. In order for multiple non-grantor trusts to be respected for the QSBS exemption, the trusts cannot have the same grantor and substantially the same beneficiaries. Note that trusts that are not identical can still fail this test. Taxpayers must be careful when structuring multiple non-grantor trusts to avoid overlapping beneficiaries. The most common stacking structure is setting up separate non-grantor trusts for each child of the grantor. Though there are other possible variations, taxpayers should be mindful, as with all planning, of whether the tax savings are actually achieving their ultimate planning objective or if it is just the allure of savings.

Miguelina Mercedes, JD, is an associate in ArentFox Schiff’s Private Clients, Trusts & Estates practice group.  Her practice focuses on wealth and transfer tax planning, charitable giving, and business succession planning for ultra-high-net-worth individuals and families, including related gift, estate and generation-skipping transfer tax considerations.  Miguelina works closely with clients in structuring and implementing sophisticated estate planning strategies specifically tailored to meet the client’s personal needs and wealth preservation goals, while remaining attentive to the deeply personal family dynamics that are unique to each client.