On July 4, 2025, President Trump signed into law the One Big Beautiful Bill Act (OBBBA), which included a significant expansion to 26 U.S. Code §1202 of the Internal Revenue Code governing Qualified Small Business Stock (QSBS). The expansion of Section 1202 is intended to increase investment in small and early-stage companies by shielding up to 100% of profits from the sale of qualifying QSBS from federal capital gains taxes for certain investors.

What Is QSBS?

Prior to changes to Section 1202 codified in OBBBA, early investors in qualified small businesses were allowed to exclude from federal income tax the greater of $10 million per issuer in capital gains from the sale of QSBS or up to 10 times adjusted basis, if certain other conditions were met. OBBBA loosens these rules and increases the amount of capital gains potentially excluded from taxes by allowing larger maximum exemptions and larger companies by asset size to qualify.

Who Qualifies for Capital Gains Exemptions for QSBS Under Section 1202?

Taxpayers eligible to benefit under Section 1202 must receive stock directly from the qualified small business. Only noncorporate taxpayers, such as individuals, partnerships, trusts, and other pass-through entities, qualify for capital gains exemption under QSBS, while corporate holders of shares do not qualify.

Issuers must be domestic C corporations operating an active business to be considered a qualified small business. S corporations are not eligible, and LLCs must convert to C corporation status prior to issuance. Issuing companies may not exceed a certain level of gross assets at the time of the issuance of QSBS and immediately after.

QSBS shares can be issued in exchange for cash, property, or services, but not stock. Certain industries are excluded from QSBS, including most services-oriented companies.

How Did QSBS Rules Change Under the OBBBA?

• The maximum capital gains exclusion per issuer increased to $15 million for QSBS
• The minimum holding period shortened from five years to three years, with tiered exemptions based on holding period:
• 50% for three years
• 75% for four years
• 100% for five years
• The maximum gross assets of the issuer at the time of issuance and immediately after increased from $50 million to $75 million, potentially allowing many more issuing companies to qualify
• New inflation adjustments to the per-issuer exclusion and gross assets cap beginning in 2027 make these exclusions potentially even more attractive to longer-term holders of QSBS

The updated rules impact shares issued on or after July 4, 2025. These rules reflect federal capital gains tax exemptions for QSBS, but treatment of QSBS gains for tax purposes at the state level varies by state.

Whether a qualifying taxpayer has an initial basis of $300,000 or $25 million, these updated rules can dramatically reduce tax liability after the sale of QSBS that meets the criteria, potentially shielding hundreds of millions of dollars in capital gains from federal income taxes.

The following examples illustrate the capital gains shielded from capital gains tax in several simplified situations.

Illustrations

Example 1: Founder Shares

On July 25, 2025, a founder receives founder common shares in his AI startup with a basis of $600,000 at the time the company converts from an LLC to a C corporation, and gross assets are $2 million. After holding the stock for five years, he sells the shares for $12 million, realizing a gain of $11.4 million.

Under the expanded rules of Section 1202, the entire $11.4 million gain may be free from federal income tax. The founder could have only shielded a maximum of $10 million under the old rules.

Example 2: Employee Options Exercise

On August 1, 2025, an executive at a biotech company with gross assets of $12 million exercises common stock options into QSBS with a basis of $4 million. After holding the stock for three years following exercise, he sells the shares for $26 million, realizing a gain of $22 million.

Under Section 1202 as modified by OBBBA, almost the entire gain is free from federal capital gains tax. The executive could not have shielded any of the gain from federal tax under the old rules, as he would have needed to hold the common stock for at least five years after exercising his stock options.

Example 3: VC Preferred Stock

On July 30, 2025, a venture capital partner purchases Series B preferred stock in a software company with a basis of $20 million that qualifies as QSBS. The company had gross assets of $70 million immediately following the Series B round. After holding the stock for five years, the VC sells her stock for $350 million, realizing a gain of $330 million.

The VC was able to shield $200 million of capital gains from federal income tax under the expanded Section 1202 rules. She could not have shielded any of the gain prior to the changes in QSBS brought on by OBBBA, as the issuer would have exceeded the gross assets cap of $50 million.

A Formal Appraisal of Stock Can Strengthen Support for QSBS Tax Exemptions

Documenting the basis of QSBS may be critical to supporting your potential exemption, particularly for shares acquired in a manner that did not involve a priced round. A formal appraisal of QSBS shares, preferably performed contemporaneously at the time of issuance, can provide documentation of basis to support a large gain and demonstrate that the issuer met the gross assets requirement. There may be other reasons that a formal appraisal of shares is needed, such as to document the taxable exchange of LLC units to a C corporation, stock option issuance under 409a, or for gift and estate planning.