Qualified Small Business Stock: Tax-Efficient Investing in 2026 and Beyond

Section 1202, also known as Qualified Small Business Stock (QSBS) is a tax-saving opportunity designed to encourage investment in small businesses. Investing in a QSBS provides an opportunity to exclude a portion or all the capital gain upon the eventual sale of the stock. While these rules have been around since 1993, they became substantially more taxpayer friendly with the passing of the One Big Beautiful Budget Act (OBBBA) on July 5, 2025.

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Requirements for QSBS

Under Section 1202, there are requirements that both the shareholder and the issuing corporation must meet to be eligible for the tax benefits:

• ‍Eligible Corporation: The company must be incorporated as a domestic C Corporation. Stock from an S-Corporation or LLC does not qualify.
• ‍Gross asset limit: The company’s gross assets must be less than or equal to $75 million dollars at the time of issuance, including any cash received from the acquisition of your shares. For stocks issued before July 5, 2025, the assets must be less than or equal to $50 million.
• Active Business requirement: At least 80% of the company’s assets must be used in the active conduct of a qualified trade or business during the shareholder’s holding period. Certain businesses are excluded under section 1202, including but not limited to service heavy fields like law and finance, hospitality businesses including hotels and restaurants, and other businesses where the primary asset is employee reputation.
• Holding Period: For stock issued before July 5th, 2025, the shareholder must hold the stock for at least 5 years to exclude the gain. For stock issued after July 5, 2025, the exclusion percentage varies depending on your holding period, 50% for 3 years, 75% for 4 years, and 100% for 5 years.  If the stock is sold before the 5-year holding period, you may be able to defer the gain if the proceeds are rolled over to a new QSBS within 60 days through a Section 1045 Rollover (see section 1045 Rollover below).
• Qualified Stock Issuance: The stock must be acquired directly from the company, any shares acquired through a third party do not qualify for QSBS treatment.

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Advantages to QSBS

• Tax Savings: The most significant benefit of QSBS is the ability to exclude a substantial amount of capital gains from federal taxes. For example, if a shareholder invests $5 million in a C-corporation that qualifies as a QSBS and sells the stock for $25 million after holding it for five years, they may be eligible to exclude up to $20 million of the gain from federal tax. For high-growth businesses, this exclusion is potentially transformative in terms of tax savings.
• Enhanced Attractiveness for Investment: QSBS incentives make investing in small businesses more attractive to potential investors, who stand to gain tax-free returns on qualifying investments. This can make it easier for business owners to attract capital and achieve higher valuations, particularly in the startup or expansion phases.
• Incentivizes Business Growth and Innovation: The active business requirement within Section 1202 encourages corporations to maintain a focus on growth and innovation. Many types of eligible businesses, including technology, manufacturing, and wholesale, stand to benefit significantly, aligning with business owners' natural ambitions to scale and innovate.

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Changes with the OBBBA:

The passing of the OBBBA in 2025 made the Section 1202 rules more favorable to the taxpayer.  By shortening the required holding period and raising both the gross asset limit and maximum gain exclusion, Section 1202 is more beneficial than ever for both taxpayers and entrepreneurs.

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Section 1045 Rollover

Taxpayers who realize capital gain on a QSBS that does not meet the required holding period have an opportunity to defer this gain into the future through a Section 1045 rollover. This allows a taxpayer to roll over proceeds from the sale of a QSBS into a new QSBS while maintaining their original holding period. The rollover must be completed within 60 days of the closing of the first transaction.

For example, a taxpayer invests $5 million into a QSBS on January 1, 2026. On February 1, 2029, the QSBS sells for $20 million. The stock was acquired after July 5, 2025, making it subject to the new rules put in place with the OBBBA. The taxpayer meets the 3-year holding period, and therefore would receive a 50% gain exclusion resulting in taxable income of $7.5 million. The taxpayer could instead choose to roll the $20 million proceeds into a new QSBS. The new QSBS is sold on February 1, 2031 for $30 million. A section 1045 rollover maintains your original holding period, making this QSBS eligible for 100% gain exclusion after meeting the 5-year holding period, allowing the taxpayer to pay no income tax on the full $25 million of capital gains.

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Conclusion

Section 1202 and Section 1045 are powerful tax-saving opportunities for entrepreneurs and investors looking to grow their companies in a tax efficient manner. While the requirements are specific, for high-growth companies the benefits can be substantial. With the passing of the OBBBA, the hurdles for tax benefits are easier to meet, and the pool of eligible businesses has expanded, opening new opportunities for investment.

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