Section 1202 QSBS: Who Qualifies and What You Can Exclude

Section 1202 lets a taxpayer other than a corporation exclude some or all of the federal capital gain from selling qualified small business stock (QSBS). The stock must be C corporation shares acquired at original issuance, and you must hold it long enough. For stock issued after July 4, 2025, the exclusion is 50% after three years, 75% after four and 100% after five, up to a per-issuer cap. If you own an S corporation, a partnership or a professional practice, you will probably not qualify as things stand. The planning questions are usually about what you do next.

This guide is for high-earning owners, S corp owners, owners of several entities and high-income professionals, including nurse practitioners. It covers the tests, the numbers, the Opportunity Zone alternative, and the mistakes that disqualify stock.

TL;DR

• QSBS must be stock in a domestic C corporation, acquired at original issuance for money, property other than stock, or services. S corporation and partnership interests are not QSBS.
• For stock acquired after July 4, 2025, the exclusion steps up from 50% (three years) to 75% (four years) to 100% (five years). The cap is the greater of $15 million or ten times basis.
• The issuer's gross assets must stay at or under $75 million for stock issued after July 4, 2025, and at least 80% of its assets must be used in an active, qualified business.
• Health, law, finance, farming, hotel and restaurant businesses, among others, are excluded fields. A clinical practice generally does not qualify.
• Opportunity Zone investing is a different tool. It defers gain you already have, while QSBS excludes gain on stock you buy or receive.

Table of Contents

• What Section 1202 does
• The tests stock must pass
• Holding periods, percentages and caps
• S corp owners, multi-entity owners and professionals: where QSBS fits
• Opportunity Zones: a different kind of deferral
• Mistakes that cost the exclusion
• Where we come in
• Our perspective
• FAQ
• Sources

What Section 1202 does

Section 1202 of the Internal Revenue Code was written to reward people who put money into young operating companies. If the stock qualifies, a noncorporate taxpayer can exclude qualifying gain from federal tax when it is sold or exchanged. Individuals, trusts and estates can claim it. Partnerships and S corporations that hold QSBS can pass qualifying gain through to eligible owners, subject to the rules in Section 1202(g).

Two points matter for most readers of this site:

• The exclusion is a federal rule. States decide on their own whether to follow federal treatment of similar tax benefits. As one example from the Opportunity Zone world, the California Franchise Tax Board stated in 2019 that California did not conform to the federal deferral and basis rules. Check your own state before you model after-tax proceeds. If you live in Idaho, our guide to the Idaho capital gains deduction is the place to start on the state side.
• The benefit belongs to the shareholder, but the tests are mostly about the company. You can do everything right personally and still lose the exclusion because of something the corporation did years earlier.

The tests stock must pass

Stock is QSBS only if each of the following holds. Think of it as a checklist you run for the company, then for your shares.

The issuer

The company must be a domestic C corporation and a qualified small business when the stock is issued. A C corporation is taxed on its own profits, unlike an S corporation or partnership, where income passes to the owners. Many owners in the $300,000 to $1,000,000 net income range run S corporations. That is usually efficient for payroll tax, but S corporation stock cannot be QSBS.

The size limit

The corporation's aggregate gross assets must be within the statutory ceiling immediately before and after the stock is issued. For stock issued after July 4, 2025, the ceiling is $75 million. Before that date it was $50 million. Gross assets is a measure of the company's assets at tax basis, plus cash raised in the round, so a company that has raised a lot of capital can cross the line.

The active business test

The company must use at least 80% of its assets in an active qualified trade or business during substantially all of your holding period. A company that parks cash or holds investments instead of operating can slip under that threshold.

Excluded businesses

The statute excludes specified fields: professional services, financial businesses, farming, extractive businesses, and hotels, motels and restaurants. The professional-services list includes health. That matters for nurse practitioners and other clinicians. If your income comes from patient care, a practice you own is generally the wrong vehicle for QSBS, even if you form a C corporation. The same type of classification question comes up for the QBI deduction, and our guides to specified service trade rules and the SSTB checklist show how that analysis works.

Original issuance

You must generally receive the shares directly from the corporation in exchange for money, property other than stock, or services. Buying shares from another shareholder usually does not qualify. Redemption rules also matter: if the company buys back stock from you or related people around the time of your purchase, some of the stock can lose its status.

Holding periods, percentages and caps

The rules depend on when you acquired the stock. That date is the first fact to pin down.

Source for both rows: 26 U.S.C. § 1202.

The cap applies per issuer. You compare the greater of the dollar figure or ten times your basis in that company's stock. If your basis in the shares is $2 million, for example, ten times basis is $20 million, which is above the $15 million figure.

A worked example

Suppose you receive shares of a qualifying C corporation after July 4, 2025, for $1 million. You sell after four years and the gain is $6 million.

• Under the new schedule, 75% of the gain, or $4.5 million, is excludable, because it is under the cap (ten times basis is $10 million, and the dollar figure is $15 million, so the cap is $15 million).
• The remaining $1.5 million is taxed under the ordinary rules for that gain.

The example is simplified and ignores state tax and other items on your return, but it shows why a fourth year matters. Holding to year five would move the exclusion to 100% of the same gain.

S corp owners, multi-entity owners and professionals: where QSBS fits

Most people searching this topic are not startup founders. They own an operating business, or earn high W-2 income, and have heard QSBS wipes out capital gains tax. The honest summary by reader type:

• S corp owners. Your stock is not QSBS. Changing from S to C status is a structural decision with consequences for how profits are taxed every year, and it should be modeled before you move. Our S corp tax planning guide explains the planning that usually comes first.
• Owners with several businesses. A new C corporation formed to hold a qualifying operating business, and issued shares directly, may be worth analyzing. The shares have to meet every test above, and the five-year clock starts at issuance. This is where entity design matters most.
• High-earning W-2 employees. If your employer offers equity in a qualifying C corporation, how and when you acquire it determines whether the shares are original issuance. Stock acquired in exchange for services can qualify under the statute.
• Nurse practitioners and other clinicians. Patient-care income falls in an excluded field. Your tax planning is more likely to center on how your practice is structured, payroll, accountable plans and deductions you can use now.

Opportunity Zones: a different kind of deferral

People searching QSBS often also search for Opportunity Zone investing, because both are named as ways to reduce tax on gains. They work differently.

QSBS excludes gain on the stock itself. Opportunity Zones defer gain you already have by reinvesting it in a Qualified Opportunity Fund (QOF), an investment vehicle that holds property in designated low-income census tracts.

Under the existing federal program, an investor generally has 180 days to put eligible gain into a QOF in exchange for an equity interest. The deferred gain is recognized on an inclusion event or on December 31, 2026, whichever is earlier. The IRS describes the benefits this way:

• A 10% basis increase after five years, and an additional 5% after seven years. Those two steps applied to investments that were made early enough, and eligible gain is recognized before January 1, 2027.
• After a ten-year hold, an investor may elect to step basis up to fair market value on a sale, which generally excludes appreciation after the investment from income. The Joint Committee on Taxation summarizes the same structure.

For investments after December 31, 2026, IRS guidance says the One Big Beautiful Bill Act made the incentive permanent, with rolling ten-year designation cycles that begin with designations effective January 1, 2027. If you are planning a gain event in 2027 or later, confirm the current QOF rules with your adviser rather than relying on the legacy program's dates.

QSBS versus Opportunity Zones at a glance

States can treat these benefits differently. Massachusetts, for example, said in a 2019 release that it generally did not adopt the federal QOF deferral and basis adjustments for its personal income tax.

Mistakes that cost the exclusion

1. Assuming S corp or LLC interests count. They must be C corporation stock, issued by the corporation.
2. Buying shares from another holder. Secondary purchases usually fail the original-issuance test.
3. Missing the date. The July 4, 2025 line changes the holding period, the cap and the asset ceiling.
4. Letting the company drift. Falling under 80% active use, or growing past the gross-asset limit at issuance, can disqualify later stock.
5. Operating in an excluded field. Health, law, finance and similar businesses fail the field test.
6. Ignoring the state. Federal exclusion does not guarantee the same result on your state return.
7. Forgetting basis. Your cap depends on basis, and tracking it is its own task. Our guide on S corp basis covers the discipline for pass-through owners.

Where we come in

QSBS planning is rarely a standalone decision for the owners we work with. It sits next to entity choice, payroll, the QBI deduction and exit timing. Our Monthly Tax Advisory is $11,997 per year, and our Quarterly Tax Strategy Sessions are $9,497 per year. Both give you year-round strategy support instead of a once-a-year conversation. If your first question is how an S corporation is set up, the S-Corp Tax Strategy Accelerator is a one-time $997.

If you are weighing a new entity, a conversion or a gain event, you can see how our engagements compare on the tax strategy comparison page.

Our perspective

Owners come to us asking whether QSBS can fix their tax bill. Most of the time the answer starts with a different question: what is the structure today, and what do you want it to look like in five years?

The exclusion is generous, and the 2025 changes made it more flexible. But it only rewards a structure that was built for it from the start. A C corporation formed and issued shares at the right time can be valuable. An S corporation or a clinical practice usually needs a different plan, and there is plenty to work with: salary modeling, accountable plans, entity design and the timing of gains.

We build custom strategy for business owners, real estate investors and high-income professionals, and we deliver it year-round so the plan is in place before the transaction, not after. That is why we favor a standing advisory engagement over a one-off filing.

Melissa

FAQ

Can an S corporation owner claim Section 1202?

Not on S corporation stock. QSBS must be stock of a domestic C corporation acquired at original issuance, so S corporation shares do not qualify. If a conversion or a new C corporation is under consideration, model the ongoing tax cost first and confirm the rules with your tax adviser.

Can a nurse practitioner use QSBS?

Generally not through a clinical practice. The statute excludes specified professional-service fields, and health is among them. A clinician could still qualify as an investor or employee holding stock in a company in a qualifying field.

How long must I hold QSBS?

For stock acquired after July 4, 2025, the exclusion is 50% after three years, 75% after four and 100% after five. For stock acquired on or before that date, the traditional rule generally requires more than five years. Both come from Section 1202.

Is an Opportunity Zone investment the same as QSBS?

No. An Opportunity Zone investment defers gain you already have by moving it into a Qualified Opportunity Fund within 180 days. QSBS excludes gain on the sale of the qualifying stock itself, and the two have separate tests and clocks.

Sources

• 26 U.S.C. § 1202: Partial exclusion for gain from certain small business stock
• Revisiting Sec. 1202: Strategic planning after the 2025 expansion (The Tax Adviser)
• Invest in a Qualified Opportunity Fund (IRS)
• Opportunity zones frequently asked questions (IRS)
• Description of Qualified Opportunity Zone Tax Provisions (Joint Committee on Taxation)
• Treasury, IRS guidance to States for nominating Qualified Opportunity Zones
• California Franchise Tax Board: Deferral of Capital Gains for Investments in Qualified Opportunity Zones
• Massachusetts TIR 19-7: Treatment of Investments in Qualified Opportunity Zones

Recommended

• Avoid Losing QBI Over $276,750: Specified Service Trade Rules (U.S.)
• 5 Step SSTB Checklist for QBI: Tax Pros and Business Owners
• QBI Aggregation Rules: How to Combine Businesses Under Section 199A
• Section 1245 Recapture: How It Works and What You Owe