New Rules for Qualified Small Business Stock Gain Exclusions

For 30 years, certain small-business founders and investors who met specific requirements could exclude up to 100% of the gain upon the sale or exchange of qualified small business stock (QSBS) under Internal Revenue Code (IRC) Section 1202. Following this past July’s enactment of the One Big Beautiful Bill Act (OBBBA), IRC Section 1202 was substantially amended, potentially allowing additional founders and investors to qualify for income tax exclusion upon a sale or exchange. Advisers should carefully review the amended provisions and discuss the implications with their clients in advance of a future sale of the business.

QSBS and the OBBBA

Previously, Section 1202 provided that founders and investors holding stock in a QSBS could exclude some or all of the capital gains tax upon a sale or exchange provided that certain requirements were met, such as that the company was a domestic C corporation, it met the “active business” requirement during substantially all of the stockholder’s holding period, and it had gross assets of $50 million or less at all times before and after the stock was issued. In addition, stock must have been received at original issuance and must have been held for more than five years prior to sale. If met, the stockholder could exclude up to the greater of $10 million of capital gains or 10 times the stockholder’s adjusted cost basis (the “capital gains exclusion amount”).

Under the OBBBA, the provisions of Section 1202 are amended as follows and will generally apply only to stock issued after July 4, 2025 – the date of the enactment of the OBBBA.

Capital Gains Exclusion – The capital gains exclusion amount increased to the greater of $15 million of capital gains (which, for the first time, is annually indexed for inflation) or 10 times the stockholder’s adjusted cost basis.

Definition of “Small Business” – The gross asset limit for qualifying as a “small business” rises to $75 million from $50 million. This gross asset limit also is indexed for inflation.

QSBS Holding Period – A tiered exclusion structure was introduced with a shorter relevant holding period: 50% exclusion for stock held more than three years, 75% exclusion for stock held more than four years, and 100% exclusion for stock held more than five years.

Note that as of July 2025, the following states do not conform to the federal QSBS exclusion, such that the gain excluded from a sale for federal income tax purposes remains fully taxable under state income tax laws: Alabama, California, Mississippi, New Jersey, and Pennsylvania. Hawaii, Massachusetts, and New York only partially conform. A June 30, 2025, bill allows QSBS exclusions in New Jersey starting Jan. 1, 2025.

The changes to QSBS treatment under the OBBBA may encourage the following planning considerations:

• Higher QSBS exclusion cap allows for less QSBS “stacking” (discussed below) and higher potential sale prices.
• Expanded eligibility for businesses as “qualified small businesses” based on gross asset limits.
• Earlier exits with partial QSBS exclusions after three or four years (but subject to 28% capital gains tax rate, rather than 20% capital gains tax rate, for any gain not excluded).

Planning Techniques

Certain presale planning techniques remain important for income and estate tax purposes. Under the provisions of Section 1202(h), for a transfer by gift, the transferee (recipient of the gift) is treated as having acquired the QSBS in the same manner and having the same holding period as the transferor. This applies whether the transferee is an individual or a trust.

One planning technique could be for a founder to transfer her QSBS to her spouse, either directly or via a Spousal Lifetime Access Trust. Because of the marital deduction, transfers directly to a spouse are not taxable gifts. Typically, a Spousal Lifetime Access Trust (SLAT) will use some of the transferor’s federal gift tax exclusion amount, but it may be structured to qualify as “qualified terminable interest trusts” for a more flexible use of the transferor’s exclusion amount.

Another planning technique may be for the founder to gift a portion of her QSBS to one or more nongrantor irrevocable trusts located in a jurisdiction with no income taxes. This technique might be combined with the prior strategy to create a Spousal Lifetime Access Nongrantor Trust (SLANT). If properly structured and administered, these nongrantor trusts can hold QSBS and potentially avoid both federal and state capital gains taxes upon the sale of such QSBS, assuming that Section 1202 requirements are met. Some jurisdictions used for these purposes include South Dakota, Nevada, Delaware, Alaska, and Wyoming.

A variation on this strategy includes the founder gifting a portion of her QSBS to one or more incomplete nongrantor (ING) trusts. Unlike other nongrantor irrevocable trusts where a founder uses some of her remaining federal gift tax exemption for the value of the QSBS transferred to the trusts, an ING is deemed “incomplete” for federal gift tax purposes (because of certain retained rights by the founder as the grantor) while being “complete” for federal (and, potentially, state) income tax purposes. This strategy may be appropriate for founders who have either used most, if not all, of their federal gift tax exemption amount, or who are mainly concerned with income, rather than estate, tax planning.

Transfers to either irrevocable nongrantor trusts or ING trusts can be combined with “stacking” QSBS exclusions. Stacking QSBS exclusions involves gifting QSBS to one or more family members, either directly or indirectly, by such trusts. If correctly executed, the individual recipients or the trusts will each be eligible for a separate QSBS exclusion from gain on a future sale of the QSBS. Early planning and transfers allow the founder to gift the QSBS while the value is relatively low (such as when close to the initial formation of the business), thereby using a smaller portion of the founder’s gift tax exemption amount and allowing the QSBS to grow in value outside of the founder’s taxable estate.

Example

Assume that Jane is a founder of Queue Bee Ess Inc., a C corporation established on Aug. 1, 2025, for which she owns 1 million shares with an initial capital contribution of $500,000. If Queue Bee Ess Inc. were to sell in December 2030 for $30 million, under Section 1202(b), Jane would be entitled to a QSBS capital gains exclusion of the greater of $15 million or 10 times her adjusted cost basis (likely utilizing the $15 million gain exclusion option, given the assumed circumstances). If, however, Jane had gifted 500,000 of her 1 million shares to an irrevocable nongrantor trust on Sept.1, 2025, when the value of such shares was only $250,000, Jane would be entitled to an additional $15 million gain exclusion, resulting in potentially no federal capital gains tax being owed upon the sale.

Now let’s assume Jane gifted the same portion to an irrevocable nongrantor trust, but sold Queue Bee Ess Inc. in September 2028. Under the amended provisions of Section 1202, only 50% of the gain would be excluded. However, this result offers a better result than under the prior provisions of Section 1202, where none of the gain would have been excluded.

Advisers and founders should use caution in structuring irrevocable trusts because of Section 643(f), which provides that two or more trusts may be treated as one trust if they have substantially the same grantor and primary beneficiary, and the principal purpose of such trusts was the avoidance of tax. In addition, in 2018, the IRS published proposed regulations to these provisions that include an anti-avoidance provision “to prevent taxpayers from establishing multiple nongrantor trusts or contributing additional capital to multiple existing nongrantor trusts in order to avoid federal income tax, including abuse of [IRC] Section 199A.” While the proposed regulations presumed a principal purpose of avoidance if the trusts resulted in significant tax benefits, the final regulations do not include such presumption. Therefore, if multiple nongrantor trusts are desired, ensure that none of the trust beneficiaries overlap (such as by creating separate irrevocable nongrantor trusts for each of the founder’s children and their descendants) and document any nontax purposes for the formation of such trusts (such as estate tax planning), and draft the trusts with different trustees, trust advisers, or distribution provisions.

Conclusion

Company founders and their advisers should carefully review the pre-existing and amended Section 1202 provisions. They should also consider viable estate planning strategies that can accomplish multiple goals of the founder and her family members. Early structuring and careful planning may help the founder have more options for stacking QSBS exclusions. Overall, the amended provisions of IRC Section 1202 may allow more founders to be eligible for QSBS exclusions, and advisers should educate themselves and their clients on these planning options.