Could the Sale of Your Company Be Tax-Free? – What Founders and Investors Need to Know About Section 1202 QSBS

Executive Summary: 

Section 1202 allows certain taxpayers to potentially exclude up to 100 percent of the amount of any eligible gain that may be realized from the sale or exchange of “qualified small business stock” (“QSBS”).¹ In addition, under current law, the allowable amount of a taxpayer’s excludable eligible gain for new issuances of QSBS is equal to at least $15 million (applicable to companies with aggregate gross assets of $75 million or less). However, as illustrated in the detailed example that follows below, in many cases a taxpayer’s exclusion may equal up to 10 times the amount of money invested and/or the fair market value (“FMV”) of any property contributed to a corporation (e.g., up to a $100 million exclusion from U.S. federal income tax on a $10 million cash investment or property contribution).

General Background:

Following the enactment of the “One Big, Beautiful Bill” on July 4, 2025 (the “OBBBA”), the amount of gain that is currently eligible for exclusion by a taxpayer with respect to newly issued QSBS is subject to a cumulative per-issuer limitation equal to the greater of either: (i) $15 million; or (ii) 10 times the taxpayer’s basis in QSBS issued by the corporation.² The specific exclusion percentage also depends upon a taxpayer’s holding period, with a 50% exclusion applying to QSBS held for at least 3 years, a 75% exclusion applying to QSBS held for at least 4 years, and a 100% exclusion applying to QSBS held for 5 years or more.³

In general, a taxpayer’s basis in QSBS typically equals the amount of cash paid to the issuing corporation in exchange for the shares. However, in some situations, a taxpayer may also contribute property to the issuing corporation in exchange for newly issued QSBS (e.g., when one or more individuals contribute cash and/or property to a newly formed corporation, or when an entity classified as a partnership for tax purposes is incorporated). In such a case, a taxpayer’s basis in its QSBS for purposes of the 10 times basis determination is equal to the contributed property’s current FMV, despite the fact that the taxpayer will otherwise obtain a “carryover” (or historic) tax basis in the QSBS received for purposes of determining the amount of realized gain upon any subsequent sale of the shares.⁴ In addition, the amount of any pre-contribution gain that may be inherent in the property at the time of the taxpayer’s contribution will not be eligible for exclusion under Section 1202.

Illustration of Potential QSBS Benefits: 

To illustrate the significant potential tax benefits that can result in connection with a sale of QSBS, assume the following basic facts: Founder A has a self-created intangible asset with zero ($0) tax basis and a current FMV of $4 million. Investor B has $1 million of cash. Investor C has $45 million of cash. On January 1, 2027, Founder A contributes its asset, and Investors B and C contribute their cash, in each case, to a newly formed C-corporation in exchange for 8%, 2% and 90%, respectively, of its outstanding stock (which qualifies as QSBS at the time of issuance). Five years later, on January 1, 2032, the business has been highly successful, and the stock held by Founder A and Investors B and C has continued to qualify as QSBS at all times. At that point, Founder A and Investors B and C are able to exit their investment by negotiating a sale of 100% of their shares to a third party for $550 million. 

Based on the assumed facts, Founder A would receive $44 million in sales proceeds (8% of $550 million) and also realize the same amount of total gain ($44 million less the tax basis of zero ($0) in the self-created intangible asset that Founder A contributed to the corporation and that effectively “carried over” to the QSBS sold). Investor B would receive $11 million in sales proceeds (2% of $550 million) and realize a gain of $10 million ($11 million less Investor B’s $1 million tax basis in the QSBS sold). Investor C would receive $495 million in sales proceeds (90% of $550 million) and realize a gain of $450 million ($495 million less Investor C’s $45 million tax basis in the QSBS sold).

Furthermore, the first $4 million of Founder A’s $44 million of total gain would not be eligible for exclusion under Section 1202 (equal to the amount of pre-contribution gain that existed in Founder A’s asset at the time the corporation was initially formed). However, the remaining $40 million of Founder A’s gain would be 100% excludable under Section 1202 (with the amount of Founder A’s exclusion being equal to 10 times the $4 million FMV of the asset that was contributed by Founder A). 

At the same time, all of Investor B’s $10 million gain would be 100% excludable. The amount of Investor B’s available exclusion would be equal to $15 million (which is the minimum exclusion applicable to newly issued QSBS following the enactment of the OBBBA and which is also greater than 10 times Investor B’s original $1 million cash investment), with $5 million of Investor B’s total exclusion going unutilized. Finally, all of Investor C’s $450 million gain would be 100% excludable for U.S. federal income tax purposes (with Investor C’s available exclusion being equal to 10 times Investor C’s original $45 million cash investment).⁵

Determining Eligibility: 

In order to potentially obtain the benefits of Section 1202, an individual or other qualifying non-corporate taxpayer must acquire and hold stock in an eligible “C-corporation.” The potential benefits of Section 1202 do not directly apply to equity interests acquired and held in “pass-through” entities, such as “S-corporations” or partnerships (or LLCs taxed as partnerships). However, an individual taxpayer’s allocable share of gain attributable to a sale of QSBS by a pass-through entity may potentially qualify as gain eligible for the Section 1202 exclusion.

In addition, assuming a qualifying taxpayer holds stock in a C-corporation for the applicable minimum required holding period (either directly or indirectly through a pass-through entity), there are three main requirements that must also be satisfied before any gain on the sale of stock is eligible for the exclusion under Section 1202: (i) the stock must be acquired directly from the relevant corporation at the time of its “original issuance”; (ii) the issuing corporation must be a “qualified small business” (in general, having “aggregate gross assets” of $75 million or less following the enactment of the OBBBA);⁶ and (iii) the issuing corporation must satisfy the “active business requirement” during substantially all of the taxpayer’s holding period.

For additional background information and further detail regarding Section 1202, including some hypothetical examples designed to illustrate certain key tax-planning opportunities and potential pitfalls, see the following full-length article: “Section 1202: Qualified Small Business Stock” (updated to reflect changes resulting from the OBBBA as of June 2026). For a helpful flowchart that can be used to conduct a preliminary evaluation of potential QSBS eligibility, see the following: “Section 1202 – Qualified Small Business Stock (“QSBS”) Eligibility Checklist” (and see also additional transactional tax resources available here).

¹All “Section” references are to the U.S. Internal Revenue Code of 1986, as amended (the “Code”).

²For stock issued after August 10, 1993, and on or before July 4, 2025 (“Pre-OBBBA QSBS”), the cumulative per-issuer limitation was equal to the greater of either: (i) $10 million; or (ii) 10 times the taxpayer’s basis in QSBS issued by the corporation.

³For Pre-OBBBA QSBS, the minimum holding period requirement is more than 5 years and a 50%, 75% or 100% exclusion generally applies, depending on when the stock was issued (with the 100% exclusion applying to stock issued after September 27, 2010, and on or before July 4, 2025).

⁴See generally, Section 1202(i) and Sections 351(a) and 358(a)(1) of the Code.

⁵It should be noted that state income taxes may still apply to a taxpayer’s sale of QSBS.

⁶For Pre-OBBBA QSBS, the “aggregate gross assets” threshold was $50 million or less.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.