Tax Update: Changes to Section 1202 provide new opportunities for qualified small business stock

August 15, 2025

Alert

When President Donald Trump signed what is commonly referred to as the One Big Beautiful Bill Act (the Tax Act) into law on July 4, 2025, it ushered in a number of tax changes. McDonald Hopkins’ tax attorneys are analyzing the language of the legislation and are preparing detailed guidance on how these changes may affect our clients and what actions may be required.

One tax provision that has significant impact for investors, founders, and early-stage executives is Section 1202 of the Internal Revenue Code (IRC) relating to special treatment of certain issuances of corporate stock meeting the requirements for “qualified small business stock” (QSBS). The Tax Act expands and modifies the QSBS rules for stock issued on or after July 4, 2025 (New QSBS), providing more companies with an attractive option for raising capital, giving more investors the opportunity to exclude taxable gain when selling newly acquired QSBS, and creating new tax structuring considerations for businesses currently taxed as pass-through entities.

Tiered holding periods for capital gain exclusion

Under prior law, a shareholder was generally required to hold QSBS for more than five years to qualify for up to a 100% exclusion of gain, and that rule continues to apply to QSBS issued before July 4, 2025 (Old QSBS). However, for QSBS issued after that date, the Tax Act introduces a new tiered approach that adjusts the amount of the exclusion based on the holding period and allows holders of QSBS to benefit sooner. For New QSBS, the following exclusions now apply:

Hold at least 3 Years: 50% exclusion
Held at least 4 Years: 75% exclusion
Held at least 5 Years: 100% exclusion

Increased per-issuer cap on exclusion

Since IRC 1202 was initially introduced effective on August 10, 1993, the maximum amount of gain taxpayers could exclude upon the sale of QSBS has been the greater of : (i) $10 million or (ii) 10 times their aggregate adjusted tax basis in the QSBS, and this limitation continues to apply for Old QSBS. Under the Tax Act, the cap has been increased for New QSBS to the greater of (i) $15 million or (ii) 10 times aggregate adjusted tax basis. The $15 million maximum gain exclusion is indexed for inflation starting in 2027.

Higher gross asset limitation

In order for the stock of a C corporation to qualify for QSBS treatment, the corporation must meet certain “small business” standards at the time the stock is issued. One requirement is that the value of the corporation’s “aggregate gross assets” both immediately before and immediately after the issuance of the stock cannot exceed a certain threshold amount. For this purpose, value is equal to the sum of the amount of cash held by the corporation plus the “aggregate adjusted basis” of all other property of the corporation. The adjusted basis of property is equal to (i) the fair market value of the property on the date it is contributed to the corporation in a non-taxable transaction (such as a contribution under IRC 351) and (ii) the corporation’s actual income tax basis in the property, in the case of property acquired by the corporation in any other way. Since the inception of IRC 1202, the applicable threshold has been $50 million, but the Tax Act has increased that threshold to $75 million for stock New QSBS. This increase may enable later-stage companies or larger startups to benefit from the QSBS exclusion, extending the potential availability of Section 1202 benefits to a broader segment of companies.

What does this mean for investors?

Track separate blocks of stock: Since Old QSBS remains subject to the historic five-year holding period requirement to obtain any exclusion of taxable gain, but New QSBS can obtain different levels of exclusion starting with just a three-year holding period, investors need to maintain accurate records distinguishing between their holdings of Old QSBS and New QSBS when considering sales of their QSBS holdings so as to obtain the most beneficial tax treatment. Investors should be careful to identify which QSBS-qualifying shares, as well as shares that don’t qualify as QSBS, if disposing of less than all of their shares of a corporation in a transaction.
Potential for more QSBS opportunities: The larger $15 million per-issuer cap may allow investors to unlock greater tax benefits on investments in more mature companies. Investors should inquire about QSBS qualification for stock offerings they are considering to factor in the potential tax benefits when evaluating the overall risk/reward profile of the investment.
Continuing considerations: Although not new concepts resulting from the recent changes in the Tax Act, investors need to be aware that when making investments that are intended to take advantage of Section 1202 through an entity:
- If the investment is acquired indirectly through (i) a corporation taxed as an S corporation (ii) a limited liability company taxed as an S corporation, a partnership or a disregarded entity or (iii) a state law partnership of any kind, then only those individuals holding interests in the investment entity on the date the QSBS is issued to the investment entity qualify for QSBS treatment.
- Each qualifying owner holding through that type of investment entity will be entitled to take advantage of the full amount of the applicable exclusion on the investor’s allocable share of the gain from the sale of the QSBS so long as all other applicable QSBS requirements are met at the time of sale.

What does this mean for businesses?

Review company values for QSBS purposes: More companies may now qualify to issue QSBS given the increase in the aggregate gross assets threshold from $50 million to $75 million. However, because the value of an asset may differ for this purpose depending on how the asset was acquired, companies evaluating the QSBS opportunity should consult with qualified professionals when making this determination.
Tax Structure Considerations: Changes made in the Tax Act when coupled with the reduction in the corporate tax rate made in 2017 mean that a wider range of businesses may be able to operate tax-efficiently as a C corporation. Businesses looking to raise capital should consider QSBS as an attractive benefit to potential investors that may make it easier to raise capital while minimizing the overall tax burden on company operations when employing a grow-and-sell strategy focused less on distributing cash from operations. Similarly, businesses that have operated in flow-through form for tax purposes (whether as partnerships or S corporation) may want to reevaluate whether operating as a C corporation may now be more beneficial to the company and its owners.

The attorneys of McDonald Hopkins are experienced in advising clients on the benefits and nuances of investments in corporations issuing qualified small business stock and assisting holders of qualified small business stock in strategically planning to maximize their tax benefits upon disposition.

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