There is a provision in the tax code that can make millions of dollars of sale gain disappear from your federal return. It’s been there for decades. It got bigger in 2025. And most business owners hear about it from a buyer’s banker after the structure is already agreed, which is a bit like learning about the lifeboats after the ship has left.
The basics
Qualified small business stock, or QSBS, is stock in a domestic C corporation that meets a list of tests. If you hold it long enough, part or all of your gain on the sale can be excluded from federal income tax, up to a cap per company. The excluded gain also escapes the 3.8% net investment income tax. 26 U.S.C. § 1202
| Stock issued before July 5, 2025 | Stock issued after July 4, 2025 | |
|---|---|---|
| Holding period | More than five years for the full exclusion | 50% excluded after three years, 75% after four, 100% after five |
| Cap per company, per shareholder | The greater of $10 million or 10 times your basis | The greater of $15 million (indexed for inflation in later years) or 10 times your basis |
| Company size when the stock was issued | Gross assets of $50 million or less | Gross assets of $75 million or less, also indexed |
The cap is a lifetime number per company. Gain you exclude from one sale of that company’s stock uses it up for later sales of the same stock.
The partial tiers carry a higher rate. For newer stock sold at three or four years, the part of the gain that isn’t excluded is taxed at up to 28%, plus the 3.8% investment income tax. Blended across the whole gain, that works out to roughly 15.9% of the gain at three years and about 8% at four, against 23.8% with no exclusion at all. Gain above the cap is taxed at the normal long-term rates.
A fictional example
An owner formed a C corporation in 2012, put in $500,000, and has held the original shares ever since. In 2026 the company sells in a stock sale, and the owner’s gain is $25 million. Illustrative only, and it assumes every test below is met.
| Amount | |
|---|---|
| Gain on the sale | $25,000,000 |
| Cap: the greater of $10 million or 10 × $500,000 basis | $10,000,000 |
| Gain excluded from federal tax | $10,000,000 |
| Federal tax that excluded gain would otherwise have drawn at 23.8% | $2,380,000 |
| Gain still taxed as usual | $15,000,000 |
$2.38 million of federal tax, gone, on one owner’s shares. Now imagine the owner had given some shares to children years earlier. That’s the stacking section below, and it’s where the numbers get serious.
The tests, and where each one breaks
QSBS is a pass-fail exam with several questions. Fail any one and the exclusion is gone.
| Test | What it requires | Where it usually breaks |
|---|---|---|
| C corporation | A domestic C corporation when the stock was issued and for substantially all of your holding period | S elections, LLCs and partnerships never qualify while they are those things |
| Original issuance | You got the stock from the company itself, for money, property or services | Shares bought from another shareholder don’t qualify |
| Gross assets | $50 million, or $75 million for newer stock, measured right before and after the stock was issued | A big capital raise just before your shares were issued |
| Active business | At least 80% of the company’s assets used in an active, qualifying business | Piles of idle cash or investment real estate on the balance sheet |
| Excluded fields | The business can’t be in a list of excluded industries | Service businesses built on people’s skill or reputation |
| Redemptions | No significant buybacks of stock around the time yours was issued | A company repurchasing shares from you or family within a couple of years of issuing new ones |
| Holding period | Three, four or five years depending on when the stock was issued | A sale that closes a few months too early |
The redemption rule is the one that blindsides people. Buybacks from you or a related person in the two years before or after your shares were issued, or buybacks of more than 5% of the company within a year either side, can disqualify the stock. There are exceptions for small amounts and for buybacks tied to death, disability, divorce or leaving the company, but a routine buyback from a departing partner, timed badly, can still taint stock issued around the same time. It looks like housekeeping. It can cost millions.
Who gets left out
S corporations and LLCs. Many family businesses in Western New York are S corporations or LLCs, and QSBS only applies to C corporation stock. When an LLC or partnership converts into a C corporation, the tax code treats the stock as having a basis equal to what the business was worth on the conversion date. Translation: the value built before the conversion is never QSBS gain. Only the growth after it can be, and only once the new holding period runs. Converting can still make sense for a company with a long runway. It rarely rescues value that already built up, and it is a real trade-off for a CPA to model, not a quick fix.
Certain kinds of businesses. The law excludes companies whose main asset is the skill or reputation of their people, plus several named industries:
- Health, law, engineering, architecture, accounting, actuarial science, consulting, athletics, performing arts, and financial or brokerage services
- Banking, insurance, financing, leasing and investing
- Farming, and oil, gas and mining
- Hotels, motels and restaurants
Manufacturing, distribution, software and many technology-driven businesses can qualify. The line can be blurry, which is exactly why the careful version gets documented long before a buyer’s diligence team asks.
How the deal structure can wreck it
QSBS rewards selling stock. Many buyers want to buy assets instead, because it gives them tax benefits going forward. In an asset sale the corporation sells and pays corporate tax on its gain first. QSBS can’t shelter that layer, so the exclusion ends up worth far less than you expected.
Your buyer’s favorite structure may cost you your exclusion. Owners who know what QSBS is worth to them in dollars before agreeing to a structure can price the difference instead of discovering it. If the buyer wants an asset deal, the QSBS value is a number to negotiate over, not a footnote.
Rollovers have their own rules. When QSBS is swapped for the buyer’s stock in a tax-free exchange, the exclusion generally carries over only for the gain built up before the swap. Growth in the new stock afterward is a separate question. Rollover equity into a buyer’s LLC or partnership raises different problems again. This is why QSBS gets modeled before the term sheet, not after it.
Selling too early isn’t always fatal. If qualifying stock held more than six months is sold, the gain can generally be deferred by reinvesting in other QSBS within 60 days. Useful for founders and investors. Less useful for an owner retiring on the proceeds.
The planning move most owners hear about too late
QSBS keeps its status when it’s given away, and the person who receives it steps into your holding period. And the cap applies per shareholder. So some families give shares to children or to certain kinds of trusts well before a sale, and each holder may be able to claim their own exclusion. Practitioners call it stacking.
Same fictional company. This time, years before any buyer appeared, the owner kept a third of the shares and gave a third each to two separate non-grantor trusts for the children.
| Owner holds everything | Owner plus two trusts | |
|---|---|---|
| Caps available | $10 million | $10 million each, $30 million in total |
| Gain excluded from federal tax | $10,000,000 | $25,000,000, all of it |
| Federal tax avoided at 23.8% | $2,380,000 | $5,950,000 |
It is legitimate, it is heavily scrutinized, and it has two traps. First, the same timing rule that applies to any gift before a sale: if the deal is already practically certain, the gift may not work. Second, the tax code lets the IRS treat multiple trusts with the same grantor and beneficiaries as one trust when avoiding tax is a principal purpose, and practitioners debate how far that reaches QSBS. Copy-paste trusts invite exactly that argument.
Washington is watching. In May 2026 a senior Treasury official said the department is taking a close look at stacking, and Section 1202 is on Treasury’s guidance plan for the year. Nothing has been issued yet. Stacking done now gets done carefully, by an attorney, with each trust built for a real reason beyond the tax.
New York’s position
New York currently follows the federal treatment, so qualifying gain excluded federally is generally excluded for New York income tax too. At New York’s top rates, that is worth real money on its own. In 2026 the State Senate proposed breaking from the federal rule, retroactive to the start of 2025. The proposal was withdrawn after pushback, but the fact that it was floated at all is a reason to plan with current law and watch for changes.
Not every state goes along. California and Pennsylvania have long refused the exclusion, and in 2026 Oregon, Vermont and Illinois broke from it too, with Maine following in part. If a move might come before the sale, the destination’s rule belongs in the plan.
The facts that decide whether it applies
- Has the company always been a C corporation? If it converted, when, from what, and what was it worth that day?
- When and how did each shareholder get their stock, and what did they pay?
- What were the company’s gross assets each time stock was issued?
- Has the company bought back any stock, from anyone, in the years around each issuance?
- Is the business in an excluded field, or close to the line?
- How much cash and investment property sits on the balance sheet?
- How long has each shareholder held their shares, and which rules apply to them?
- How much of your expected gain could the cap cover?
- Where will you live when the sale closes?
QSBS that isn’t documented is QSBS you’ll argue about. Owners who expect to rely on it typically have their CPA document it early, while the people who know the history are still around. A buyer’s diligence team, or an IRS examiner, will want board minutes, stock ledgers and balance sheets from years ago. Reconstructing them under a deadline is how exclusions get lost.
How Morrowgate handles this. QSBS is part of every Morrowgate pre-sale review. Greg works through the facts above with your CPA, puts a dollar figure on the exclusion, and makes sure that number is on the table before the structure is negotiated, not discovered after it. For families thinking about stacking, the attorney is in the room from the first conversation.
Questions owners ask
Does an S corporation qualify for QSBS?
No. Only stock in a C corporation qualifies, and only for the period it was a C corporation. A company that converts gets a fresh start: the stock’s basis is set at the company’s value on the conversion date, and only growth after that can be excluded.
Is excluded QSBS gain subject to the 3.8% investment income tax?
No. Gain excluded under Section 1202 isn’t included in income, so it isn’t subject to the net investment income tax either.
What if the company sells before the five-year mark?
For stock issued after July 4, 2025, a partial exclusion starts at three years. For older stock, there is no partial exclusion, but gain on stock held more than six months can generally be deferred by reinvesting in other QSBS within 60 days.
Does New York tax QSBS gain?
Not under current law. New York follows the federal exclusion. A 2026 proposal to change that was withdrawn, and owners planning a sale keep an eye on Albany for that reason.
Where this guidance stops
This article is general education on Section 1202 and qualified small business stock: how the rules and the options generally work. It is not tax, legal or investment advice, and nothing here is a recommendation for your situation. Rules change and outcomes turn on the facts, which is why a CPA and an attorney look at a family’s own numbers before anything is done.
Sources
- 26 U.S.C. § 1202 (Office of the Law Revision Counsel)
- 26 U.S.C. § 1045: Rollover of gain from qualified small business stock
- Congressional Research Service: Tax provisions in P.L. 119-21
- Manatt: QSBS changes under the One Big Beautiful Bill
- California Franchise Tax Board: Summary of federal income tax changes
- Loeb & Loeb: New York legislature considers change to QSBS treatment
- TaxProf Blog: State QSBS conformity
- Venable: QSBS stacking in the crosshairs