QSBS §1202: The Federal Exclusion on Your Founder Exit, and What California Still Taxes

Go deeper: excluding gain on qualified small business stock under Sections 1202 and 1045 on Big Sale Tax.

QSBS §1202 key facts

Key facts: QSBS exclusion by acquisition date

Rule	Stock acquired on or before July 4, 2025	Stock acquired after July 4, 2025
Holding period and exclusion	5 years for the exclusion	3 years: 50%; 4 years: 75%; 5 years: 100%
Per-issuer cap	Greater of $10 million or 10× basis	Greater of $15 million or 10× basis
Company gross-assets limit when stock issued	$50 million	$75 million
California	Taxes the full gain	Taxes the full gain

Source: IRC §1202 (26 U.S.C. 1202), Cornell LII, read October 18, 2026, as amended by P.L. 119-21 (signed July 4, 2025). California does not conform for individual sellers. Federal dollar caps and the gross-assets limit are indexed for inflation for tax years after 2026.

What is the QSBS exclusion under IRC §1202?

IRC §1202, the Qualified Small Business Stock (QSBS) exclusion, lets a qualifying founder exclude up to $10 million OR 10× their basis (whichever is greater) of capital gain on the sale of C-corp founder stock acquired on or before July 4, 2025 from federal income tax after a 5+ year hold. Codified since 1993, expanded to 100% exclusion in 2010.

2025 update (P.L. 119-21, signed July 4, 2025): for stock acquired after July 4, 2025, the per-issuer cap rises to $15 million (indexed for inflation after 2026), the exclusion phases in at 50% after 3 years, 75% after 4 years and 100% after 5 years, and the company gross-assets limit rises to $75M. Stock acquired on or before July 4, 2025 keeps the old rules: $10M cap, 5-year hold, $50M limit.

For a California founder selling a successful startup exit, this can remove millions of gain from the federal return, and it’s a statutory exclusion in the Internal Revenue Code that doesn’t require any structure, trust, or annuity.

Who qualifies for the QSBS exclusion?

1. C-corporation. The company must be a domestic C-corp (NOT an S-corp or LLC). If your startup is an S-corp or LLC at exit, §1202 doesn’t apply.
2. Founder/employee stock, not options. The stock must be ORIGINAL ISSUE acquired directly from the company (founder stock, ISO/NSO exercise BEFORE exit, regulated private placement). Stock bought from another shareholder doesn’t qualify.
3. Held long enough. Stock acquired on or before July 4, 2025 needs a continuous 5-year hold from issuance; sold sooner, it gets no §1202 exclusion (but see §1045 rollover below). For stock acquired after July 4, 2025, a 3-year hold earns a 50% exclusion, 4 years 75%, and 5 years 100%.
4. Company under the gross-assets limit. At the time the stock was issued, the company’s aggregate gross assets must not have exceeded $50M ($75M for stock issued after July 4, 2025, indexed for inflation after 2026). Many pre-seed, seed and Series A startups fit under it.
5. Active business in qualified industry. Company must use 80%+ of assets in a qualified trade or business. Excluded: financial services, professional services (law/accounting/consulting), real estate, farming, mining, hospitality.

How much gain can you exclude under §1202?

The exclusion limit is the GREATER of:

• $10 million per issuer per taxpayer (lifetime) for stock acquired on or before July 4, 2025, or $15 million for stock acquired after July 4, 2025 (indexed for inflation after 2026), OR
• 10× the aggregate adjusted basis of QSBS stock sold in that tax year

For a founder who got 1M shares at $0.0001 basis ($100 total cost), the 10× cap = $1,000. So the dollar cap controls: for older stock, $10M of gain is excluded and normal capital-gains tax applies above that; for stock acquired after July 4, 2025, the cap is $15M.

Example: California founder, $15M exit (stock acquired before July 5, 2025)

Item	Amount
Sale of founder stock	$15,000,000
Cost basis (original purchase)	$100
Capital gain	$14,999,900
§1202 exclusion (federal, capped at $10M)	−$10,000,000
Remaining taxable gain	$4,999,900
Federal tax on remaining (20% + NIIT 3.8%)	−$1,189,976
California state tax (~13.3% on FULL $15M gain, CA does NOT conform to §1202)	−$1,994,987
Net to founder	$11,815,037

In this example, the federal §1202 exclusion removes about $2.38M of federal tax (the federal tax that would otherwise apply to the first $10M). California still taxes the full gain at ordinary rates. California does NOT conform to §1202 for individual sellers.

Under the new rules, the same $15M gain on stock acquired after July 4, 2025 could be fully excluded federally after a 5-year hold (the earliest such sales are in July 2030). The California tax would still apply.

Does California follow the §1202 exclusion?

California, Pennsylvania, Mississippi and Alabama do not conform to the federal §1202 exclusion. A California founder still owes CA marginal income tax on the FULL gain, even the portion excluded on the federal return.

For a $15M California exit, that means $1.99M in CA tax even with the full $10M federal exclusion. This is where stacking §1202 with the structured installment sale makes sense: it spreads the California portion across multiple years.

Can you combine §1202 with an installment sale?

Most §1202-qualifying founders can:

1. Claim the federal §1202 exclusion in Year 1 (up to the $10M or $15M cap, excluded from federal income tax)
2. Structure the residual gain as an installment sale to spread the California state tax across 10-30 years at low CA marginal rates
3. Take a cash carve-out at closing for immediate needs (downpayment on a house, paying off debt, etc.)

For a founder with $15M of qualified gain who has no immediate cash need, one structure to model is: claim the $10M §1202 exclusion + structure the remaining $5M as a 20-year installment sale + a ~$1M cash carve-out for liquidity, which in this illustration comes to roughly $13M net (vs ~$11.8M from a straight cash sale at California rates). Your figures depend on your income, state and the payment terms.

What if you cannot hold the stock long enough? The §1045 rollover

If you didn’t hold the QSBS for the period §1202 requires (5 years for stock acquired on or before July 4, 2025; at least 3 years for a partial exclusion on newer stock), you can use IRC §1045 to roll over the gain into REPLACEMENT QSBS within 60 days of sale. The new QSBS inherits your holding period from the old. After 5 total years (counting both the old and new holding periods), you can sell with the §1202 exclusion.

Common use case: company gets acquired at year 4. Roll the gain into a new QSBS investment, hold for 1+ more year, sell with the full exclusion.

What if the startup fails? The §1244 ordinary loss

If your QSBS-eligible startup FAILS (worth $0 at exit), §1244 lets you claim up to $50K single / $100K MFJ as an ORDINARY LOSS (rather than capital loss limited to $3K/yr). Combine with regular capital-loss treatment for the rest. It is the downside counterpart to §1202’s upside.

What should a QSBS founder do before the exit?

1. Verify the C-corp election was in place for the entire holding period. If the company converted from LLC to C-corp at year 2 and you sell at year 5, you only have 3 years of QSBS holding, which doesn’t qualify for full §1202.
2. Get a §1202 qualification letter from the company. The company should certify in writing that gross assets were under the limit ($50M, or $75M for stock issued after July 4, 2025) when YOUR stock was issued. Memorialize at the time of stock issuance, not at sale.
3. Track basis carefully. Founder stock often has near-zero basis but employee stock from ISO exercises has the strike price as basis. Keep records.
4. Coordinate with your CPA on the year of sale. §1202 interacts with AMT (alternative minimum tax): 7% of the excluded gain is an AMT preference item for stock acquired before Sept 28, 2010; a 100% exclusion on later stock carries none. Ask your CPA how AMT applies to a 50% or 75% partial exclusion on stock issued after July 4, 2025.
5. For gain above the cap ($10M or $15M), plan the structure BEFORE closing. The residual gain above the §1202 cap can be installment sale-structured. But the installment sale assignment paperwork must be in place before escrow opens. See the installment sale timing rules.

Frequently asked questions

How much gain can I exclude under QSBS?

For stock acquired on or before July 4, 2025, the cap is the greater of $10 million or 10 times your basis. For stock acquired after July 4, 2025, it is the greater of $15 million (indexed for inflation after 2026) or 10 times basis.

How long must I hold QSBS?

Stock acquired on or before July 4, 2025 needs a continuous 5-year hold. For stock acquired after July 4, 2025, a 3-year hold earns a 50% exclusion, 4 years earns 75% and 5 years earns 100%.

Does California tax QSBS gain?

Yes. California does not conform to the federal §1202 exclusion, so a California founder owes California tax on the full gain. On the $15 million exit example on this page, that is about $1.99 million of California tax even after the $10 million federal exclusion.

Does an LLC or S-corp qualify for §1202?

No. The company must be a domestic C-corporation, and the stock must be original issue. If a company converts from an LLC to a C-corp at year 2 and you sell at year 5, you have only 3 years of QSBS holding period.

What if I sell before the holding period ends?

IRC §1045 lets you roll the gain into replacement QSBS within 60 days of the sale. The new stock inherits your holding period, so you can qualify for the §1202 exclusion after 5 total years.