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How the One Big Beautiful Bill Impacts Qualified
Small Business Stock Under IRS Code Section 1202

The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, introduces significant changes to the U.S. tax code, including notable expansions to the tax benefits associated with Qualified Small Business Stock (QSBS) under Section 1202 of the Internal Revenue Code (IRC). These changes aim to incentivize investment in startups and small businesses by offering enhanced tax exclusions for capital gains, making it an attractive opportunity for founders, investors, and early employees. This article explores the key modifications to Section 1202 under the OBBBA, their implications, and planning considerations for taxpayers.

Background on Section 1202 and QSBS

Section 1202, enacted in 1993, allows non-corporate taxpayers (individuals, trusts, estates, and certain pass-through entities) to exclude a portion or all of the capital gains from the sale of QSBS held for more than five years. To qualify as QSBS, the stock must meet several requirements:

• Issuer Requirements: The stock must be issued by a domestic C corporation with gross assets not exceeding $50 million at the time of issuance and immediately after.
• Active Business Requirement: At least 80% of the corporation’s assets must be used in a qualified trade or business during substantially all of the taxpayer’s holding period. Excluded businesses include those in hospitality, financial services, farming, mining, and certain professional services like law or health.
• Original Issuance: The stock must be acquired directly from the corporation at its original issuance in exchange for money, property (other than stock), or services (not as an underwriter).
• Holding Period: Historically, the stock must be held for more than five years to qualify for the full exclusion.

Under pre-OBBBA law, taxpayers could exclude up to 100% of the gain from the sale of QSBS acquired after September 27, 2010, limited to the greater of $10 million or 10 times the taxpayer’s adjusted basis in the stock. For stock acquired earlier, exclusion rates were 50% (August 11, 1993–February 17, 2009) or 75% (February 18, 2009–September 27, 2010), with a portion of the excluded gain subject to Alternative Minimum Tax (AMT) as a preference item.

Key Changes to Section 1202 Under the OBBBA

The OBBBA introduces three significant expansions to QSBS benefits, effective for stock acquired after July 4, 2025, making the provisions more flexible and attractive for investors and entrepreneurs. These changes are:

1. Reduced Holding Period with Tiered Exclusions:
   • The OBBBA lowers the holding period required for QSBS benefits, introducing a tiered exclusion structure:
     • 3-Year Holding Period: A 50% gain exclusion applies for QSBS held for at least three years.
     • 4-Year Holding Period: A 75% gain inclusion applies for QSBS held for at least four years.
     • 5-Year Holding Period: The full 100% gain exclusion remains for QSBS held for more than five years.
   • This change allows investors and founders to realize tax benefits sooner, particularly benefiting those involved in secondary transactions or earlier exits. For example, an investor selling QSBS after three years could exclude 50% of the gain, significantly reducing their tax liability compared to prior law, which offered no exclusion before five years.
2. Increased Gain Exclusion Limit:
   • The per-issuer gain exclusion cap has been raised from $10 million to $15 million (indexed for inflation) for stock acquired after the effective date. The alternative limit—10 times the taxpayer’s adjusted basis—remains unchanged.
   • This increase allows taxpayers to exclude a larger portion of their gains, particularly for high-growth startups where gains often exceed the previous $10 million cap. For instance, an investor with a $1 million basis in QSBS could now exclude up to $15 million or 10 times their basis ($10 million), whichever is greater, compared to the prior $10 million cap.
3. Expanded Gross Assets Threshold:
   • The gross assets threshold for a corporation to qualify as a qualified small business has been increased from $50 million to $75 million (also indexed for inflation) at the time of stock issuance and immediately after.
   • This adjustment broadens the pool of eligible companies, allowing larger startups and small businesses to qualify for QSBS benefits. It reflects the economic reality of higher valuations in modern startups, particularly in technology and life sciences sectors.

These changes apply to QSBS issued on or after July 4, 2025, and for taxable years beginning after that date. For stock acquired before this date, the prior rules (five-year holding period, $10 million cap, $50 million asset threshold) continue to apply.

Implications for Stakeholders

The OBBBA’s enhancements to Section 1202 have far-reaching implications for various stakeholders in the small business and startup ecosystem:

• Founders and Early Employees: The reduced holding period is a significant win for founders and early employees who receive stock as compensation. Secondary transactions, where early stakeholders sell shares before a full exit, are now more tax-efficient with the 50% and 75% exclusions after three and four years, respectively. This flexibility can improve liquidity and financial planning.
• Investors: Venture capitalists and angel investors benefit from the higher $15 million exclusion cap and the expanded $75 million gross assets threshold, which make a broader range of investment opportunities eligible for QSBS benefits. The tiered exclusions also reduce the risk of holding investments for the full five years, encouraging earlier-stage investments.
• Startups and Small Businesses: The increased gross assets threshold allows more companies, particularly those in capital-intensive industries like technology or manufacturing, to qualify for QSBS status. This can make such companies more attractive to investors, potentially increasing access to capital.
• Tax Planning Opportunities: The tiered exclusions and higher cap create new planning opportunities, such as timing stock sales to align with the three- or four-year holding periods or structuring investments to maximize the 10x basis exclusion. Additionally, Section 1045 rollovers (allowing tax-free reinvestment of QSBS gains into new QSBS within 60 days) remain available, providing further flexibility for investors exiting before the five-year mark.

Planning Considerations and Challenges

While the OBBBA’s changes enhance the appeal of QSBS, taxpayers must navigate several complexities to maximize benefits and ensure compliance:

1. Documentation and Compliance: The IRS is expected to increase scrutiny of QSBS claims due to the expanded benefits and potential for abuse. Taxpayers should maintain rigorous documentation, such as QSBS attestation letters from issuing corporations, to substantiate eligibility. This includes verifying the corporation’s gross assets, active business activities, and compliance with the original issuance requirement.
2. State Tax Considerations: Section 1202 provides a federal tax exclusion, but state tax treatment of QSBS varies. Some states conform to federal rules, while others do not, potentially reducing the overall tax savings. Taxpayers should consult with advisors to understand state-specific implications.
3. Redemption Traps: The OBBBA does not alter the strict redemption rules under Section 1202, which disqualify stock if the issuing corporation redeems more than a de minimis amount of stock (5% or 2% for related parties) within a specified period before or after issuance. Taxpayers must carefully monitor corporate redemptions to avoid inadvertently disqualifying QSBS.
4. Active Business Requirement: The requirement that 80% of the corporation’s assets be used in a qualified trade or business remains complex, with limited IRS guidance on what constitutes a qualified trade. Businesses in gray areas (e.g., certain tech-enabled services) should seek professional advice to confirm eligibility.
5. Timing and Structuring Investments: Investors should align stock acquisitions with the OBBBA’s effective date (July 4, 2025) to benefit from the new rules. For existing holdings, strategies like Section 1045 rollovers or gifting QSBS to family members for estate planning can leverage the higher $15 million exclusion cap.
6. AMT and NIIT Considerations: For QSBS issued after September 27, 2010, and held for more than five years, the 100% exclusion is not subject to AMT or the 3.8% Net Investment Income Tax (NIIT). However, for the new 50% and 75% exclusions (three- and four-year holding periods), a portion of the excluded gain may be treated as an AMT preference item, subject to a 7% add-back and a maximum 28% tax rate on the non-excluded portion. Taxpayers should model these impacts when planning sales.

Example Scenario

Consider an investor who acquires QSBS in a tech startup for $2 million on August 1, 2025. The startup’s gross assets are $60 million at issuance, qualifying under the new $75 million threshold. If the investor sells the stock for $20 million after three years (August 1, 2028), the gain is $18 million. Under the OBBBA:

• Exclusion: 50% of the $18 million gain ($9 million) is excluded from federal tax.
• Taxable Gain: The remaining $9 million is taxed at a maximum capital gains rate of 28%, resulting in a federal tax of approximately $2.52 million (plus potential AMT and state taxes).
• Comparison to Prior Law: Without the OBBBA, no exclusion would apply before five years, and the entire $18 million gain would be taxable, resulting in a federal tax of approximately $3.6 million (at a 20% capital gains rate) plus 3.8% NIIT ($684,000), totaling $4.284 million.

By holding the stock for five years, the investor could exclude the full $18 million (up to the $15 million cap), paying no federal tax, a significant improvement over prior law.

Conclusion

The One Big Beautiful Bill Act significantly enhances the tax benefits of Qualified Small Business Stock under Section 1202, making it a powerful tool for startup founders, investors, and early employees. The reduced holding periods, increased gain exclusion cap, and expanded gross assets threshold create new opportunities for tax-efficient investing and liquidity. However, the complexity of QSBS requirements, coupled with potential IRS scrutiny, underscores the need for careful planning and professional guidance. Taxpayers should work with experienced tax advisors to navigate these rules, ensure compliance, and optimize their tax strategies in light of the OBBBA’s transformative changes.

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The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.