Section 1202 QSBS Exclusion: How to Exclude Up to $10 Million in Capital Gains

By Yarik Yarosh, CPA ·September 5, 2026 ·5 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

Section 1202 of the Internal Revenue Code is one of the most powerful tax benefits available to founders and early investors, and it is also one of the most underutilized. It allows a taxpayer to exclude from federal income tax up to the greater of $10 million or 10 times the adjusted basis of Qualified Small Business Stock (QSBS) held for more than 5 years. For a founder who invested $100,000 and sells for $5 million, the entire $4.9 million gain can be excluded from tax. Zero federal capital gains tax.

✓Key takeaway

Section 1202 QSBS requirements:

C-Corporation. The stock must be in a domestic C-Corporation. S-Corps, LLCs, partnerships, and sole proprietorships do not qualify. The entity must be a C-Corp at the time the stock is issued AND for substantially all of the holding period.
$50 million gross asset test. At the time the stock is issued (and immediately after), the corporation’s aggregate gross assets (cash plus adjusted basis of other property) must not exceed $50 million. This is measured at issuance, not at sale. A company that was under $50 million when the founder received stock but has grown to $500 million by the time of sale still qualifies.
Active business requirement. At least 80% of the corporation’s assets (by value) must be used in the active conduct of a qualified trade or business during substantially all of the taxpayer’s holding period.
Excluded businesses. Certain businesses do NOT qualify for QSBS: professional services (health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage), banking, insurance, financing, leasing, investing, farming, mining, hospitality (hotels, restaurants, motels). Technology companies, manufacturing, retail, and most product businesses DO qualify.
Original issuance. The stock must be acquired at original issuance (directly from the corporation in exchange for money, property, or services). Stock purchased on the secondary market (from another shareholder) does NOT qualify, unless it was gifted or inherited from someone who held qualifying stock.
5-year holding period. The stock must be held for more than 5 years. Stock held less than 5 years does not qualify for the exclusion (but may qualify for a rollover under Section 1045 if held more than 6 months and rolled into new QSBS within 60 days).
Exclusion amount. The greater of: (a) $10 million ($5 million for married filing separately), or (b) 10 times the taxpayer’s adjusted basis in the stock. For stock acquired for services (basis = compensation income recognized), the basis is the amount included in income.
State conformity. Not all states follow Section 1202. California is the most notable nonconformist: it does not recognize the QSBS exclusion, meaning a California resident selling QSBS pays California capital gains tax (up to 13.3%) even though the gain is excluded federally.

How does QSBS planning work in practice?

Hypothetical example

Round numbers. For current guidance, see 26 U.S.C. 1202 (QSBS exclusion). A software company founder incorporates a C-Corporation and invests $200,000 in cash. After 7 years, the company is acquired for $8 million (founder’s share).

Without Section 1202:

Sale price: $8,000,000
Basis: $200,000
Capital gain: $7,800,000
Federal capital gains tax (20% + 3.8% NIIT): $1,857,600
State tax (varies): $0-$1,000,000+
Total federal tax: $1,857,600

With Section 1202:

Exclusion: greater of $10,000,000 or 10 x $200,000 = $2,000,000
The $10 million cap applies (it is greater)
Gain: $7,800,000
Excluded: $7,800,000 (under the $10 million cap)
Taxable gain: $0
Federal capital gains tax: $0
Savings: $1,857,600

Stacking through multiple shareholders: Each shareholder has their own $10 million exclusion. If the founder and their spouse each hold stock (acquired separately at original issuance), the combined exclusion is $20 million. If the founder also gifted stock to children (who hold it for 5+ years), each child has their own $10 million exclusion.

Planning consideration: Section 1045 rollover. If the founder sells at year 3 (before the 5-year mark), they can roll the gain into new QSBS within 60 days under Section 1045. The 5-year clock restarts on the new stock, but the gain is deferred.

Planning consideration: C-Corp vs. S-Corp timing. Many startups begin as LLCs or S-Corps for simplicity and convert to C-Corps when seeking venture capital. The QSBS clock starts when the C-Corp issues stock, not when the business was originally formed. Converting from an S-Corp to a C-Corp restarts the clock. Founders anticipating a 5+ year exit should consider starting as a C-Corp if QSBS eligibility is a priority.

Illustrative numbers only, not a real client and not advice for your facts.

What are the requirements to qualify for the QSBS exclusion?

Section 1202 allows up to 100% exclusion of gain on the sale of Qualified Small Business Stock, but the requirements are strict. The stock must be issued by a domestic C-Corporation with gross assets of $50 million or less at the time of issuance and at all times before the stock was issued. You must acquire the stock at original issuance (not on the secondary market) in exchange for money, property, or services. You must hold the stock for at least 5 years. The corporation must use at least 80% of its assets in an active trade or business (not investment management, banking, insurance, farming, mining, or hospitality), and it must remain a C-Corporation during substantially all of your holding period.

Related guides:

Want this checked against your own situation?

Start with a Diagnostic: a CPA licensed in the US and Canada reads your file and tells you in writing what's wrong and how to fix it, three to four business days after you finish the questions. The report is $250. If you hire us for any work after that, you get the $250 back as a discount on that work. Or send us your return or your letter and get a fixed price, free.

Start a Diagnostic →See prices

Get a fixed price, free

Get the next cross-border guide by email

One or two plain-English guides a week on US-Canada tax. No spam, unsubscribe anytime.

Cite this page

Yarik Yarosh, CPA. "Section 1202 QSBS Exclusion: How to Exclude Up to $10 Million in Capital Gains." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-section-1202-qsbs-exclusion

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.