Planning Opportunities for Qualified Small Businesses and Updated IRC Section 1202 Rules Under the OBBBA

For entrepreneurs, investors, and founders, recent updates to the One Big Beautiful Bill Act (OBBBA) expand one of the most powerful tax-planning tools available: the Qualified Small Business Stock (QSBS) exclusion under IRC Section 1202.

With larger potential capital-gain exclusions and a shorter holding period for newly issued shares, the OBBBA expands meaningful opportunities for significant tax savings. Careful planning and documentation are key to taking full advantage.

What Are the QSBS Eligibility Requirements?

To qualify for Section 1202 treatment, stock must meet several technical tests:

Original Issuance Requirement - QSBS must be issued directly by a qualified small business (QSB) to the shareholder in exchange for cash, property, or services.

• Stock splits, tax-free contributions, or certain redemptions can jeopardize eligibility.
• Limited exceptions apply for QSBS received by gift, at death, or through distributions from a pass-through entity (PTE).
• The issuing corporation must meet timing and de minimis restrictions on stock redemptions to preserve QSB status.

Active Trade or Business Requirement - At least 80 percent of the company’s asset value must be used to operate an active trade or business during the shareholder’s holding period.

Small Business Requirement (Gross-Asset Test) - The company’s adjusted-basis assets must not exceed $75 million (up from $50 million before the OBBBA, adjusted annually for inflation) both immediately before and after the stock issuance.

Opportunities for Buyers: Choice of Entity and Shareholder Considerations

For both buyers and founders, early entity decisions play a major role in whether QSBS benefits are available down the road.

Choice of Entity - QSBS benefits apply only to stock issued by a domestic C corporation that maintains QSB status throughout “substantially all” of the shareholder’s holding period. 

Eligible Shareholders - Individuals, trusts, and pass-through entities can own QSBS. Gains may flow through PTEs such as partnerships, LLCs, or S corporations, allowing qualifying owners to claim Section 1202 benefits under certain conditions.

Additional Planning Considerations:

• Start-ups should weigh the pros and cons of forming as a C corporation versus as a pass-through entity. This previous article touches on the choice of entity comparison: https://www.redpathcpas.com/blog/choice-of-entity
• LLCs may “check the box” to elect C corporation status.

Opportunities for Sellers: Expanded Capital-Gain Exclusions

Shareholders who meet the QSBS requirements can benefit significantly upon sale:

• A capital-gain exclusion on the greater of $15 million or 10 times basis (increased from $10 million under prior law) on a per-shareholder basis.
• A potential tax-free rollover into another qualifying QSB under IRC Section 1045 if the stock is held at least six months, creating both liquidity and reinvestment opportunities.

QSBS Timing Considerations

For eligible stock acquired after July 4, 2025, new OBBBA rules reduce the minimum holding period for the gain exclusion to:

• 50 percent exclusion after three years
• 75 percent exclusion after four years
• 100 percent exclusion after five years

Planning for Success

The expanded QSBS benefits emphasize the need for careful planning, and these final considerations help ensure eligibility is preserved and fully optimized.

Document Qualification - Taxpayers bear the burden of proof. Maintain detailed financial, legal, and tax records showing that both the company and the shareholder meet each requirement. Early coordination among tax, legal, and accounting advisors is critical.

State and Local Tax Conformity - Because state treatment varies, shareholders should confirm whether their jurisdiction conforms to federal Section 1202 rules. For example:

• Minnesota conforms to federal treatment, allowing both federal and state capital-gain exclusions on Minnesota-based gains.
• California does not conform; therefore, QSBS gains remain subject to state tax (up to 13.3 percent for individuals).

Is Your Business Positioned to Benefit from QSBS?

The OBBBA’s changes to Section 1202 widen the door to tax planning opportunities for both business owners and investors, but only if qualification is established and maintained.

Curious as to how this might benefit you? Connect with us at Redpath to evaluate entity structure, shareholder eligibility, and documentation strategies that preserve QSBS status and maximize long-term value.