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

For entrepreneurs, investors, and founders, recent updates to the Opportunity to Build Better Businesses 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 offers meaningful opportunities, but also introduces new complexity. 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 reorganizations, 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 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 individual 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 remaining 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, while tiered S corporation structures can also create planning flexibility.
• Each choice affects long-term tax outcomes and access to the QSBS exclusion.

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

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

Planning for Success

With expanded QSBS benefits comes the need for careful planning, and these final steps 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.

• Minnesota conforms, allowing both federal and state capital-gain exclusions.
• California does not conform; 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 open the door to new 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.