The recent expansion of the Qualified Small Business Stock program in the One Big Beautiful Bill Act makes a powerful tax-saving strategy even more enticing for businesses and investors.
The QSBS provision is part of Section 1202 of the Tax Code, which was originally enacted in 1993 and allowed 50% of the gain from selling QSBS to be excluded from income. That percentage later increased to 75% and then 100%.
"Even before the reconciliation bill, Section 1202 Qualified Small Business Stock was one of the most powerful and unique incentives in all of the tax law because you're talking about an exclusion from income — not a deferral, but an exclusion," said Tony Nitti, a principal at EY US Tax. "The ability to exit an investment in a business and not pay any federal income tax while receiving cash, that's just not something you can get elsewhere throughout the Code. So it was already very popular, but the reconciliation bill really represents a refresh of some of these dollar limitations, but also a significant expansion of the incentive itself."
The new tax law raises the asset cap for qualifying businesses, increases the capital gains exclusion, introduces a tiered tax benefit for early exits, and allows significantly higher tax-free gains under the 10x exclusion rule. That presents potential implications for startup founders, investors and wealth planners, such as bigger opportunities for tax savings, shifts in investment strategies, and new considerations for long-term financial planning.
Nitti has been hearing interest from clients at EY in the possible tax savings. "Clients just really want to understand what these changes mean and how quickly they can benefit from them," he said. "It opens up a much larger universe of corporations that people can invest into and receive QSBS because of the changes to the definition of a small business, so there's absolutely a lot of excitement right now about the expanded 1202 provision."
The new tax law increased the individual selling shareholders' maximum limitation from $10 million to $15 million for stock issued after July 4, Nitti noted. "So $15 million of exclusion at a 23.8% federal tax rate, that's a $3.5 million federal tax savings," he said. "That's got people very excited. The other thing that gets people excited is, previously you had to hold QSBS for five years to get the exclusion, and sometimes you just couldn't make it to five years. An offer came along, it was just too good to pass up. But the new law is going to allow you to claim a 50% exclusion if you hold stock issued after July 4, 2025, for three years, 75% for stock held after four years, and then you'll get the full 100% after five years. Now investors don't feel like they have to have a five-year time horizon prior to exit in order for the investment to make sense. Even if they can get to three years and get a 50% exclusion, that's going to be valuable to them."
Businesses need to be structured as C corporations in order to qualify, and that's prompting discussions within partnerships about converting into a C corp.
For stock issued prior to the July 4, 2025 date, before the reconciliation bill, to be a small business, a company had to have less than $50 million of assets, but that threshold has now increased under the new tax law.
"Normally that test is measured by tax basis of assets," said Nitti. "But for something like a partnership converting to a corporation, it's actually measured by the fair market value of assets. Prior to July 4, if a partnership wanted to convert to a C corporation to eventually benefit from QSBS, the value of its assets had to be less than $50 million, but the reconciliation bill increased that threshold where the definition sits for a qualified small business from $50 million to $75 million. So now you've got partnerships out there that maybe had between $50 and $75 million of value of assets that previously couldn't convert to a C corporation, but now can."
Nevertheless, there are some challenges that remain even after passage of the new tax law, such as determining whether the stock qualifies. "The biggest challenge that we face in practice is that this exclusion is claimed at the selling shareholder level, so some individuals who own stock, when they sell that stock, they're going to be the ones on their tax return to exclude the gain," said Nitti. "But most of the requirements that have to be satisfied in order for that stock that was sold to be QSBS, most of those requirements apply at the corporate level, and so a shareholder needs some transparency into the corporation's activities to ever be able to make the determination that their stock is, in fact, QSBS. That's always been a challenge with this QSBS designation. And that's not going away here in the new law. A shareholder who's ready to exit an investment might do some research on the internet and see, hey, there's a possibility here my stock is QSBS. But if they don't have buy-in from the corporation to get an analysis done, or at least open up the books and records for their entire holding period, that shareholder can be stuck a little bit where they can't make the determination whether their stock is QSBS."
He would like to see more guidance from the Treasury and the IRS about QSBS and its expansion. "Even though 1202 has been in the code since 1993 there is a noticeable lack of guidance about Section 1202," said Nitti. "We don't have any particularly meaningful regulations. We have very limited case law. We have maybe 12 or 13 private letter rulings, so sometimes there's just a lot of uncertainty when trying to make this QSBS determination because basic definitional guidance hasn't been provided yet. Some of the more complicated aspects of Section 1202, the IRS has not spoken on just yet, so that's only going to become magnified now that there's more dollars at stake in terms of exclusions. Hopefully the Service gets us some guidance here in the near future so that we can apply these laws with more confidence."
He hopes to see that guidance despite
"There have been some rumblings around the industry — never necessarily confirmed — that there was a guidance package in the works as of about a year and a half ago," said Nitti. "That makes us all very optimistic. How those plans may have changed with some of the changes that have taken place at the Service, we don't know. At this point, whether there's a guidance package or not could best be described as a rumor, and an unverified one at that. But it's very comforting to know that there's even a rumor that a guidance package is being put together because I think people are very hopeful and wishing that we do get some of the guidance necessary to make some of these determinations that had have to be made to find out if the stock is QSBS."
Taxpayers will be able to use such guidance in case they're challenged by the IRS at some point.
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Despite the possible complications, businesses and their investors will want to take a closer look at the QSBS provision. "There's not many provisions of the Code that allow you to sell anything for cash and walk away without any federal tax liability, so the expansion of a provision like that is certainly worthy of attention," said Nitti.
