Section 1202 of the Internal Revenue Code offers a potential federal capital gains exclusion on sales of qualified small business stock (QSBS) — a major planning topic for U.S. startup equity.

How it works

To qualify, stock generally must be acquired at original issue from a domestic C-corporation that meets active business and gross asset tests at issuance. Holding periods (often five years), per-issuer gain limits, and exclusions for certain industries apply. Tax law has changed over time — recent legislation expanded exclusions for eligible stock, but individual facts control outcomes.

Founders incorporating as LLCs or converting entities late can inadvertently forfeit benefits. Redemptions, significant asset growth before issuance, and ineligible businesses (many service and finance models) are common tripwires.

QSBS status is analyzed stock-by-stock and holder-by-holder. M&A structures (asset vs stock sales) affect whether buyers inherit or sellers preserve benefits.

Why it matters

• Founders: C-corp QSBS planning belongs early in company formation and before major recapitalizations. After-tax exit math can differ sharply from headline proceeds.
• Investors: Seed and early-stage funds track QSBS for LP reporting. Acquirers may price QSBS value into deal terms or require tax indemnities.

Common mistake

Assuming all startup stock automatically qualifies — without verifying C-corp status, original issue, asset tests, and holding period from day one.

Related ideas

• Qualified small business stock (QSBS)
• C-corp vs LLC for venture-backed startups
• Tax diligence in M&A