Stock qualifying under Section 1202 of the Internal Revenue Code of 1986, as amended (the “Code”), as Qualified Small Business Stock (“QSBS”) allows eligible non-corporate taxpayers to potentially exclude a portion or all of the gain from selling the stock held for a minimum period of time (as explained below), with a 100 percent exclusion available, subject to certain caps, for stock acquired after September 27, 2010. The federal tax legislation enacted on July 4, 2025, (the One Big Beautiful Bill Act or “OBBBA”) also expands the benefits of QSBS as explained below. The exclusion of capital gain on sale is designed to encourage investment in small business. The exclusion can benefit startup founders, early investors, angel investors, and employees who receive stock in a qualifying company. Section 1202 of the Code has many rules and exceptions, and continued compliance with the rules is essential to preserving QSBS status of the stock, including dispositions of the stock at death and tax-free reorganizations.

Key Requirements for Qualifying as QSBS

• Domestic C Corporation. The business must be incorporated as a U.S. C corporation.
• Gross Asset Limitation. The corporation’s aggregate gross assets must not have exceeded $50 million at any point from August 10, 1993, until immediately after the stock issuance. This threshold has been increased to $75 million under the OBBBA effective after July 4, 2025, with inflation adjustments starting in 2027.
• Active Business Requirement. For most of the taxpayer’s holding period, the corporation must use at least 80 percent of its assets in a qualified trade or business.
• Qualified Trade or Business. The business must be in an active field, excluding specific types of business such as professional services, finance, farming, mineral production, and hospitality.
• Original Issuance of Stock. The stock must be acquired directly from the corporation when it was originally issued, with exceptions noted below, which are particularly relevant in estate planning.
• Capital Gain Exclusion. QSBS stockholders can exclude up to $10 million in capital gain (or 10 times the taxpayer’s adjusted basis, whichever is greater) from federal income tax for stock issued on or before July 4, 2025 (the “Exclusion Limit”). For QSBS acquired after July 4, 2025, the Exclusion Limit has been increased to $15 million (or 10 times the taxpayer’s adjusted basis, whichever is greater), with an inflation adjustment commencing in 2027. With respect to exclusion from state income tax, different states have varying rules regarding QSBS, and some may not conform to federal rules.
• Holding Period. For stock issued on or before July 4, 2025, the taxpayer must hold the stock for at least five years before selling it, and, subject to the Exclusion Limit, 100 percent of capital gain is excluded after the five-year holding period. Under the OBBBA, for stock issued after July 4, 2025, subject, in each case, to the Exclusion Limit, 50 percent of capital gain is excluded for stock held at least three years, 75 percent of capital gain is excluded for stock held at least four years, and 100 percent of capital gain continues to be excluded for stock held at least five years. The tacking of holding periods in the case of deaths and reorganizations is discussed below.

Transfers of QSBS Shares to Heirs and Trusts

Holders of QSBS can pass to heirs and trusts the capital gain exclusion benefit provided by the QSBS status. Specifically, Section 1202(h) of the Code provides that, in the event of a transfer by gift or death, the transferee is treated as having acquired the stock in the same manner and having the same holding period as the transferor.

As with the gift of non-QSBS corporate stock or other assets, the value of a gift of QSBS for gift tax purposes will be based on its fair market value on the date of the gift. Gifting QSBS while the company’s valuation is still relatively low can minimize gift tax consequences while preserving maximum upside for later exclusion. The QSBS tax benefits can be also preserved when qualifying stock is transferred to family trusts. However, transferring QSBS to a trust that is a separate taxpaying entity[1] provides for even greater estate planning opportunities.

Specifically, a key strategy in tax and estate planning with QSBS is to gift QSBS to multiple family members or multiple family irrevocable non-grantor trusts with differing terms and provisions. Because the QSBS exclusion applies to each taxpayer, each recipient of the gifted QSBS shares can potentially claim their own $10 million or now $15 million (or 10 times adjusted basis, whichever is greater) exclusion. This effectively multiplies or “stacks” the potential tax-free gain across multiple family members or trusts.

One caution in using multiple non-grantor trusts to stack the QSBS benefits is Section 643(f) of the Code, which will result in the Internal Revenue Service treating two or more trusts as one trust for tax purposes if (i) the trusts have substantially the same grantor and primary beneficiary, and (ii) the principal purpose of establishing multiple trusts was avoidance of tax. Indeed, the Treasury issued proposed regulations in 2018, which presumed a principal purpose of avoidance if the trusts resulted in a significant income tax benefit that could not have been achieved without the creation of the separate trusts, which presumably would cover stacking of trusts to multiply QSBS exclusions. However, the presumption of tax avoidance was not included in the final regulations, leaving little guidance regarding the number of separate trusts in the stacking of QSBS exclusions, which may be regarded as abusive. As a result, it generally is advisable to set up separate trusts for each family member and to provide for different trustees for each trust and to include other provisions that may differentiate the trusts.

One caution is that contributing QSBS shares to a partnership can lead to the loss of QSBS status.

Transfers of QSBS in Mergers and Acquisitions

QSBS status of stock can be preserved in mergers and acquisitions through careful planning. Qualifying stock can retain its QSBS status in a statutory merger under Section 351 of the Code and in tax-free reorganizations under Section 368 of the Code. In a tax-free reorganization, if stock of the acquiring corporation qualifies for QSBS status and is received in exchange for QSBS shares of the target corporation, the shares of the acquiring corporation generally continue their QSBS status and the holding period of the target stock tacks onto the holding period of the new stock acquired. If the target stock is QSBS in the hands of a shareholder and exchanged in a tax-free reorganization for acquiring corporation stock that would not otherwise qualify for QSBS status, the shareholder could nevertheless be eligible to exclude gain under Section 1202 of the Code—limited to the amount of the gain that would have been realized at the time of the reorganization based on the fair market value of the target stock—if the combined holding periods for the target stock and the acquired stock meet the five-year or less holding period requirement. The five-year or less holding period requirement does not need to be met at the time of the reorganization so long as it is satisfied in the aggregate (i.e., by tacking on the shareholder’s holding period of the target stock) upon a later disposition of the acquired stock.

Conclusion

The use of QSBS in family estate planning is a useful tool, particularly when stacking of tax-free gain across multiple family members or non-grantor trusts. The changes to Section 1202 of the Code in the July 4, 2025, OBBBA tax legislation make QSBS stock even more favorable and usable in the context of estate planning. Nevertheless, the rules with respect to the transfer of QSBS and the tacking of holding periods are intricate and the failure to comply with all necessary requirements could result in significant adverse tax consequences. Accordingly, prior to engaging in any planning transaction involving QSBS, taxpayers should always consult with their estate and tax planning counsel.

[1] For income tax purposes, trusts are classified as either “grantor” trusts or “non-grantor” trusts based upon the provisions of Subpart E of Part I of Subchapter J of the Code. When a trust is classified as a grantor trust, the donor of property (or a third-party in certain circumstances) is treated as the owner of the trust property for income tax purposes, requiring such deemed owner to report all matters of income and deduction with respect to the trust property on his or her own individual income tax returns. When a trust is classified as a non-grantor trust, the trust is treated as a separate taxpaying entity, requiring the trustees of the trust to file annual income tax returns for the trust, reporting all matters of income and deduction. A trust will be classified as a grantor trust or a non-grantor trust depending, inter alia, on the terms of the trust, the powers that have been retained by the settlor, the trustees then serving, and certain provisions as it relates to the beneficiaries.