Qualifying Small Business Stock Rule

What is qualified small business stock?

Qualified small business stock is a type of tax-favored investment in certain small businesses. Section 1202 of the Internal Revenue Code allows a taxpayer other than a corporation to exclude some or all of the gain from the sale of qualified small business stock if applicable requirements are met.

The One Big Beautiful Bill Act (OBBBA) of 2025 modified the exclusion of gain on the sale of qualified small business stock, the per-issuer limitation on the exclusion of such gain, and the aggregate gross asset limitation on a qualified small business.

For qualified small business stock acquired after July 4, 2025, the required holding period is reduced from five years and the percentage of gain that is excluded depends on the taxpayer’s holding period.

For such stock acquired after July 4, 2025, the percentage of gain that is excluded is:

• 50 percent for stock held at least three years and less than four years
• 75 percent for stock held at least four years and less than five years
• 100 percent for stock held at least five years

Different rules apply to stock acquired on or before July 4, 2025. Generally, qualified small business stock acquired before that date must be held for at least five years to qualify for the Section 1202 exclusion. For qualified small business stock acquired after February 17, 2009, and before September 28, 2010, the percentage of gain that may be excluded is 75 percent. For qualified small business stock acquired after September 27, 2010 and before July 5, 2025, the percentage of gain that may be excluded is 100 percent.

Only certain businesses qualify

To be considered qualified, the small business that you wish to invest in must be a C corporation, and meet several requirements:

It must be “active”

“Active” means that 80 percent of the business’s assets are used in a qualified trade or business. Start-up activities and research and development activities may meet this test.

It must be engaged in a trade or business

Almost any trade or business for profit may qualify. However, certain businesses do not qualify, including:

• Professional services
• Finance and investment services
• Banking
• Leasing
• Insurance
• Mining
• Restaurant and lodging

It may not have assets in excess of the applicable limit

Among the requirements for a corporation to be a qualified small business is an aggregate gross asset limitation. Before and immediately after the issuance of stock, the aggregate gross assets held by the corporation may not exceed the applicable limit. Aggregate gross assets generally consist of cash plus the aggregate adjusted basis of other property held by the corporation.

For stock issued after July 4, 2025, the aggregate gross asset limitation is $75 million. The $75 million amount is indexed for inflation for taxable years beginning after 2026.

For stock issued on or before July 4, 2025, the $50 million aggregate gross asset limitation applies.

Only certain investors qualify

A qualified investor is a noncorporate investor. Pass-through entities such as S corporations and partnerships may also qualify.

Generally, the stock must be acquired at original issuance rather than purchased on the secondary market. However, special rules may preserve qualified small business stock treatment when stock is acquired through certain gifts, inheritances, or other transfers.

If your partnership distributes qualified stock to you as a partner, the tax benefit is preserved. There is one limitation. The tax benefit is preserved only to the extent that your share of the gain does not exceed your interest in the partnership on the date the stock was acquired.

Only certain stock qualifies

The stock must be newly issued by the business (i.e., it can’t be purchased on the secondary market). You may purchase it directly or through an underwriter. You can also acquire it in exchange for services to the business. The stock does not have to be common stock. For instance, it can be preferred stock or even convertible preferred stock.

To prohibit attempts to avoid the new issue requirement, there are anti-churning rules in place that may disqualify your stock if there have been sales or purchases in the qualified stock between you and the qualified small business, or if there have been significant redemptions of stock by the issuer during the two-year period beginning one year before the issuance of the stock.

Required holding period

For qualified small business stock acquired after July 4, 2025, the holding period is:

• At least three years but less than four years: 50 percent of eligible gain may be excluded.
• At least four years but less than five years: 75 percent of eligible gain may be excluded.
• At least five years: 100 percent of eligible gain may be excluded.

For qualified small business stock acquired on or before July 4, 2025, the new holding-period rules do not apply. Such stock generally must be held for at least five years for gain to be eligible for exclusion under Section 1202.

For purposes of determining the acquisition date, the acquisition date is the first day on which the stock was held by the taxpayer, determined after application of the applicable holding-period rules under Section 1223.

Tax consequences

Exclusion of gain

For qualified small business stock acquired after July 4, 2025, the percentage of gain eligible for exclusion depends on the taxpayer’s holding period.

A taxpayer who holds such stock for at least three years but less than four years may exclude 50 percent of eligible gain. A taxpayer who holds the stock for at least four years but less than five years may exclude 75 percent. A taxpayer who holds the stock for at least five years may exclude 100 percent.

For example, assume an individual acquires qualified small business stock at its original issuance after July 4, 2025. If the individual sells the stock after holding it for at least three years but less than four years, 50 percent of the eligible gain may be excluded, assuming the other requirements are met

In contrast, qualified small business stock acquired before July 4, 2025, must generally have been held for at least five years for any gain to be eligible for exclusion under Section 1202.

Under the American Recovery and Reinvestment Act of 2009, the Creating Small Business Jobs Act of 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the American Taxpayer Relief Act of 2012, and the Taxpayer Increase Prevention Act of 2014, the then 50 percent exclusion was increased to 75 percent for stock issued after February 17, 2009 and before September 28, 2010, and to 100 percent for stock issued after September 27, 2010 and before January 1, 2015. The Protecting Americans from Tax Hikes Act of 2015 made the 100 percent exclusion permanent for stock issued after September 27, 2010 and before July 5, 2025.

Limitation on the exclusion

For qualified small business stock acquired after July 4, 2025, the per-issuer limitation for the taxable year is the greater of:

1. 10 times the aggregate adjusted bases of qualified small business stock issued by the corporation and disposed of by the taxpayer during the taxable year or
2. $15 million

The $15 million amount is indexed for taxable years beginning after 2026.

Once the per-issuer limitation on the exclusion of eligible gain of a taxpayer with respect to a corporation is reached, then notwithstanding any increase in the limitation in a subsequent year, including an increase resulting from indexing, the dollar amount of the per-issuer limitation for stock issued by the corporation and acquired by the taxpayer is zero.

For qualified small business stock acquired on or before July 4, 2025, the prior $10 million dollar amount generally continues to apply.

28 percent tax rate on nonexcluded gain

Under the rules applicable to qualified small business stock in which only part of the gain is excluded, the portion of gain included in taxable income may be subject to a maximum 28 percent rate under the regular tax rates applicable to the net capital gain of individuals.

For stock qualifying for the 100 percent exclusion, eligible gain is excluded from gross income, subject to the applicable per-issuer limitation and other Section 1202 requirements.

Short sales

Your qualified small business stock loses its tax-favored treatment if you sell stock short in the qualified small business during the five-year holding period. You can avoid this result if you treat the short sale as an actual sale of a portion of the qualified stock, thus reducing your holdings.

AMT considerations

Under prior law, 7 percent of certain excluded qualified small business stock gain was treated as an alternative minimum tax preference.

For qualified small business stock acquired after September 27, 2010, the 100 percent exclusion rule provides that the minimum tax preference does not apply.

For qualified small business stock acquired after July 4, 2025, the minimum tax preference also does not apply.

Under the Creating Small Business Jobs Act of 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the American Taxpayer Relief Act of 2012, and the Taxpayer Increase Prevention Act of 2014, there is no AMT tax preference for excluded gain for stock issued after September 27, 2010 and before January 1, 2015. The Protecting Americans from Tax Hikes Act of 2015 made the provision for no AMT tax preference for excluded gain for stock issued after September 27, 2010 permanent.

Special considerations

Rollover option

A taxpayer may roll over gain from the sale of one qualified small business stock into another qualified small business stock purchased within 60 days of the sale. However, you must hold the original stock for a minimum of six months.

The basis of the new stock is reduced to the extent of the deferred gain.

Compensation

Qualifying businesses often use their stock as an incentive to attract and maintain key employees. The tax benefit associated with qualified small business stock is available through these arrangements. However, if you are to receive such stock as part of your deferred compensation plan, the holding period will not commence until the value of the stock is included in your income.

Post-OBBBA example

On September 3, 2026, A, an individual, purchases 500 shares of stock of X corporation upon the original issuance of the stock. The stock meets the requirements to be qualified small business stock.

On October 16, 2029, when A has held the stock for at least three but less than four years, A sells the 500 shares of X stock at a gain of $2,500. The applicable percentage of gain eligible to be excluded under the provision is 50 percent, or $1,250.

A acquired the stock after July 4, 2025, the eligible gain is less than the amount of the per-issuer limitation, and A has had no other gain on qualified small business stock in the current or any prior year. A may exclude $1,250 of eligible gain for taxable year 2029.

Prepared by Broadridge Advisor Solutions. © 2026 Broadridge Financial Services, Inc.

RISK DISCLOSURE: Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance does not guarantee future results.

This material is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. The content is developed from sources believed to be providing accurate information; no warranty, expressed or implied, is made regarding accuracy, adequacy, completeness, legality, reliability, or usefulness of any information. Consult your financial professional before making any investment decision. For illustrative use only.

While we specialize in tax planning, please note we do not offer specific tax services; so you will want to consult your tax preparer before implementing any tax planning strategies introduced by us. Any reduction in taxes would depend on an individual’s tax situation.

SECURITY REMINDER: E-mail transmission may not be secure.  If you would like to be contacted by other means please alert Paragon Financial Advisors.  By your use of email, Paragon Financial Advisors assumes you agree to our transmission of information by e-mail.  Please do NOT send Social Security numbers or account numbers, confidential or privileged information via E-mail.

CONFIDENTIALITY NOTICE:  All e-mail sent to or from this address will be received or otherwise recorded by Paragon Financial Advisors and is subject to archival, monitoring or review by, and/or disclosure to the Securities and Exchange Commission. This email and any files transmitted with it are confidential and are intended solely for the use of the individual or entity to which they are addressed. This communication represents the originator’s personal views and opinions, which do not necessarily reflect those of Paragon Advisors. If you are not the original recipient or the person responsible for delivering the email to the intended recipient, be advised that you have received this email in error, and that any use, dissemination, forwarding, printing, or copying of this email is strictly prohibited. If you received this email in error, please immediately notify info@paragon-adv.com