How the One Big Beautiful Bill Act expands exclusions for gains on small business stock
The OBBBA expands the scope and benefits of this provision designed to incentivize investment in startups and small businesses. Under section 1202, it mainly enacts the following three changes applicable to QSBS issued after July 4, 2025:
- A tiered exclusion correlated to shorter holding periods
- An increased per-issuer limitation
- An increased gross asset threshold for qualification
Tiered exclusion correlated to shorter holding periods
The OBBBA reduces the holding periods required to benefit from QSBS exclusions. Now, investors can enjoy a 50% exclusion for stock held for at least three years, 75% exclusion for stock held for at least four years, and 100% exclusion for stock held for at least five years. This makes QSBS more attractive by allowing investors to realize tax benefits sooner.
With the OBBBA’s new 50% or 75% exclusion, the includible gain on sale of QSBS with a three- or four-year (but less than five-year) holding period is subject to a 28% capital gains rate, which is higher than the standard capital gains rate of 15% or 20% on the sale of nonqualifying stock.
For QSBS subject to the 50% exclusion, this would result in a 14% rate on such gain (and for QSBS subject to the 75% exclusion, a 7% rate). (Of the gain on the sale of QSBS held for more than three years but less than four, 50% is excluded while 50% will be subject to the 28% capital gains rate, resulting in a blended effective rate of 14%.) In addition, the gain not excluded may also be subject to the net investment tax.
Increased per-issuer limitation
The OBBBA raises the cap on the amount of gain that a taxpayer may exclude from taxation. Prior to the change, that cap was generally the greater of either $10 million or 10 times the basis of the stock sold. Under the OBBBA, the $10 million component of the cap is increased to $15 million. Calculating the excludable gain is similar under the increased cap to how it was calculated prior to the change.
This higher exclusion cap allows investors to shield more of their gains from taxes, making investments in qualified small businesses even more appealing.
Increased gross asset threshold for qualification
The asset threshold for a company to qualify as a small business under section 1202 (in other words, the amount of assets a company may hold and still qualify to issue QSBS) has been increased from $50 million to $75 million. This change allows larger startups to qualify for QSBS benefits, broadening the range of companies that can attract investment under these favorable tax conditions.
More favorable exclusions for small business stock: Implications for small businesses and their investors
For small and midsize businesses, especially those structured as C corporations or considering incorporation, the expanded QSBS benefits could significantly enhance their appeal to investors. The shorter holding periods align better with the investment cycles of many private equity firms, making equity investments more appealing and potentially unlocking new sources of capital. This is particularly relevant for businesses in high-growth sectors like technology, life sciences, and advanced manufacturing.
For investors, the ability to realize partial exclusions after just three or four years aligns better with typical investment horizons and reduces the risk profile of QSBS investments. It also allows for more dynamic portfolio management, enabling earlier exits without forfeiting all tax benefits. Overall, this makes QSBS a more viable strategy for portfolio companies. In turn, this could lead to increased funding for startups and growth-stage businesses, especially in sectors in which early exits are common, such as life sciences and technology.
What small businesses should do in the short and long term
Short term: Businesses and their advisors should take proactive steps to assess their eligibility under the revised section 1202 rules:
- Evaluate entity structure: Businesses operating as partnerships or S corporations may want to explore converting to C corporation status to take advantage of the QSBS exclusion.
- Document qualification early: Establishing and maintaining documentation that supports QSBS eligibility—such as gross asset valuations and business activity classifications—is crucial, especially for businesses nearing the $75 million threshold.
- Review capitalization strategies: Companies should consider how new equity infusions, redemptions, or reorganizations might affect QSBS status.
Long term: The OBBBA’s expansion of section 1202 may influence how small businesses plan for growth and exit. Consider the following:
- Capital strategy: Businesses should consider how QSBS eligibility can be used as a selling point when raising capital.
- Exit planning: Founders and early investors should incorporate QSBS timelines into their exit strategies to maximize tax efficiency.
- Compliance and monitoring: As the IRS issues further guidance, businesses must stay informed and adapt their practices to remain compliant.
What investors should do in the short and long term
Short term: The OBBBA’s expansion of small business stock exclusion benefits may open new doors for investors, but they also may require a more nuanced approach to due diligence and portfolio strategy. These immediate steps can help investors make the most of the updated QSBS framework:
- Reevaluate holding period strategies: With partial exclusions now available at three and four years, investors should revisit their exit timelines. While the full 100% exclusion still requires a five-year hold, the ability to realize 50% or 75% exclusions earlier may justify earlier exits in certain scenarios—especially when weighed against market conditions or liquidity needs.
- Incorporate QSBS eligibility into deal screening: Investors should assess whether target companies qualify for QSBS treatment early in the deal process. This includes verifying C corporation status, gross asset thresholds, and business activity classifications. Deals that meet these criteria may offer superior after-tax returns.
- Coordinate with portfolio companies: Investors should work closely with portfolio companies to ensure they maintain QSBS eligibility throughout the investment period. This includes monitoring redemptions, recapitalizations, and changes in business activity that could jeopardize qualification.
- Clarify partnership attribution rules: For investors holding QSBS through partnerships or funds, it’s essential to understand how the new rules affect attribution and eligibility. The OBBBA retains the look-through rule, but the IRS may issue further guidance that could impact how gains are allocated and excluded.
- Document everything: Investors should maintain thorough records of stock acquisition dates, valuations, and corporate qualifications. This documentation will be crucial in substantiating QSBS claims during an audit or sale.
Long term: Investors should consider how QSBS eligibility fits into broader portfolio strategy, fund structuring, and exit planning. Consider the following steps:
- Integrate QSBS into fund design: Investment funds—particularly those targeting early-stage or growth-stage companies—should consider structuring themselves to maximize QSBS benefits. This may involve revisiting fund documentation, holding company structures, and the timing of capital deployment to ensure alignment with QSBS requirements.
- Educate portfolio companies: Investors can proactively help portfolio companies maintain QSBS eligibility. This includes advising on entity structure, tracking gross assets, and avoiding disqualifying activities. A well-informed portfolio is more likely to preserve the tax benefits that investors are counting on.
- Plan for layered exits: With partial exclusions now available at three and four years, investors may consider staggered exit strategies that balance liquidity needs with tax optimization. This could involve secondary sales, recapitalizations, or phased divestitures that align with QSBS holding periods.
- Build QSBS into value propositions: For investors raising new funds or courting co-investors, the enhanced QSBS benefits can be a compelling part of the value proposition. Demonstrating a clear strategy for identifying and managing QSBS-eligible investments may differentiate a fund in a competitive capital environment.
- Monitor regulatory developments: The IRS will likely issue further guidance on the QSBS provisions, especially around qualifying business activities and the gross assets rule partnership attribution, redemptions, and qualifying business activities. Investors should stay engaged with tax advisors and industry groups to anticipate and respond to these developments.
