Entrepreneurs creating new businesses have had an important benefit enhanced by the One Big Beautiful Bill Act of 2025 (OBBBA, H.R. 1, P.L. 119-21) – the Section 1202 Small Business Stock capital gain exclusion. There are many tax planning considerations, including the choice of form of entity for the business, and employee stock option considerations.
Qualified Small Business Stock gain exclusion.
Before the adoption of OBBBA, noncorporate taxpayers could exclude from taxable income capital gains from the sale or exchange of qualified small business stock held for more than five years.
Before the change, the exclusion was (still applies for qualified stock acquired before July 5, 2025):
- 100% of the gain for qualified stock acquired after September 27, 2010;
- 75% of the gain for qualified stock acquired after February 17, 2009 and before September 28, 2010; and
- 50% of the gain for qualified stock acquired before February 18, 2009 (increased to 60% of the gain attributable to periods before 2019 if the stock was issued by a corporation in an empowerment zone and acquired after December 21, 2000.)
For stock acquired before September 28, 2010, 7% of the excluded gain is a tax preference item for alternative minimum tax reporting.
Excludable gain on dispositions of qualified stock from any single issuer for a tax year is limited to the greater of (1) $10 million, reduced by the aggregate amount excluded for the issuer’s stock in prior years ($5 million for married, filing separately); or (2) 10 times the taxpayer’s adjusted basis in all of the issuer’s stock disposed of during the tax years.
Gains on dispositions of qualified stock held by a pass-through entity for more than five years is passed through to partners, shareholders and participants who held interests in the entity when it acquired the stock and at all times thereafter. The exclusion can’t reflect any increase in the person’s share of the entity after the entity acquired the stock.
In addition to the exclusion, taxable gains from sales of qualified stock may be deferred under Internal Revenue Codes Section 1045 by reinvesting the sale proceeds in stock of another qualified small business within 60 days after the sale.
Qualified small business stock is stock issued after August 10, 1993, and acquired by the taxpayer at the original issue, directly or through an underwriter, in exchange for money or property, or as compensation for services provided to the corporation. The issuing corporation must be a domestic C corporation other than a regulated investment company, cooperative, or other pass-through corporation.
Both before and immediately after the qualified stock is issued, the corporation’s aggregate gross assets must not exceed $50 million, with parent-subsidiary controlled groups treated as one corporation. During substantially all of the taxpayer’s holding period, at least 80% of the value of the corporation’s assets must be used in the active conduct of qualified trades or businesses.
A qualified business does not include the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business if its principal asset is the reputation or skill of employees. Hospitality, farming, insurance, finance and mineral extraction also are not qualified businesses.
Note that retail, manufacturing, and research to develop a product are qualifying businesses.
How OBBBA changes the thresholds.
OBBBA changes the gain exclusion by creating tiers, effective for stock issued or acquired and to tax years commencing after July 4, 2025. The exclusion ratios are 50% after three years, 75% after four years, and 100% after five years. The per-issue dollar cap for post-enactment shares is increased from $10 million to $15 million reduced by the aggregate amount excluded for the issuer’s stock in prior years ($7.5 million for married persons filing separately), indexed for inflation after 2026. The post-enactment aggregate-asset ceiling is increased from $50 million to $75 million, indexed for inflation after 2026.
There is no alternative minimum tax preference for the excluded gains for these shares.
The higher asset ceiling means the stock of more corporations will qualify for the exclusion.
Shareholders who have capital gains from sales of qualified small business stock will be eligible to exclude more of their gains from taxable income.
The holding period requirement to qualify for a partial exclusion has been relaxed, so more sales of qualified small business stock will qualify for some exclusion from taxable income.
In the past, the thresholds haven’t been indexed for inflation. Under OBBA, the thresholds will be automatically increased for inflation after 2026.
Family tax planning tip.
Giving family members cash to purchase qualified small business stock can increase the exclusion threshold for the family. (Up to $15 million per family member.)
Choice of entity considerations.
Making a decision about what form a business should be requires having a long-term horizon and a crystal ball.
According to a Bureau of Labor Statistics report in 2024, about 20% of startups that opened for business in 2013 failed during the first year. About 39% of startups failed within the first three years. About 50% of startups failed within the first five years. About 65% failed within the first ten years. It seems the odds are against realizing a gain from the sale of startup stock. Only a handful of shareholders do.
To qualify for small business stock to qualify for the exclusion, it must be issued by a corporation that qualifies when the stock is issued. The corporation that issues the stock must be a regular “C” corporation (including an LLC that elects to be taxed as a C corporation – most don’t.) Stock issued by an “S” (passthrough entity) corporation doesn’t qualify, but stock issued by a former S corporation after terminating its S election and becoming a C corporation can qualify.
Why is this important?
Business startups typically generate losses during their first few years. Losses of a C corporation are “locked” in the business and aren’t deductible for its owners. Losses of passthrough entities are eligible to be deducted on the income tax returns of their owners, subject to limitations like basis limitations, passive activity loss limitations, and at risk limitations.
Owners of general partnerships and sole proprietorships include their shares of “at risk” debt in their investment for the limitation for deducting business losses. (If the business fails, they are liable for the debt.)
Passthrough entities aren’t subject to double taxation, like C corporations. The owners pay income taxes on the entity’s taxable income and add that income to their tax basis (cost for computing taxable gain) for the sale of their ownership interest.
Partnerships and sole proprietorships have an advantage of being able to possibly liquidate by distributing their assets tax-free.
For businesses whose business plans don’t include having a public offering of their shares or selling the business at a multiple asset value for the foreseeable future, these are good reasons to choose passthrough structures, not C corporations.
For businesses that are adequately capitalized and are developing significant intellectual property or significant net income for a high multiple valuation that is expected to be sold soon after five years, or that plan to make a public offering of their shares, C corporations look more attractive.
Employee Stock Options and the Qualified Small Business Stock Capital Gain Exclusion.
The Ninth Circuit Court of Appeals has confirmed the Tax Court in holding employee stock options don’t qualify as stock for the Small Business Stock Capital Gain Exclusion. The court also ruled the holding period of employee stock options before exercising them isn’t included for the 5-year holding period requirement. The shares must be owned to start the clock.[1]
Any ordinary income for stock acquired by exercising an employee stock option isn’t eligible for the Small Business Stock Capital Gain Exclusion.
As explained below, determining when the holding period begins becomes complicated when employee stock options have a vesting schedule and the employer or other option granter permits an early exercise of employee stock options. For nonqualified stock options, the employee may elect under Section 83(b) to treat the early exercise as taxable for regular tax and alternative minimum tax reporting. When that election is made, the holding period starts on the date of exercise. When that election isn’t made, the holding period starts on the later of the vesting date or the date of exercise.
For incentive stock options, the regular tax holding period starts on the date of exercise, regardless of vesting. The Section 83(b) election to treat the early exercise as taxable only applies for the alternative minimum tax and the option is treated as a nonqualified option for alternative minimum tax reporting. (The holding period might start on different dates for regular tax and AMT reporting. Note there is no AMT adjustment relating to most Small Business Stock Capital Gain Exclusions. For stock acquired before September 28, 2010, 7% of the excluded gain is a tax preference item for alternative minimum tax reporting.)
[1]Natkunanathan v. Commissioner, 110 AFTR 2d 2012-5193, July 12, 2012.
