The One Big Beautiful Bill Act (OBBBA) substantially boosts the already significant tax break provided to qualified small business stock (QSBS) investors covered in Section 1202.
Section 1202 allows investors in small businesses to shield a portion of the gain from being taxed when they sell the stock. This tax legislation encourages investment in small businesses because the changes double down on this incentive, making it an even more appealing proposition.
Pre-OBBBA Gain Exclusion Criteria
Prior to the OBBBA, for stock to be considered QSBS and therefore eligible for this gain exclusion, it needed to follow these strict requirements:
- The stock held must have been in an entity taxed as a domestic C corporation.
- The stock must have been acquired from the corporation by direct issue.
- The corporation’s aggregate gross assets could not exceed $50 million.
- At the time the stock was acquired, the corporation must have been operating an active trade or business.
- The stock must have been owned over a five-year holding period.
For individuals who held this qualifying stock, the available gain exclusion was computed as the greater of:
- $5 million for married couples filing separately and $10 million for married couples filing jointly.
- 10 times the adjusted basis of the stock sold in the year.
OBBBA Modifications
The enhanced benefits featured in the OBBBA more favorably define what qualifies as QSBS and offer greater benefits to those who qualify. The following modifications were made.
Tiered Gain Exclusion Based on Holding Period
Prior to the OBBBA, Section 1202 was an all-or-nothing qualifier regarding the holding period. If an investor held the stock less than five years before sale, it would not qualify for the tax break. If held for five years or more, though, it would qualify.
For stock acquired after July 4, 2025, shareholders can benefit from tax exclusions based on the duration of holding the stock. After three years, they may exclude 50% of the gain. Holding the stock for four years allows for a 75% exclusion, and after five years, shareholders can exclude 100% of the gain.
Increased Lifetime Cap on Gain Exclusion
Previously, when the stock was sold, the gain that could be shielded from taxation was the greater of two numbers: 10 times the adjusted basis of the stock sold or $10 million. The OBBBA modifies the $10 million component to $15 million, and the modification will be indexed annually for inflation. This allows QSBS acquired after July 4, 2025, to see an even greater tax-free gain when the stock sells.
Corporate-Level Gross Assets Ceiling Increased to $75 Million
Under the old rules, for a company to qualify as a small business under Section 1202, the gross assets could not exceed $50 million. The OBBBA increases the threshold to $75 million, significantly expanding the pool of companies that could fall under this definition of QSBS.
Overall, these enhanced and expanded tax breaks under Section 1202 make investing in small businesses an even more attractive endeavor.
Since these benefits would only be available for stock in C Corporations, new companies should certainly consider the potential tax incentives down the line when it comes to selecting an entity structure.
For questions about your qualified small business stock or to learn more about the changes in the OBBBA, contact your RKL advisor.
