For most high-earning technology professionals, the largest financial event of their career is not a salary. It is a liquidity event: an acquisition, a tender offer, or an initial public offering that turns years of equity into cash. How much of that equity you keep, rather than pay in taxes, often comes down to a single provision of the tax code that many employees have never heard of.
That provision is the Qualified Small Business Stock exclusion under Section 1202. In the right circumstances, it can make a substantial portion of your gain entirely free of federal tax. In 2025, federal legislation expanded it in ways that make it more accessible and more valuable than it has been in over a decade. If you hold or expect to receive stock in a private company, the changes are worth understanding now, well before any exit.
What QSBS Is, In Plain Terms
Section 1202 allows eligible shareholders to exclude gain from the sale of stock in certain small C corporations. To qualify, the stock generally must be acquired at original issuance directly from the company, the company must be a domestic C corporation engaged in an active qualifying business, and a number of other requirements must be met throughout the holding period.
The exclusion was designed to reward people who take the risk of backing or building young companies. For founders and early employees, it has long been one of the most powerful tax benefits available anywhere in the code. The recent changes widen the door considerably.
What Changed in 2025
The expanded rules apply to stock acquired after July 4, 2025. Stock acquired on or before that date continues to follow the older rules. This distinction matters, and we will return to it.
For stock acquired after that date, three things improved.
- A shorter, tiered holding period. Under the old rules, you had to hold QSBS for more than five years to exclude any gain. Now there is a graduated schedule: a 50% exclusion after three years, a 75% exclusion after four years, and the full 100% exclusion after five years. The five-year payoff is still the best outcome, but partial benefits are now available years earlier.
- A higher exclusion cap. The amount you can exclude per company rose from the greater of ten million dollars or ten times your basis, to the greater of fifteen million dollars or ten times your basis. Beginning in 2027, the fifteen million dollar figure is indexed for inflation.
- A broader definition of a qualifying company. The limit on a company’s gross assets at the time the stock is issued rose from fifty million dollars to seventy-five million dollars, also indexed for inflation starting in 2027. This brings a wider range of growth-stage startups within reach, so employees at larger and later companies may now hold qualifying stock where they previously could not.
The Two-Regime Problem
Because the new rules apply only to stock acquired after July 4, 2025, many people will end up holding two different kinds of QSBS in the same company: older shares under the prior rules and newer shares under the expanded ones.
These blocks have to be tracked separately. They can carry different holding-period requirements, different exclusion percentages, and different caps. You generally cannot reset the clock on older stock by exchanging it for new stock to capture the more favorable terms. For anyone with equity granted or exercised across multiple years, careful recordkeeping is no longer optional. It is the difference between claiming the benefit and losing it in an audit.
The Tax Math on Partial Exclusions
The new three-year and four-year tiers are valuable, but they are not as clean as the full five-year exclusion. When you exclude only 50% or 75% of the gain, the portion that remains taxable is taxed at a 28% federal rate rather than the usual long-term capital gains rate, and the net investment income tax of 3.8% may also apply.
In practice, that produces an effective federal rate of roughly 15.9% on a sale at the three-year mark and roughly 7.95% at the four-year mark, compared with zero federal tax on the excluded portion at five years. Excluded QSBS gain is generally not treated as an alternative minimum tax preference item under the new rules, which removes a complication that existed in earlier versions of the law. The point is that waiting to cross the next threshold can change your result significantly, and the timing of a sale deserves real analysis rather than a reflexive decision to sell at the first opportunity.
The California Problem
This is the part that surprises many technology professionals, and it is especially important for those living and working in California.
California does not conform to Section 1202. The state explicitly declines to recognize the QSBS exclusion and taxes the entire gain as ordinary income, at rates reaching 13.3%. This is true even when your federal tax on the same gain is zero.
The practical effect is large. A fully excluded ten million dollar federal gain can still generate well over one million dollars of California tax. Founders and employees often assume that a clean federal exclusion means a clean exit. In California, it does not.
A common question is whether incorporating the company in a more favorable state solves this. It does not, because state tax on the gain generally follows the residency of the seller, not the location of the company. The levers that actually move the California outcome are different, and they require planning well ahead of a sale.
The Planning Levers Worth Knowing
None of the following is a recommendation, and each carries conditions and risks that require professional guidance. They are the strategies sophisticated founders and employees explore with their advisors, ideally long before a transaction is on the horizon.
- Holding-period timing. Because the exclusion now steps up at three, four, and five years, the calendar around a sale can be worth a great deal. Knowing exactly when each block of stock crosses each threshold is foundational.
- Section 1045 rollover. If you need to sell before reaching the holding period, reinvesting the proceeds into new qualifying stock within sixty days can defer the gain and preserve the path to an eventual exclusion.
- Exclusion stacking with trusts. Because the cap applies per taxpayer and per company, gifting shares to one or more properly structured non-grantor trusts can multiply the total exclusion available across a family. Where those trusts are situated can also affect state tax exposure, though California applies its own rules to trust income and these structures must be built with care.
- Charitable giving. Donating appreciated QSBS to a donor-advised fund or charitable trust before a sale can produce a federal deduction while addressing the portion of gain that would otherwise be taxable, including at the state level.
- Residency planning. A genuine change of residence before a sale can change the state tax result, but California scrutinizes these moves aggressively. A short-term relocation around a transaction is unlikely to survive review. A real, well-documented move made well in advance is a different matter.
- Entity and conversion timing. Companies that begin as LLCs sometimes convert to C corporations to turn on QSBS eligibility. The conversion must be structured carefully to preserve original-issuance treatment and to start the holding-period clock correctly.
Who Should Be Paying Attention
If you are a founder, an early employee with exercised options, an investor in private companies, or someone who expects to receive equity in a venture-backed startup, QSBS may be among the most valuable planning opportunities available to you. The employees who capture the full benefit are almost always the ones who understood the rules early, kept clean records, and coordinated their decisions before the exit rather than after.
It is also worth confirming eligibility rather than assuming it. Certain businesses, including many in services, finance, and a handful of other categories, do not qualify, and stock bought on the secondary market generally does not receive original-issuance treatment. The details determine everything.
A Long-Term Perspective
Equity is how wealth is created in technology, and tax is the largest cost most people will ever pay against it. The expansion of Section 1202 has made one of the best benefits in the code more flexible and more generous, but it has also added complexity, two parallel sets of rules, and a state-level trap that can quietly erase a large share of the benefit for California residents.
The value lies in coordination. The federal exclusion, the state exposure, the holding-period timing, and any trust or charitable structure all interact, and they are far easier to optimize before a transaction than to repair afterward.
At Carrara, we help technology professionals plan around concentrated equity and liquidity events, working alongside tax and legal advisors so that the strategy is in place well before the exit, when the opportunities are greatest.
This article is provided for educational purposes only and does not constitute tax, legal, or investment advice. Tax laws are complex, vary by state, and continue to change. QSBS eligibility depends on specific facts. Please consult qualified tax, legal, and financial advisors regarding your particular situation.