QSBS §1202 — Up to $10M Tax-Free on Your Founder Exit

The most under-used founder exit benefit

IRC §1202 — the Qualified Small Business Stock (QSBS) exclusion — lets a qualifying founder exclude up to $10 million OR 10× their basis (whichever is greater) of capital gain on the sale of their C-corp founder stock. Tax-free at the federal level. Held for 5+ years. Codified since 1993, expanded to 100% exclusion in 2010.

For a California founder selling a successful startup exit, this can be the difference between $3M and $0 in federal tax — and it’s the one IRS-blessed exclusion that doesn’t require any structure, trust, or annuity.

Who qualifies — the 5 §1202 tests

1. C-corporation. The company must be a domestic C-corp (NOT an S-corp or LLC). If your startup is an S-corp or LLC at exit, §1202 doesn’t apply.
2. Founder/employee stock, not options. The stock must be ORIGINAL ISSUE acquired directly from the company (founder stock, ISO/NSO exercise BEFORE exit, regulated private placement). Stock bought from another shareholder doesn’t qualify.
3. Held 5+ years. Continuous holding period of 5 years from issuance date. Stock issued less than 5 years before sale gets ZERO §1202 exclusion (but see §1045 rollover below).
4. Company under $50M gross assets. At the time the stock was issued, company’s aggregate gross assets must have been under $50M. Most pre-seed/seed/Series A startups qualify.
5. Active business in qualified industry. Company must use 80%+ of assets in a qualified trade or business. Excluded: financial services, professional services (law/accounting/consulting), real estate, farming, mining, hospitality.

The math: $10M cap OR 10× basis (whichever is greater)

The exclusion limit is the GREATER of:

• $10 million per issuer per taxpayer (lifetime), OR
• 10× the aggregate adjusted basis of QSBS stock sold in that tax year

For a founder who got 1M shares at $0.0001 basis ($100 total cost), the 10× cap = $1,000. So the $10M cap controls — $10M of gain excluded. Above $10M, normal capital-gains tax applies on the excess.

Example — California founder, $15M exit

Item	Amount
Sale of founder stock	$15,000,000
Cost basis (original purchase)	$100
Capital gain	$14,999,900
§1202 exclusion (federal, capped at $10M)	−$10,000,000
Remaining taxable gain	$4,999,900
Federal tax on remaining (20% + NIIT 3.8%)	−$1,189,976
California state tax (~13.3% on FULL $15M gain — CA does NOT conform to §1202)	−$1,994,987
Net to founder	$11,815,037

The federal §1202 exclusion saves ~$2.38M (the federal tax that would otherwise apply to the first $10M). California still taxes the full gain at ordinary rates — California does NOT conform to §1202 for individual sellers.

⚠ California-specific gotcha: no state conformity

California, Pennsylvania, Massachusetts, Mississippi, New Jersey, and a few others do not conform to the federal §1202 exclusion. A California founder still owes CA marginal income tax on the FULL gain — even the portion that’s federally tax-free.

For a $15M California exit, that means $1.99M in CA tax even with the full $10M federal exclusion. This is where stacking §1202 with the SIS makes sense — to spread the California portion across multiple years.

The §1202 + SIS stacking play

Most §1202-qualifying founders can:

1. Claim the federal $10M exclusion in Year 1 (tax-free at federal level)
2. Structure the residual gain as an SIS to spread the California state tax across 10-30 years at low CA marginal rates
3. Take a cash carve-out at closing for immediate needs (downpayment on a house, paying off debt, etc.)

For a founder with $15M of qualified gain who has no immediate cash need, the optimal structure is: claim $10M §1202 exclusion + structure remaining $5M as 20-year SIS + ~$1M cash carve-out for liquidity = roughly $13M net (vs ~$11.8M from straight cash sale at California rates).

The §1045 rollover (when you can’t hold 5 years)

If you didn’t hold the QSBS for the full 5-year period required by §1202, you can use IRC §1045 to roll over the gain into REPLACEMENT QSBS within 60 days of sale. The new QSBS inherits your holding period from the old. After 5 total years (counting both the old and new holding periods), you can sell with the §1202 exclusion.

Common use case: company gets acquired at year 4. Roll the gain into a new QSBS investment, hold for 1+ more year, sell with the full exclusion.

The §1244 ordinary-loss flip side

If your QSBS-eligible startup FAILS (worth $0 at exit), §1244 lets you claim up to $50K single / $100K MFJ as an ORDINARY LOSS (rather than capital loss limited to $3K/yr). Combine with regular capital-loss treatment for the rest. Founder downside protection that pairs naturally with §1202’s upside.

The 5 things every QSBS-eligible founder should do BEFORE the exit

1. Verify the C-corp election was in place for the entire holding period. If the company converted from LLC to C-corp at year 2 and you sell at year 5, you only have 3 years of QSBS holding — doesn’t qualify for full §1202.
2. Get a §1202 qualification letter from the company. The company should certify in writing that gross assets were under $50M when YOUR stock was issued. Memorialize at the time of stock issuance, not at sale.
3. Track basis carefully. Founder stock often has near-zero basis but employee stock from ISO exercises has the strike price as basis. Keep records.
4. Coordinate with your CPA on the year of sale. §1202 has interaction effects with AMT (alternative minimum tax) — 7% of the excluded gain is an AMT preference item for stock acquired before Sept 28, 2010 (post-2010 stock = 0% AMT). Plan accordingly.
5. For amounts above $10M, plan the structure BEFORE closing. The residual gain above the §1202 cap can be SIS-structured. But the SIS assignment paperwork must be in place before escrow opens. See the SIS timing rules.