Qualified Small Business Stock (QSBS): Definition and How It Works in California

By Eric Ridley, attorney, Ridley Law. Updated October 2026.

Qualified small business stock (QSBS) is C corporation stock whose gain a seller who holds it long enough can partly or fully exclude from federal income tax. The rule is section 1202 of the Internal Revenue Code, and California does not follow it.

How it works in California

Ridley Law’s guide QSBS, Section 1202, and California has more. Under 26 U.S.C. § 1202, stock acquired after July 4, 2025 gets a 50 percent exclusion after three years, 75 percent after four and 100 percent after five. Stock acquired earlier needs more than five years. The excluded gain per company is capped at the greater of $15 million for newer stock ($10 million for older stock), with the $15 million indexed after 2026, or 10 times the stock’s basis (§ 1202(b)). For stock issued after July 4, 2025, the company’s gross assets can’t exceed $75 million before and immediately after the issuance. The limit was $50 million before that.

California doesn’t conform. The Franchise Tax Board’s Schedule D (540) instructions say California does not conform to the section 1202 exclusion and tell filers to enter the entire gain. A Californian who sells QSBS can owe no federal tax on the gain and full California income tax on it.

Why it matters

The cap applies to each taxpayer, so families sometimes give shares to children or to separate nongrantor trusts so that each holder has its own cap, a practice called stacking. A recipient by gift is treated as having acquired the stock the same way, and for the same holding period, as the donor (§ 1202(h)). Stacking helps only on the federal side, since California taxes the gain regardless of who holds the stock.

Common mistakes

Giving shares to a grantor trust and expecting a second cap. A grantor trust’s income is generally reported by the grantor. Letting the company buy back stock from the holder or a related person around the time of issuance, which can disqualify the stock (§ 1202(c)(3)). And assuming California follows the federal exclusion.

Related terms

• Incomplete Gift Nongrantor Trust (ING Trust): nongrantor trusts used for stacking need care in California, which taxes ING trust income to the grantor.
• Grantor Trust: a gift to a grantor trust doesn’t create a separate taxpayer with its own QSBS cap.
• Step-Up in Basis: the other way built-in gain disappears: a new basis at death instead of an exclusion.

Part of the California estate planning glossary. For the full treatment, see QSBS, Section 1202, and California.