QSBS, Section 1202, and California

Founders and early investors hear about Section 1202 as the rule that makes a startup exit tax-free. For federal tax, it can be. For a California resident, it isn’t, and the gap can run to seven figures on a single sale. I’m not a CPA and I don’t prepare returns or give investment advice. I form corporations, draft the stock documents that Section 1202 depends on, and fold founder stock into estate plans, so this page explains the law on both sides and ends with the questions to take to your tax advisor. It’s part of my series on keeping a California company in good standing, which starts with the California LLC annual requirements page.

What is QSBS under Section 1202?

Qualified small business stock is stock in a C corporation that a noncorporate taxpayer acquired at original issue, and Section 1202 lets that holder exclude some or all of the gain on sale from federal income. The stock must be issued by a domestic C corporation that meets the gross assets test when the stock is issued, and acquired at original issue for money, property other than stock, or services (26 U.S.C. § 1202(c)(1)).

The corporation also has to stay qualified. During substantially all of your holding period, it must be a C corporation and meet the active business requirement (26 U.S.C. § 1202(c)(2)(A)). Under that requirement, at least 80 percent of its assets, by value, are used in the active conduct of one or more qualified trades or businesses (26 U.S.C. § 1202(e)(1)(A)).

The federal requirements at a glance

Requirement	Rule	Authority
Entity	Domestic C corporation, for substantially all of the holding period	26 U.S.C. § 1202(c)(2), (d)(1)
How you got the stock	At original issue, for money, property (not stock), or services	26 U.S.C. § 1202(c)(1)(B)
Size	Aggregate gross assets of $75 million or less before and immediately after issuance, for stock issued after July 4, 2025 ($50 million before)	26 U.S.C. § 1202(d)(1); Pub. L. 119-21 amendment note
Active business	At least 80% of assets used in a qualified trade or business	26 U.S.C. § 1202(e)(1)
Holding period	At least 3 years for stock acquired after July 4, 2025; more than 5 years for earlier stock	26 U.S.C. § 1202(a)(1), (b)(2)
Cap per issuer	Greater of $15 million ($10 million for earlier stock) or 10 times basis	26 U.S.C. § 1202(b)(1), (b)(4)

Which businesses don’t qualify?

A long list of service and asset-heavy businesses. The statute excludes any trade or business involving services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services, and any business whose principal asset is the reputation or skill of its employees (26 U.S.C. § 1202(e)(3)(A)).

It also excludes banking, insurance, financing, leasing, investing, and similar businesses, farming, businesses producing products eligible for depletion deductions, and operating a hotel, motel, restaurant, or similar business (26 U.S.C. § 1202(e)(3)(B) to (E)). In Ventura County that rules out a lot: the medical group, the engineering firm, the family farm, and the restaurant. Technology, manufacturing, and many product companies are the typical fits.

What changed in 2025?

The One Big Beautiful Bill Act, Public Law 119-21, signed July 4, 2025, expanded Section 1202 for stock acquired after that date. The FTB’s summary lists the changes: a tiered exclusion after three and four years, a cap of $15 million instead of $10 million, and a gross assets limit of $75 million instead of $50 million, with both limits adjusted for inflation beginning in 2027.

Years held (stock acquired after July 4, 2025)	Federal exclusion
At least 3 years	50%
At least 4 years	75%
5 years or more	100%

That table is the statute’s (26 U.S.C. § 1202(a)(1)(B), (a)(5)). Stock acquired on or before July 4, 2025 keeps the older rules. For stock acquired after September 27, 2010 and on or before July 4, 2025, the exclusion is 100 percent after more than five years (26 U.S.C. § 1202(a)(4)).

The per-issuer cap for newer stock is $15 million, indexed for years after 2026, or 10 times your basis if that’s greater (26 U.S.C. § 1202(b)(1), (b)(4)(B)). The $75 million gross assets limit is also indexed after 2026 (26 U.S.C. § 1202(d)).

Does California follow Section 1202?

No. The California statute is one sentence: Section 1202 of the Internal Revenue Code, relating to the 50-percent exclusion for gain from certain small business stock, does not apply (Rev. & Tax. Code § 18152).

The FTB’s analysis of the 2025 federal law is as direct. Asked “Does California Conform?” for the Section 1202 expansion, it answers no, and says California does not conform to the federal small business stock exclusion, so it doesn’t conform to the 2025 changes either. California’s own taxation of the gain doesn’t depend on which federal version applies. The whole gain is in.

The FTB’s Schedule CA instructions list gain on the sale of qualified small business stock under IRC Sections 1045 and 1202 among the items where the California gain or basis can differ from federal. Section 1045 is the federal rule that lets you defer QSBS gain by rolling into new QSBS. Ask your CPA how any federal rollover is being reported for California.

How California taxes the gain

As ordinary income. The FTB says California has no lower rate for capital gains and taxes all capital gains as ordinary income. Its rates range from 1 percent to 12.3 percent, plus an additional 1 percent tax on the portion of taxable income over $1,000,000, for a top rate of 13.3 percent, according to the FTB. The 1 percent tax is in Rev. & Tax. Code § 17043(a).

What does California’s nonconformity cost? A worked example

A founder in Westlake Village received common stock at formation of a Delaware C corporation in 2019, paying $100,000. The company is a software business with well under $50 million of gross assets. In 2026 she sells the stock for $12.1 million, a $12 million gain, and she’s a California resident all year.

	Federal	California
Gain	$12,000,000	$12,000,000
Excluded	$10,000,000 (the $10 million cap for pre-July 2025 stock, which beats 10 times her $100,000 basis)	$0 (Rev. & Tax. Code § 18152)
Taxable	$2,000,000	$12,000,000

California taxes all $12 million as ordinary income. Most of it falls in the 13.3 percent bracket, so her California tax on the sale approaches $1.6 million, before any other income or deductions. The federal treatment of the $2 million that isn’t excluded is a question for her CPA.

The same founder under the new rules

Now suppose the stock had been issued in August 2025 and she sells in September 2028, a little over three years later. Federally, 50 percent of the eligible gain is excluded (26 U.S.C. § 1202(a)(1)(B)). California still excludes nothing. The 2025 law made the federal answer better at three and four years, and left the California answer where it was.

What if I move out of California before I sell?

That’s a residency question, and it’s harder than it sounds. For a nonresident, California gross income includes only income from sources within California (Rev. & Tax. Code § 17951(a)). Whether you’re a nonresident on the sale date, and where the gain is sourced, depend on facts the FTB examines closely when the numbers are large.

I don’t give relocation advice for tax purposes. If a move is on the table, bring it to a CPA or tax attorney who handles California residency audits, well before any letter of intent is signed. Leaving the state has estate planning consequences too, because your trust and powers of attorney were drafted for California law.

Can an LLC or S corporation issue QSBS?

No. The stock has to be in a C corporation, and the corporation must be a C corporation during substantially all of your holding period (26 U.S.C. § 1202(c)(2)(A)). An LLC taxed as a partnership has no stock. An S corporation has stock, but it isn’t a C corporation.

Converting an LLC to a C corporation

Converting can start the clock, with a limit. If you transfer property to a corporation for its stock, the stock is treated as acquired on the date of the exchange, and its basis is treated as no less than the fair market value of the property you contributed (26 U.S.C. § 1202(i)(1)). The practical result: appreciation that built up inside the LLC before conversion isn’t eligible for the exclusion. Only growth after the conversion is.

For gross assets, contributed property is also counted at fair market value when contributed (26 U.S.C. § 1202(d)(2)(B)). A valuable LLC can be too big to qualify on the day it converts. My pages on C corp vs. S corp for a California small business and LLC vs. S corp in California cover it.

What records protect a Section 1202 claim?

The ones created at issuance. The exclusion turns on facts from years earlier: how and when you got the stock, what you paid, and what the company’s gross assets were at the time. Corporate records prove each of them, and drafting those records is the part of Section 1202 I work on.

• Board approval of each issuance, with the date, number of shares, price, and what was paid.
• A stock ledger showing original issuance to you, not a later transfer from another shareholder.
• Proof of payment: the wire, the property assignment, or the services agreement.
• A gross assets snapshot at each issuance, computed as cash plus adjusted basis of other property (26 U.S.C. § 1202(d)(2)(A)).
• Redemption history. Certain purchases of stock by the corporation from you or related persons, or redemptions of more than 5 percent of the stock by value in the two-year window starting a year before the issuance, can disqualify stock (26 U.S.C. § 1202(c)(3)).
• Any 83(b) election filed for restricted founder stock. Keep the copy, and have your CPA confirm how it bears on the holding period.

How does QSBS fit into an estate plan?

Federally, QSBS status survives a gift or death. A person who receives the stock by gift or at death is treated as having acquired it the same way as the transferor, and gets credit for the transferor’s holding period (26 U.S.C. § 1202(h)(1), (h)(2)).

That’s why federal planners gift QSBS to children or trusts before a sale. The per-issuer cap applies per taxpayer, so each recipient may have a separate cap (26 U.S.C. § 1202(b)(1)). Whether that works for your family depends on gift tax, trust design, and timing, and your CPA and I would work on it together. My page on gift tax in 2026 covers the federal gift rules.

For California, none of this helps with Section 1202 itself, because California doesn’t apply it to anyone. A trust holding founder stock is still worth having for probate avoidance and control, and the stock has to be assigned into the trust to count. See business succession planning in California and trust funding.

What should I ask my CPA?

Bring these to your CPA or tax attorney before a sale, and ideally before the company issues stock:

1. Is my stock QSBS on the facts, including the active business and gross assets tests?
2. Was it acquired on or before July 4, 2025, or after? Which holding period and cap apply?
3. What’s my federal exclusion, and how is any non-excluded gain taxed?
4. What’s my California tax on the full gain, and should I make estimated payments?
5. If I’m considering a Section 1045 rollover, how is it reported for California?
6. Does gifting stock to family members or trusts help, and what are the gift tax costs?
7. If I’m thinking about moving, what would the FTB look at to decide my residency?

Frequently asked questions

Does California recognize QSBS?

No. Rev. & Tax. Code § 18152 says Section 1202 does not apply for California personal income tax. A California resident pays California tax on the full gain.

Did the 2025 federal changes to Section 1202 apply in California?

No. The FTB’s analysis says California does not conform to the federal small business stock exclusion and so doesn’t conform to the 2025 changes. The tiered exclusion, the $15 million cap, and the $75 million asset test are federal only.

What is the California tax rate on a QSBS sale?

The same as ordinary income. The FTB says California’s rates run from 1 percent to 12.3 percent, plus 1 percent on taxable income over $1,000,000 (Rev. & Tax. Code § 17043), for a top rate of 13.3 percent.

What is the Section 1202 exclusion limit in 2026?

For stock acquired after July 4, 2025, the greater of $15 million per issuer or 10 times basis; for earlier stock, the greater of $10 million or 10 times basis (26 U.S.C. § 1202(b)). The $15 million figure is indexed for inflation starting after 2026. These limits are federal only.

Can S corporation stock be QSBS?

No. The corporation must be a C corporation during substantially all of the holding period (26 U.S.C. § 1202(c)(2)(A)).

Do nonresidents pay California tax on QSBS gains?

A nonresident’s California gross income includes only income from California sources (Rev. & Tax. Code § 17951(a)). Whether a particular stock sale is California-source, and whether you were in fact a nonresident on the sale date, are questions for a tax advisor.