QSBS, Section 1202, and California

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

Who this page is for: founders, early employees and investors who live in California and hold stock in a C corporation. The stacking sections matter most for estates from $15 million to $100 million and above, where one exit can be several times the federal cap.

QSBS stacking means giving founder stock to separate taxpayers before a sale, usually nongrantor trusts for children, so each one claims its own Section 1202 cap: $10 million per taxpayer for stock acquired on or before July 4, 2025, and $15 million for stock acquired after that date. On a large exit it can cut federal tax by millions. It does almost nothing for California, which excludes no QSBS gain for anyone and taxes a trust’s whole income when a trustee or a noncontingent beneficiary lives here.

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.

Old stock and new stock: two sets of federal rules

Section 1202 now runs two regimes side by side, and the dividing line is July 4, 2025, the date Public Law 119-21 was enacted. The exclusion percentage and the cap turn on when you acquired the stock, and the acquisition date is the first day you held it after applying the holding-period rules of Section 1223 (26 U.S.C. § 1202(a)(6)). The $75 million gross assets test turns on when the corporation issued the stock: the increase applies to stock issued after July 4, 2025 (Pub. L. 119-21, § 70431(c)(3)).

Authority for the table: 26 U.S.C. § 1202(a)(1), (a)(3) to (a)(6), (b)(4), (b)(5), and 26 U.S.C. § 57(a)(7). The gross assets limit is $50 million for stock issued on or before July 4, 2025 and $75 million for stock issued after (Pub. L. 119-21, § 70431(c)).

The cap for newer stock is reduced by gain you excluded on older stock of the same company, in earlier years or the same year (26 U.S.C. § 1202(b)(4)(B)). And if your eligible gain on newer stock of one company exceeds the cap in any year, your cap for that company is zero for each later year, whatever indexing would have added (§ 1202(b)(5)(B)). The indexing language for the $75 million test landed in subsection (b) instead of subsection (d), so the codified section now has two paragraphs numbered (4) in subsection (b).

What is QSBS stacking?

QSBS stacking is giving founder stock to other taxpayers before a sale so that each can claim a separate Section 1202 cap, which applies per taxpayer and per company under 26 U.S.C. § 1202(b)(1). Someone who receives stock by gift is treated as having acquired it the same way the donor did and gets credit for the donor’s holding period (§ 1202(h)(1), (h)(2)(A)).

The recipient has to be a separate taxpayer. A nongrantor trust is one. A grantor trust’s income goes into computing the grantor’s own taxable income (26 U.S.C. § 671), so planners treat it as the founder for cap purposes. That rules out most spousal lifetime access trusts, because a trust whose income may be paid to the grantor’s spouse is a grantor trust (26 U.S.C. § 677(a)(1)). See SLATs in California and the grantor trust definition.

Married founders shouldn’t count on a second cap from a spouse. A married person filing separately gets half the dollar cap (§ 1202(b)(3)(A)), and on a joint return the excluded gain is allocated equally between the spouses for later years (§ 1202(b)(3)(B)).

1. Confirm the stock qualifies first

   Original issue, C corporation status, gross assets at issuance and the active business test all have to hold before a gift is worth making. A gift can’t fix stock that was never QSBS.

2. Use one nongrantor trust per beneficiary

   Each trust needs a different primary beneficiary and real terms of its own, because of the multiple-trust rule below.

3. Make the gift early

   The gift has to be complete while the sale can still fall apart. Once a deal is practically certain, the gain stays with the donor.

4. Report the gift with a qualified appraisal

   A gift to a trust uses lifetime exemption, which is $15,000,000 per person for 2026 (Rev. Proc. 2025-32). A complete Form 709 with an appraisal meeting Treas. Reg. § 301.6501(c)-1(f)(3) starts the three-year clock on the value.

5. Settle each trust’s California residency

   Who serves as trustee and how distributions are written decide whether California taxes the trust (Rev. & Tax. Code § 17742).

The multiple-trust rule in Section 643(f)

The income tax code has a rule aimed at this. Two or more trusts are treated as one trust if they have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and a principal purpose of the trusts is avoiding federal income tax. A husband and wife are treated as one person (26 U.S.C. § 643(f)).

Treasury finalized a regulation under the statute in 2019. It aggregates trusts with substantially the same grantors and primary beneficiaries when a principal purpose for establishing one or more of them, or for adding cash or property to them, is avoiding federal income tax, and it applies to taxable years ending after August 16, 2018 (Treas. Reg. § 1.643(f)-1; T.D. 9847, 84 Fed. Reg. 2952). In the same release Treasury dropped its proposed definition of “principal purpose” and said that arrangements made before the regulation took effect can be tested under the statute and its legislative history.

There’s a scope question. Section 643(f) and the regulation apply “for purposes of this subchapter,” meaning Subchapter J, the trust income tax rules, while Section 1202 sits in Subchapter P. Whether aggregation reaches the Section 1202 cap is unsettled. Section 1202 has its own grant of authority for regulations to prevent avoidance of its purposes through “split-ups, shell corporations, partnerships, or otherwise” (26 U.S.C. § 1202(k)), and the IRS can also argue substance over form. Treat a stack of look-alike trusts as a risk the IRS can attack, not a rule you can count on either way.

The defensible version is one nongrantor trust for each child, with a different primary beneficiary and terms that would make sense without any tax benefit. Three trusts for the same child, signed the same week, with no reason to exist beyond three more caps, is the arrangement the rule describes. I found no reported decision applying § 643(f) to a QSBS stacking plan.

What does stacking save on a $40 million exit? A worked example

In this hypothetical, three nongrantor trusts cut federal tax on a $40 million gain from $7,140,000 to $0 under Section 1202 as amended in 2025, while California tax stays near $5.2 million in every version under the Franchise Tax Board’s 2025 rate schedule.

• The founder. Unmarried, a California resident all along. She received common stock at formation of a C corporation in 2019 for $50,000. The stock qualifies as QSBS. Because she acquired it before July 5, 2025 and after September 27, 2010, the exclusion is 100 percent after five years and the cap is the greater of $10 million or 10 times basis, which here is $10 million per taxpayer.
• The gifts. In 2021 she gives a block of stock to each of one, two or three nongrantor trusts, one per child, each block appraised at $1,000,000 when given and reported on Form 709. Each block later carries $10 million of the sale gain.
• The sale. The company is acquired in 2027. Total gain is $40 million.
• Federal tax. 23.8 percent on gain above each taxpayer’s cap: the 20 percent capital gain rate (26 U.S.C. § 1(h)(1)(D)) plus the 3.8 percent net investment income tax (26 U.S.C. § 1411). Lower brackets are ignored, which slightly overstates the tax.
• California tax. Each taxpayer is taxed on its whole gain under the FTB’s 2025 rate schedule, which tops out at 12.3 percent and uses the same brackets on Form 540 for a single filer and on Form 541 for a trust, plus 1 percent on taxable income over $1,000,000 (Rev. & Tax. Code § 17043). Each trust has a California trustee, so California taxes it. No deductions. The 2027 schedule isn’t published yet.
• Distributions. The trusts keep the gain rather than distributing it.

Federal tax falls by $2,380,000 for each trust that absorbs a full $10 million block, until the gain runs out at three trusts. California tax barely moves. The only California savings come from each trust’s own lower brackets and its own $1,000,000 threshold for the extra 1 percent, about $29,000 per trust.

Had the founder acquired her stock after July 4, 2025, the cap would be $15 million per taxpayer, and two trusts would cover a $40 million gain. The earliest that stock can reach the 100 percent tier is July 2030, five years after acquisition.

Cases won and lost

Section 1202 cases are few. Most of the federal cases below were lost on proof or timing, and the California case is a constitutional win that ended the state exclusion for later years.

What changes in California

• No exclusion, no rollover. Section 1202 doesn’t apply for California (Rev. & Tax. Code § 18152), and neither does the Section 1045 rollover into new QSBS (§ 18038.4).
• The old California version is gone. California had its own exclusion and deferral in §§ 18152.5 and 18038.5, limited to California-based companies. After Cutler, FTB Notice 2012-03 treated both sections as invalid and disallowed all of them for tax years beginning on or after January 1, 2008. The Legislature then passed AB 1412 (Stats. 2013, ch. 546), which allowed a 50 percent exclusion for tax years beginning in 2008 through 2012, with a test that 80 percent of the company’s payroll be in California, waived penalties and interest on the resulting tax, and repealed § 18152.5 as of January 1, 2016.
• Trusts are taxed on residency. California taxes a trust’s entire taxable income if a fiduciary or a beneficiary whose interest isn’t contingent is a California resident (Rev. & Tax. Code § 17742(a)). With several trustees, that income is apportioned by the number who live here (§ 17743). In Steuer v. Franchise Tax Bd. (2020) 51 Cal.App.5th 417, the court held California-source income is taxed in full whatever the trustees’ residence, and that a beneficiary whose distributions are in the trustee’s absolute discretion has a contingent interest.
• Throwback on distributions. If no tax was paid on accumulated trust income because a resident beneficiary’s interest was contingent, the income is taxed to that beneficiary when distributed, figured as if received ratably over the year of distribution and up to five prior years (§ 17745(b), (d)). A trust sited outside California defers the question. It doesn’t end it for California children.
• ING trusts don’t help. Since 2023, the income of an incomplete gift nongrantor trust is taxed to the California grantor (§ 17082(a)). See Nevada trusts and California taxes.
• Rates. California’s brackets run to 12.3 percent, plus 1 percent on taxable income over $1,000,000 (§ 17043). For taxable years beginning in 2025 it’s called the Behavioral Health Services Tax, after the Mental Health Services Act was renamed. Trusts pay it too.
• Community property. A gift of community property is treated as made one-half by each spouse, and each spouse files a gift tax return (IRS Instructions for Form 709). One spouse can’t give away community personal property without the other’s written consent (Fam. Code § 1100(b)). For § 643(f), spouses count as one grantor.
• The step-up alternative. Stock held until death takes a basis equal to its value at death (26 U.S.C. § 1014(a)), and for community property the surviving spouse’s half gets the same treatment (§ 1014(b)(6)). A gift gives that up. See community property step-up.

What works and what fails

More on how these plans go wrong is on estate planning strategies that backfire, and how stacking compares with other techniques is in the strategy comparison.

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?

Who this is for

Founders, early employees and investors who hold C corporation stock in a company with a realistic path to a large exit, and families whose trusts already hold founder shares. I draft the trusts and gift documents and coordinate their timing with the deal. Your CPA runs the Section 1202 analysis and prepares the returns.

Working with Ridley Law

I work alongside your CPA and, where the matter calls for it, co-counsel. Work at this level is built for each family and quoted in writing before any drafting starts.

The first call is free and runs 30 minutes, by phone or Zoom. Book my 30-minute call or call 805-244-5291.

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.

How does QSBS stacking work?

By giving founder stock to separate taxpayers, usually nongrantor trusts for children, before a sale so each can claim its own Section 1202 cap. A person who receives stock by gift is treated as acquiring it the way the donor did, with the donor’s holding period (26 U.S.C. § 1202(h)).

Does QSBS stacking reduce California tax?

No. California applies no QSBS exclusion (Rev. & Tax. Code § 18152), and it taxes a trust’s entire income when a trustee or a noncontingent beneficiary is a California resident (§ 17742). Stacking changes the federal answer. In California the only savings come from each trust’s own lower brackets, about $29,000 per trust in the example above.