A Tax Break That Could Shape Your Exit
Key Takeaways: The qualified small business stock (QSBS) exclusion under Section 1202 of the Internal Revenue Code may let Buffalo founders exclude some or all of their federal gain when they sell eligible startup stock, worth potentially millions at exit. To qualify, you generally must get stock at original issuance from a domestic C corporation that stays under the gross asset limit and uses at least 80% of its assets in a qualified business; certain industries are excluded. Stock issued on or before July 4, 2025 generally needs a holding period of more than five years and is capped at the greater of $10 million or 10x basis. Stock issued after that date can earn partial exclusions after three and four years, with a $15 million cap and a $75 million asset limit. Early choices, entity type, LLC conversions, 83(b) elections, redemptions, and asset levels, can protect or cost you eligibility. New York generally follows federal adjusted gross income, so excluded gain often escapes New York tax too, though residency issues and separate state definitions can change that result. Plan with counsel and tax advisors from day one.
QSBS is a federal tax benefit that may let founders exclude some or all of the gain when they sell eligible startup stock. It comes from Section 1202 of the Internal Revenue Code (26 U.S.C. § 1202). If you meet the requirements, the exclusion can be worth millions at exit. For Buffalo founders, the stakes rise because New York generally builds its personal income tax on federal adjusted gross income, meaning choices at formation can affect state taxes too. Qualifying isn’t automatic; it depends on how your company is organized and operated, how you get your shares, and how long you keep them.
Getting QSBS right starts on the day you form your company, not the day you sell it. Roach, Lennon & Brown, PLLC works with founders across Western New York as outsourced general counsel, helping them structure companies with long-term goals in mind. Call 716-235-3025 or schedule a consultation with our team.
How Section 1202 Works in Plain Terms
Section 1202 lets eligible non-corporate shareholders leave part or all of their gain from qualified small business stock out of federal taxable income. Congress passed it to encourage investment in young operating businesses and has amended it several times. The biggest recent change came from the federal budget reconciliation law signed July 4, 2025, the One Big Beautiful Bill Act, which created new rules for stock issued after that date.
What Makes Stock "Qualified"
Your stock generally must meet several requirements under 26 U.S.C. § 1202(c) and (d):
- The company must be a domestic C corporation when it issues the stock and during substantially all of your holding period.
- You generally must acquire the stock at original issuance, directly from the company or through an underwriter, for money, property, or services (not underwriting services). Buying from another shareholder usually doesn’t count, though gifts and transfers at death keep QSBS status.
- The company’s aggregate gross assets must not exceed the statutory limit before or immediately after the stock is issued (on or after August 10, 1993).
- At least 80% of assets, by value, must be used in an active qualified trade or business during substantially all of your holding period.
Some industries are excluded under 26 U.S.C. § 1202(e)(3), including health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage, banking, insurance, financing, investing, farming, certain mining and oil and gas, hotels, motels, and restaurants, plus any business whose main asset is an employee’s reputation or skill. AI, software, and data infrastructure companies often qualify, but each business model needs careful review.
Holding Periods and Exclusion Limits
How much you can exclude depends on when your stock was issued and how long you held it. The table below covers stock acquired after September 27, 2010; earlier stock may get a smaller exclusion percentage. Starting in 2027, the $15 million cap and $75 million asset limit are adjusted for inflation, so confirm current figures with your tax advisor.
| Feature | Stock Issued On or Before July 4, 2025 | Stock Issued After July 4, 2025 |
|---|---|---|
| Minimum holding period | More than 5 years for the 100% exclusion | 50% at 3 years, 75% at 4 years, 100% at 5 years |
| Per-issuer gain cap | Greater of $10 million or 10x basis | Greater of $15 million or 10x basis |
| Gross asset limit | $50 million | $75 million |
💡 Pro Tip: The QSBS cap generally applies per taxpayer, per company. Gifting shares to certain family members or non-grantor trusts may allow more gain to be excluded in some situations, an overlap of estate and startup planning worth discussing with counsel.
Why the QSBS Exclusion Depends on Early Decisions
Most QSBS problems come from decisions made long before anyone thinks about selling. Buffalo founders often ask whether to form an LLC first and convert later. That can work, but LLC interests aren’t stock, the holding period starts only once you hold C corporation stock. On conversion, the stock’s basis for QSBS purposes is generally treated as no less than the fair market value of the contributed assets, so only post-conversion appreciation can qualify.
How you receive founder shares also matters. Founders often get restricted stock that vests over time. Without a Section 83(b) election, shares are generally treated as acquired when they vest, so the QSBS holding period may run from each vesting date instead of the grant date. Read our guide to the 30-day 83(b) election deadline.
Redemptions and Other Common Traps
Certain stock buybacks can disqualify shares that would otherwise be eligible. Under 26 U.S.C. § 1202(c)(3), redemptions from you or a related person within two years before or after issuance, or significant redemptions from any shareholders within one year before or after issuance, can taint the stock. Other traps include excess cash or investment assets unrelated to the business, and too much non-operating real estate. Assets rising past the limit after issuance won’t disqualify shares already held, but can block later-issued stock from qualifying. None of these issues is necessarily fatal, but each deserves attention as it arises, not just at closing.
Where New York Law Fits In
New York’s tax code ties some investment concepts directly to Section 1202. Under New York Tax Law § 1503, a "qualified investment" is stock or an interest acquired as provided in Internal Revenue Code Section 1202(c)(1)(B). That provision applies to a specific state tax article, not personal income tax on QSBS gain generally, but it shows New York borrows the federal original-issuance concept in some contexts.
New York personal income tax generally starts with federal adjusted gross income, so gain excluded federally often escapes state tax too. That link isn’t guaranteed for every taxpayer. Nonresidents, part-year residents, and founders who move between states face separate sourcing and residency questions, and some states don’t follow Section 1202. This matters especially for Canadian and Toronto-area founders building U.S. companies in Buffalo or Niagara Falls, since Canadian tax law doesn’t recognize Section 1202.
State "Small Business" Definitions Are Different
New York defines a "small business taxpayer" for its own purposes, and that definition doesn’t match federal QSBS rules. Under the state’s corporate franchise tax, a small business taxpayer generally has entire net income of no more than $390,000, has received no more than $1 million total for stock, capital contributions, and paid-in surplus, isn’t part of certain affiliated groups, and has 100 or fewer full-time in-state employees, excluding general executive officers. Confirm these thresholds with your tax advisor, as they can change. A company can qualify as QSBS federally while being too large for New York’s small business status, and vice versa, your tax planning must account for both.
Building a QSBS Strategy With a Long-Term Legal Partner
Protecting QSBS eligibility takes ongoing work because many rules apply throughout your holding period. Each funding round, cap table change, stock repurchase, and asset shift is a chance to keep or lose eligibility. When one team oversees your corporate governance, contracts, and records, it becomes easier to maintain documentation you may need at exit.
Our firm serves as outsourced in-house counsel for growing companies, coordinating with your CPA and outside advisors when needed. New York corporations are governed by the New York Business Corporation Law, and well-organized formation records, board consents, and stock ledgers can help support a QSBS position later. A QSBS exclusion for startup founders lawyer can help you keep these records in order year after year.
💡 Pro Tip: Ask your company to issue a QSBS representation letter or keep an ongoing gross-asset log. If the IRS ever questions your exclusion, contemporaneous records can be far more persuasive than reconstructions years later.
Frequently Asked Questions
1. Can an LLC issue qualified small business stock?
No, not while taxed as a partnership. An LLC that converts to, or elects to be taxed as, a C corporation may issue qualifying stock after that point, but special basis rules generally limit the exclusion to post-conversion appreciation.
2. Do employees and investors qualify, or only founders?
Any non-corporate taxpayer who acquires stock at original issuance and meets the other requirements may qualify, including angel investors and employees who exercise stock options. For option holders, the holding period generally starts at exercise, not grant.
3. What happens if I sell before meeting the holding period?
If you’ve held the stock more than six months, Section 1045 may let you defer the gain by reinvesting proceeds in new QSBS within 60 days. This deferral must be elected, it’s not automatic, so plan timing before an early sale. For stock issued after July 4, 2025, a partial exclusion may already be available after three years.
4. Does QSBS eliminate New York tax on my gain?
In many cases, federally excluded gain is also excluded from New York taxable income because the state conforms to federal adjusted gross income. Your residency, state modifications, and individual situation can change that result. Confirm treatment with your advisors before a sale.
5. Can AI or data center companies qualify?
Many technology companies can qualify, subject to exceptions. Companies with significant non-operating real estate, or that depend mainly on consulting or other excluded services, may face tougher questions under 26 U.S.C. § 1202(e). Each business model needs its own review.
Setting Your Company Up for a Stronger Exit
The QSBS exclusion can be one of the most valuable tax benefits available, but generally only if eligibility is built in early and maintained over time. Entity choice, how you receive shares, 83(b) elections, redemptions, and asset levels all matter. New York law adds its own layer, generally following federal adjusted gross income while keeping separate definitions. Because every company’s facts differ, consult an attorney and tax professional about your specific circumstances.
If you’re forming a company or preparing for a funding round, now is the time to review your QSBS position. Roach, Lennon & Brown, PLLC advises Buffalo and Western New York founders as a long-term legal partner. Call 716-235-3025 or reach out through our contact page. Schedule a consultation with our team.
Disclaimer: This content is for informational purposes only and is not legal advice. Every case is unique, and results may vary. Consult an attorney about your specific circumstances.