The State-Level Tax Trend That's Raising Taxes on QSBS Sales
Last summer's One Big Beautiful Bill Act, or OBBB, modified the federal tax exclusion for IRC Section 1202 qualified small business stock (QSBS), making the exclusion significantly more valuable. When certain holding period requirements are satisfied, taxpayers are permitted to exclude some, or all, of the capital gain on the sale of QSBS. The value of the QSBS exclusion is clear: Section 1202 allows clients with significant holdings in start-up corporations to potentially avoid paying capital gains taxes on multi-million-dollar stock sales. That said, a growing trend has begun to impact the QSBS exclusion at the state level: decoupling. At least seven states and the District of Columbia do not recognize the QSBS exclusion—and the list is growing. The tax implications can be substantial—meaning that clients should carefully evaluate their state-level tax liability and consider planning strategies prior to any QSBS-related liquidity event.
The Section 1202 QSBS Exclusion: Background
Under IRC Section 1202, qualifying taxpayers can exclude all or a portion of the capital gain realized upon disposition of QSBS, if the taxpayer satisfies the holding period requirement. To be classified as QSBS in the first place, the stock must have been issued by a domestic C corporation at original issuance (or in certain tax-free transactions). The stock must also have been issued by a corporation when its aggregate gross assets did not exceed a certain threshold level (discussed below). The corporation must satisfy certain active business requirements.
Prior to the OBBB, the QSBS exclusion was limited to the greater of (1) $10 million or (2) ten times the owner's adjusted basis in the stock. The OBBB increased the per-issuer exclusion amount from $10 million to $15 million (or ten times the owner's adjusted basis in the stock).
Under the OBBB, a new tiered exclusion structure exists for QSBS acquired after July 4, 2025, as follows (1) 50% exclusion for QSBS held for at least three years, (2) 75% exclusion for QSBS held for at least four years or (3) 100% exclusion for QSBS held for five years or more.
The OBBB also increased the relevant gross asset threshold. Prior to the OBBB, issuing corporation's tax basis in their aggregate gross assets could not exceed $50 million at any time before or immediately after issuing the QSBS. The OBBB increased the threshold to $75 million, so more companies now qualify.
State Law Changes: The Impact of Decoupling
Most states conform to federal tax law. When a state "conforms", it means that they recognize the federal rule. Clients who reside in conforming states are also entitled to the QSBS exclusion at the state-tax level.
States are permitted to decouple, or elect not to conform, to federal tax provisions on a case-by-case basis. In recent months, several states—including California, Maine, Pennsylvania, Mississippi, Alabama,
Oregon, Illinois and the District of Columbia—have elected to decouple from Section 1202. New York proposed, and quickly withdrew, a similar proposal. While taxpayers in these states remain entitled to the QSBS exclusion at the federal level, they'll be subject to state-level taxes on the gain.
The risks associated with investing in startup companies are real and significant. The QSBS tax exclusion provides a powerful offset and is often a motivating factor for investors. Considering the impact of state-level tax exposure on potentially significant gains is becoming even more important as states consider decoupling in order to raise revenue.
First, it's important to identify any QSBS positions and potential future liquidity events. Clients who are positioned to realize significant tax savings (absent imposition of state-level taxes) may wish to consider a bona fide change in state residency. While dramatic, in some cases even moving to a neighboring state can generate significant tax savings.
Transferring QSBS to a trust situated entirely in a non-tax state can potentially help clients in decoupled states avoid state-level taxes. However, the success of the trust strategy will depend on how the client's state of residency deals with out-of-state trusts.
Either of these strategies will very likely be examined. It's important to work with qualified tax and legal counsel—and to work well in advance of the actual liquidity event. Last-minute transfers and moves can easily be questioned, especially when substantial dollar amounts are involved. Maintaining documentation is always critical, starting from the date of the original stock issuance.
Conclusion
The OBBB expansion of the QSBS gain exclusion has created a number of planning opportunities, particularly for high-net-worth clients. Section 1202 is also one area where state-level taxes cannot be ignored—and both clients and advisors should continue to monitor the changing legislative landscape. Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.