QSBS: the section 1202 tests get answered on your balance sheet, and July 2025 changed which version you get

The question people ask about qualified small business stock is whether their shares qualify. The question that decides it is what the company's balance sheet said on a handful of specific days, most of which have already happened.

Section 1202 measures the corporation, not the shareholder. Two of its three main tests run on numbers a bookkeeper produces: the aggregate gross assets on the day each block of stock was issued, and the composition of the asset base for as long as anybody holds it. The third one, the redemption rule, runs on the cap table and a four-year window. None of them can be reconstructed at exit from a pitch deck.

Three versions of the rules are live at once

The One Big Beautiful Bill Act, Public Law 119-21, rewrote parts of section 1202 on July 4, 2025. It did not replace the old rules. It added a second set alongside them, and the statute now sorts your shares by when they were acquired.

The pivot is the phrase "applicable date" in section 1202(a)(6), which means the date that paragraph was enacted. Stock acquired on or before July 4, 2025 keeps the old regime: a single holding period of more than five years, and an exclusion percentage that depends on which window the stock was issued in. Stock acquired after that date gets the new one.

Three separate effective dates sit behind that table, and they are not the same date, which is where most summaries go wrong. Section 70431(c)(3) of the Act applies the gross assets change to stock issued after July 4, 2025. Section 70431(b)(4) applies the per-issuer cap change to taxable years beginning after July 4, 2025. Section 70431(a)(6) applies the tiered exclusion generally to taxable years beginning after that date, with one piece backdated to 2010.

That backdated piece is worth naming because it quietly cleaned up a wart. The Act struck section 1202(a)(4)(C) and instead amended section 57(a)(7) so the alternative minimum tax preference for excluded section 1202 gain now reaches only stock acquired on or before September 27, 2010. Anything issued after that date carries no AMT preference on the excluded portion, and the change takes effect as if it had been part of the 2010 legislation.

The per-issuer cap moved, and it is a ceiling on gain rather than on proceeds

Section 1202(b)(1) caps eligible gain from any one corporation at the greater of a dollar limit or ten times the aggregate adjusted bases of the stock you disposed of that year. Founder stock bought for a few hundred dollars gets nothing from the ten times figure, so the dollar limit is the operative number for almost everyone.

For stock acquired on or before July 4, 2025, that limit is $10,000,000, reduced by eligible gain taken into account in prior years. For stock acquired after that date, section 1202(b)(4)(B) sets it at $15,000,000, and section 1202(b)(4) as added by section 70431(c)(2) indexes the $15,000,000 for inflation in taxable years beginning after 2026, rounded to the nearest $10,000, off a 2025 base year. A married individual filing separately takes $5,000,000 against the old bucket and half the indexed amount against the new one.

The two buckets are tracked separately and the reductions cross over, so somebody holding both pre-2025 and post-2025 stock in the same company is running two limits at once. Once the eligible gain on post-date stock exceeds the limit in any year, subparagraph (B) of that inflation paragraph sets the limit for every later year to zero for that corporation.

Whatever is not excluded is not taxed at the usual long-term rate. Section 1(h)(7) defines the non-excluded slice as "section 1202 gain", section 1(h)(4)(A)(ii) folds it into 28-percent rate gain, and section 1(h)(1)(F) taxes that category at 28 percent. Selling at three years under the new tiers means half the gain is excluded and the other half lands in the 28 percent bucket rather than the 20 percent one, which makes the difference between year three and year five larger than the headline percentages suggest.

The gross assets test is cash plus tax basis, not book value

Section 1202(d)(1) defines a qualified small business as a domestic C corporation whose aggregate gross assets never exceeded $75,000,000 at any time on or after August 10, 1993 and before the issuance, and do not exceed $75,000,000 immediately after the issuance, counting the money raised in that issuance. That second prong catches the round itself. A company at $70,000,000 that raises $10,000,000 issues stock that fails, even though it was under the ceiling that morning.

Section 1202(d)(2)(A) defines aggregate gross assets as the amount of cash plus the aggregate adjusted bases of other property held by the corporation. Three consequences follow from that wording.

Adjusted basis is a tax number. A fully depreciated asset contributes close to nothing here while it still sits on the GAAP balance sheet at cost less accumulated depreciation. The test and your financial statements will disagree, and the test is the one that governs.

Contributed property gets marked up. Section 1202(d)(2)(B) says the adjusted basis of property contributed to the corporation is determined as if the basis, immediately after the contribution, were the fair market value at the time of contribution. Intellectual property assigned in at a nominal basis counts at what it was worth.

Liabilities are not subtracted anywhere. The word is gross, and a company with $80,000,000 of cash and $75,000,000 of debt has $80,000,000 of aggregate gross assets.

Section 1202(d)(3) then aggregates all members of a parent-subsidiary controlled group into one corporation for this purpose, with the section 1563(a)(1) threshold dropped from at least 80 percent to more than 50 percent. A holding structure does not split the ceiling.

Because the first prong reads "at all times", this is a continuous test rather than an annual one. The evidence that satisfies it is a dated schedule of cash and tax basis at each issuance date, built when the issuance happened.

The 80 percent test is an asset composition test

Section 1202(c)(2)(A) requires the corporation to meet the active business requirements during substantially all of your holding period, and section 1202(e)(1) sets those requirements: at least 80 percent by value of the assets used in the active conduct of one or more qualified trades or businesses, and the corporation must be an eligible corporation.

Section 1202(e)(3) lists what a qualified trade or business is not. Services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage are out, as is any business whose principal asset is the reputation or skill of its employees. So are banking, insurance, financing, leasing and investing; farming, including raising or harvesting trees; extraction of products eligible for depletion; and operating a hotel, motel or restaurant.

Around that sit four asset tests that read directly off the ledger:

• Section 1202(e)(5)(B): a corporation fails for any period during which more than 10 percent of the value of its assets in excess of liabilities is stock or securities in other corporations that are not subsidiaries. A treasury policy that parks cash in corporate bonds can trip this.
• Section 1202(e)(6): assets held as reasonably required working capital count as actively used, as do assets held for investment and reasonably expected to be used within two years to fund research and experimentation or working capital growth. After the corporation has existed for two years, no more than 50 percent of its assets can qualify as active by reason of this paragraph. A large raise that sits in the bank past the second birthday is the usual way a software company fails the 80 percent test.
• Section 1202(e)(7): more than 10 percent of total asset value in real property not used in the active conduct of a qualified trade or business fails the test, and owning, dealing in or renting real property is not itself active conduct.
• Section 1202(e)(5)(A): stock and debt in a subsidiary is disregarded and the parent is deemed to own its ratable share of the subsidiary's assets and conduct its ratable share of its activities. More than 50 percent of vote or value makes a corporation a subsidiary for this purpose.

Pre-revenue companies get explicit protection. Section 1202(e)(2) treats assets used in section 195 start-up activities, in activities producing expenditures treated as research or experimental under section 174 or section 174A, or in in-house research described in section 41(b)(4), as used in the active conduct of a qualified trade or business, and says the determination is made without regard to whether there is any gross income yet.

Redemptions, where the statute and the regulation say different things

Section 1202(c)(3)(A) says stock is not qualified small business stock if, at any time in the four-year period beginning two years before issuance, the corporation purchased any of its stock from that holder or a related person. Section 1202(c)(3)(B) says stock issued in a two-year period beginning one year before issuance fails if the corporation bought back more than 5 percent of the aggregate value of all its stock during that window.

Read on its own, that would disqualify most companies that have ever bought a share back. The only substantive regulation under section 1202 exists to soften it. Regulation 1.1202-2(a)(2) and (b)(2) each add a de minimis rule with two conditions that both have to be met: the aggregate amount paid exceeds $10,000, and more than 2 percent of the relevant stock is acquired. A $9,000 buyback fails the dollar prong and is ignored no matter what percentage it represents.

Four situations are disregarded outright under Regulation 1.1202-2(d). Stock acquired by the seller in connection with services as an employee or director and purchased incident to retirement or another bona fide termination of those services. Stock purchased from a decedent's estate, beneficiary, heir, surviving joint tenant or surviving spouse, within three years and nine months of the death. A purchase incident to the selling shareholder's disability or mental incompetency. A purchase incident to divorce within the meaning of section 1041(c).

The employee exception is drafted for employees and directors. The clause for independent contractors at Regulation 1.1202-2(d)(1)(ii) is marked "[Reserved]", so a repurchase from a departing contractor sits outside it and has to clear the de minimis rule on its own numbers.

One more provision saves a common arrangement. Regulation 1.1202-2(c) says a transfer of stock by a shareholder to an employee or independent contractor is not treated as a purchase by the issuing corporation, even where Regulation 1.83-6(d)(1) deems the stock to have passed through the corporation first. A founder moving shares to an early hire directly does not create a redemption.

What has to be in the records

Everything above is decided on days that are already in the past by the time anyone cares. A buyer's diligence team, or your own preparer five years from now, will be asking for evidence of facts that nobody wrote down.

The workpaper that answers section 1202 is short. For each issuance: the date, the class, whether it was issued for cash, property or services, and a statement of cash plus adjusted bases immediately before and immediately after. For each year: the asset composition split between active use, working capital, portfolio securities and non-active real property, with the value basis stated. For the whole history: every repurchase of stock with its date, counterparty, amount paid, and the percentage of the relevant stock it represented.

Bookkeeping produces all of it. Producing it in the month it happens costs almost nothing. The version assembled in a data room three years later is an estimate, and an estimate is what a buyer discounts.

The cheapest place to build it is the monthly close, next to the fixed asset roll and the cash reconciliation, on the day the issuance happens.