The One Big Beautiful Bill Act (OBBB) enhanced the federal tax exclusion for certain gain from qualified small business stock under IRC § 1202, with the aim of encouraging investment. One expert discussed how small businesses are responding – including via potential entity changes.
Qualified Small Business Stock Exclusion
Under § 1202, noncorporate taxpayers holding qualified small business stock can exclude from gross income a percentage of any gain realized on the sale or exchange of that stock. The specific percentage to be excluded depends on stock acquisition date and the length of time the taxpayer held the stock.
The OBBB made several taxpayer-friendly modifications to § 1202, impacting qualified small business stock issued after July 4, 2025. (Note that stock issued before this date is generally subject to pre-OBBB rules.)
Under prior law, 100% gain exclusion was generally only available after a taxpayer held stock for five years. The OBBB established a tiered holding period allowing for partial exclusions before the five-year mark. Specifically, taxpayers can exclude 50% of the gain for stock held for at least three years, 75% for stock held for at least four years, and 100% for stock held for five years or more.
The OBBB also raised the maximum gain exclusion per taxpayer per issuer from $10 million to $15 million. This new limit is indexed for inflation for tax years beginning after 2026. Note, an alternate cap of 10 times the taxpayer’s aggregate tax basis in qualified small business stock sold in a tax year (10x cap) still applies.
In addition, the OBBB increased the aggregate gross assets threshold for a company to qualify as a small business, for purposes of issuing qualified small business stock. Pre-OBBB, that threshold was $50 million – now it is $75 million and indexed for inflation.
Small Business Response
Brian Masterson, a partner at Frost Brown Todd, unpacked the OBBB changes to § 1202 and shared how his small business clients are reacting.
Masterson noted that the prior gross assets threshold of $50 million “had basically been in the law, unadjusted for inflation, since 1993 which is when § 1202 was enacted.” He views the OBBB change as “a big increase.” And the new tiered holding period structure “creates more flexibility from an exit strategy perspective,” said Masterson.
Masterson told Checkpoint he’s seen a significant uptick in client inquiries regarding the § 1202 changes and potential changes in business entity. The provisions apply only for C corporations, he explained, “so if you’re a partnership or an S corporation, you can’t take advantage of it.”
“There’s hardly a day that goes by where somebody is not calling us saying, ‘Hey, I’ve heard about the changes and the expansion in the §1202 exclusion. I’m very interested in converting from a partnership or an S corporation into a C corporation.'” However, he’s advising his clients to carefully consider the broad implications of such an entity change.
C Corp Conversion Considerations
Businesses should assess their current structure and future growth projections to determine if converting to a C corporation to take advantage of § 1202 is beneficial. “It goes back your traditional choice-of-entity analysis,” Masterson explained.
C corporations are subject to corporate income tax rates, which can be lower than individual income tax rates for certain income levels. In addition, the potential for tax-free gain on exit can make C corporations more attractive to investors.
However, C corporations are subject to double taxation – once at the corporate level on profits and again at the shareholder level when profits are distributed as dividends. This is a significant consideration for businesses that regularly distribute earnings to owners. In addition, some buyers prefer asset purchases (which allow for a step-up in basis) over qualified small business stock purchases, potentially impacting sales price.
Masterson walks clients through what they will lose if they convert from a pass-through, whether a partnership or S corporation, to a C corporation. His questions to clients: “What does double taxation mean for you? Are the tax savings worth it in the end?”
Another consideration is how much a business may be worth in the near future. Masterson gave the example of a business that is worth $40 million now but expects to be worth the same in five-plus years. “Is it really worth converting? I would tell you the answer is no.” He elaborated that for this $40-million business, you’d only have a $20 million § 1202 exclusion. “Something like that may not be enough to justify double taxation.”
Another question he asks pass-through clients is whether they have been pulling out net profit and “taking a cash distribution to fund [their] lifestyle.” If they intend to do the same after a C corporation conversion, “that’s a dividend that’ll be subject to double taxation,” he explained.
One more discussion point with clients considering conversion, said Masterson, is that “to get the § 1202 benefit, it has to be a sale of stock.” That means certain lost tax benefits for stock buyers, and a potentially lower sales price than clients may expect. A stock buyer cannot, for example, amortize and depreciate assets inside a C corporation, he explained. “We factor in a potential haircut.”
Other Considerations for Small Businesses
When evaluating their ability to take advantage of the § 1202 expansion, Masterson noted a few additional factors that businesses should consider. That includes interplay with other tax provisions.
One such provision is the new domestic research and experimental expenditure deduction under IRC § 174A. Masterson pointed out that § 174A can reduce a company’s adjusted tax basis, potentially allowing companies with enterprise values well above $75 million to still fall within the definition of a qualified small business for § 1202 purposes. That’s because under § 174A, “the value of that R&D is zero,” he explained.
Masterson has raised this interaction with some of his clients who “might not have been as interested in § 1202” because their business value is “a lot higher than $75 million.” Putting § 1202 and § 174A together is “a nice combination,” he added.
One other key consideration, said Masterson, is “that the entity is engaged in what would be an eligible trade or business for § 1202.” He noted the “pretty long list of things that are not eligible” under § 1202. That list includes law firms, physician practices, and accounting firms.
For more on the qualified small business stock exclusion under § 1202, see Checkpoint’s Federal Tax Coordinator 2d ¶ I-9100.
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