Angel investors and founders often overlook one of the biggest tax breaks for startups. Section 1202 lets you exclude some or all of your gain when you sell qualified small business stock (QSBS). Although people sometimes call it a credit, it is actually an exclusion from income. And for a successful exit, it can save millions.
Section 1202 basics for angel investors
- You may exclude up to 100% of your gain on QSBS held long enough.
- The exclusion for each company is the greater of a dollar cap or 10 times your basis. The cap is $10 million for stock issued before July 5, 2025, and $15 million for stock issued after July 4, 2025.
- For stock acquired after September 27, 2010, the excluded gain isn’t subject to the alternative minimum tax.
- Founders, employees, angel investors and many fund investors can all qualify.
Example for founders
A company sells for $50 million. The founder owns 20%, so she receives $10 million. Her basis is close to zero, so her gain is about $10 million. If her stock qualifies as QSBS, she can exclude the entire gain from federal income tax.
Example for angel investors
Another company sells for $500 million. An angel investor put in $100,000 early and now owns 2.5%. So he receives $12.5 million, and his gain is $12.4 million.
Ten times his $100,000 basis is only $1 million. So the $10 million cap applies instead. As a result, he can exclude $10 million and pays tax on the remaining $2.4 million, assuming the stock was issued before July 5, 2025.
Key Section 1202 requirements
- Holding period. Hold the stock more than five years. For stock issued after July 4, 2025, a partial exclusion starts after three years.
- C corporation. The company must be a domestic C corporation, and you must buy the stock directly from it.
- Size limit. The company’s gross assets can’t exceed $50 million before and right after the investment. For stock issued after July 4, 2025, the limit is $75 million.
- Qualified business. Many fields don’t qualify. For example, these include most professional services, finance, farming, mining, hospitality and real estate.
- Non-corporate owner. Corporations that invest don’t get the exclusion.
For the full rules, read our guide to QSBS and Section 1202 or the text of Section 1202. Also note that California does not follow the federal exclusion.
What this means for angel investors and founders
Section 1202 is a strong reason to consider a C corporation over an LLC for a high-growth startup. If you are a founder, check whether your company’s stock qualifies. If you are an angel investor, ask each startup whether it tracks its QSBS status.
Get help with QSBS planning
We help founders and angel investors document QSBS eligibility and plan exits. To discuss your situation, call (415) 842-2940 or book a free 15-minute call.