Don’t Let Capital Gains Tax Haunt You: Take Advantage of the Qualified Small Business Stock Exclusion

Private-equity funds have long haunted the halls of mature, cash-flowing businesses, drawn by the comfort of favorable tax treatment through capital-gain rates and carried-interest structuring. Yet, in the dim corners of the tax code lies a rarely explored opportunity: the Qualified Small Business Stock (QSBS) exclusion under IRC §1202. For those willing to uncover it, this provision can eliminate all federal income tax on exit for eligible investments—a hidden advantage that too often remains in the shadows.

The Basics: What § 1202 Provides

Section 1202 permits non-corporate taxpayers to exclude capital gain on the sale of qualified small-business stock (QSBS) of a C-corporation, up to the greater of $10 million (per taxpayer per issuer) or 10× basis. For stock acquired after July 4 2025, the cap increases to $15 million (indexed beginning 2027).

• Stock must be originally issued by a domestic C-corporation after Aug 10 1993 (and after Sept 27 2010 for the 100% exclusion under old law).
• The corporation’s aggregate gross assets must not exceed $50 million immediately before and after issuance ($75 million for stock acquired after July 4 2025).
• Stock must be held > 5 years for a full exclusion. For stock acquired after July 4 2025: 3 years = 50%, 4 years = 75%, 5 years = 100%.
• At least 80% of assets must be used in the active conduct of a qualified trade or business, excluding health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage, banking, insurance, financing, leasing, investing, farming, extraction, or operating a hotel, motel, or restaurant.

When these tests are met, individuals and flow-through entities (e.g., partnerships, PE funds) can sell QSBS with zero federal tax. Each partner’s exclusion applies only if they were partners when the partnership acquired the QSBS and their interest has been maintained through disposition.

Why Private Equity Rarely Uses It — and Why It Should

Most PE investments are made through LLCs or S corporations, or into C-corps already exceeding the $50 / $75 million threshold—instantly disqualifying them. Yet growth-equity and lower-middle-market deals can qualify with deliberate structuring.

The misconception is that § 1202 is “for startups.” In reality, any operating company under the asset threshold can issue new QSBS to fund expansion or acquisitions, even if it’s profitable and mature.

Structuring Opportunities for Funds

New-Issue Rollover Structures. When buying an existing LLC or S corp, an acquirer can contribute assets into a newly formed C corporation (via check-the-box or § 351 exchange) and have new shares qualify as QSBS going forward. Legacy owners may incur tax on the deemed sale, but future appreciation can be tax-free.

Management Rollover Equity. Instead of profits-interest programs in LLCs, structure the portfolio company as a C corp issuing QSBS to management. After five years, exit gains can be fully excluded. Preferred instruments that don’t need QSBS status can sit in a parallel LLC vehicle.

Fund-Level Pass-Through. Because § 1202 eligibility flows through partnerships, each LP can claim its own $10 million / $15 million cap (or 10× basis). A single QSBS exit can thus deliver multiple tax-free allocations across LPs and co-investors.

Partial Step-Ups and Stacked Exclusions. Separate issuances to different entities or family members can “stack” exclusions—each qualifying taxpayer gets its own cap. GPs and LP co-investors can plan issuances accordingly.

Practical Hurdles

• C-Corporation Friction: C-corps create double-tax exposure on distributions, but for growth-stage plays where value is realized on exit, the trade-off is usually immaterial.
• Documentation: Maintain records substantiating aggregate-asset values at issuance and the corporation’s qualified-business status.
• Redemption Rules: Significant redemptions within the 2-year pre / 1-year post window can disqualify stock. Watch § 1202(c)(3).
• Conversions and Recaps: Conversions to LLCs or redemptions before 5 years destroy QSBS status.
• State Conformity: Not all states follow the federal exclusion — California does not conform.

Case Study: Growth-Equity Inflection

A fund invests $10 million in a C-corp with $20 million pre-money assets. Five years later, the company sells for $150 million. The fund’s QSBS proceeds of $50 million include a $40 million gain excluded from federal tax. If held through a partnership, each LP receives their proportionate share tax-free (up to their § 1202 cap). The after-tax IRR differential versus a taxable C-corp exit can exceed 25–30%.

Strategic Implications for Private Equity

• Tax-efficient differentiation: QSBS structuring can justify premium valuations or attract co-investors seeking tax-free outcomes.
• GP alignment: QSBS-eligible management equity enhances after-tax retention and reduces dilution pressure.
• Exit flexibility: QSBS sales are typically straight stock sales. Based on specific structural and deal facts, a QSBS sale may potentially be structured as a stock sale (tax-free to sellers) while still allowing future buyers to make certain elections to allow for basis step-up adjustments through other techniques.

Section 1202 was intended for “small businesses,” yet it can be a private-equity superpower when deployed at formation or recap—before the asset threshold is breached. In an environment of tight spreads and compressed returns, QSBS planning delivers asymmetric upside: zero federal tax on exit.

This Halloween, no ghost or goblin is as scary as the prospect of a missed opportunity to achieve zero federal tax on an exit. An increasingly saturated deal space with narrowing spreads, QSBS planning may be the highest ROI structuring tool and best kept secret in the private-equity toolkit.

Questions about making QSBS work in your structure? Reach out to Robert Garner or any member of LP’s Tax Planning group.