Congress Supersized the QSBS Exclusion and NJ Finally Signed On

For 30 years the qualified small business stock (QSBS) exclusion sat demurely in Section 1202 of the Internal Revenue Code, a generous benefit that few founders planned for and many discovered only after it was too late to qualify. That obscurity is ending. The One Big Beautiful Bill Act, signed into law on July 4, 2025, delivered the most significant expansion of QSBS since the 100 percent exclusion arrived in 2010. And this year, New Jersey, long one of the few holdout states that taxed QSBS gains in full, enacted its own conforming exclusion effective. If you are forming, funding or preparing to sell a startup in the Garden State, the math just changed significantly in your favor.

The Fundamentals Have Not Changed

Section 1202 allows noncorporate taxpayers to exclude capital gain from the sale of qualified small business stock. The core eligibility rules are as strict as they ever were:

the issuer must be a domestic C corporation
the stock must be acquired at original issuance, directly from the company, in exchange for money, property or services
stock purchased from another shareholder does not qualify
at least 80 percent of the corporation’s assets must be used in the active conduct of a qualified trade or business

and the statute excludes a long list of service fields including health, law, accounting, consulting, financial services and hospitality. A software startup qualifies; a law firm does not.

These requirements are unforgiving, and the IRS has issued little comprehensive guidance on their contours. Qualification is determined by facts established at issuance and maintained afterward, which is why QSBS planning belongs at formation, not at exit.

Congress Shortened the Wait and Raised the Ceiling

For stock issued after July 4, 2025, the Act made three changes that matter enormously. First, the rigid five year holding period gave way to a tiered schedule. Shareholders may now exclude 50 percent of gain after three years, 75 percent after four years and 100 percent after five years. An early exit no longer means forfeiting the entire benefit. Gain that is taken into account but not excluded under the partial tiers is taxed at a 28 percent rate rather than the standard long term capital gains rate; that makes the timing of a sale a genuine planning decision.

Second, the per issuer exclusion cap rose from $10 million to $15 million–indexed for inflation after 2026–or if greater, ten times the taxpayer’s basis in the stock.

Third, the aggregate gross asset ceiling that defines a qualified small business increased from $50 million to $75 million, also indexed. That last change expands the universe of companies whose later stage rounds can still produce qualifying stock, and because the 10 times basis alternative keys off what investors paid, the larger asset threshold meaningfully raises the theoretical maximum exclusion.

Two Regimes Now Run in Parallel

The enhancements apply only to stock issued after July 4, 2025. Shares issued on or before that date remain governed by the old rules, meaning a five year holding period, a $10 million cap and a $50 million asset test. Founders and funds now hold portfolios that straddle both regimes, and the difference between a July 2025 issuance and an August 2025 issuance can be worth millions. Cap tables should be reviewed with issuance dates in mind, and companies contemplating new rounds, option exercises or convertible note conversions should document exactly when stock is deemed issued.

New Jersey Finally Joined the Party

The federal exclusion was always only part of the picture for New Jersey residents. Because the state’s gross income tax is not the same as federal adjusted gross income, QSBS gains that were entirely tax free in Washington remained fully taxable in Trenton at rates reaching 10.75 percent. New Jersey shared that dubious distinction with only a handful of states including California and Pennsylvania.

That ended on June 30, 2025. Effective for tax years beginning on or after January 1, 2026, capital gains from the sale of QSBS are excluded from New Jersey gross income to the extent they are excluded federally under Section 1202. The state exclusion piggybacks on the federal, so a sale that qualifies for the 100 percent federal exclusion now escapes New Jersey tax entirely. On a $15 million gain, conformity is worth over $1.6 million in state tax alone. For founders who once weighed a move across the Delaware before an exit, the calculation has changed.

One caution on timing. The New Jersey exclusion applies to gains realized in 2026 and later years. A qualifying sale that closed in December 2025 received no state benefit, and nothing in the new law reaches back to fix that.

What Founders and Investors Should Do Now

Entity choice deserves a fresh look. Many startups begin life as LLCs for simplicity and convert to C corporations when institutional money arrives. The QSBS clock does not start at formation, but on conversion; its timing has real consequences. Existing C corporations should confirm and document their qualified small business status at every issuance, because proving eligibility years later, at exit, is far harder than papering it contemporaneously. Investors should track holding periods against the new three, four and five year tiers and model the 28 percent rate on any partial exclusion before agreeing to a sale date. And New Jersey sellers with flexibility on closing should remember that the state exclusion was turned on with the 2026 tax year.

QSBS has always rewarded early, careful planning and punished improvisation. The rewards just got substantially larger. If you are forming a company, negotiating a financing or contemplating an exit and want to understand how the new federal and New Jersey rules apply to your situation, contact me or another qualified (pun intended) attorney to start the conversation.