Search Funds and Capital Gains Tax: A QSBS Primer

Searchers evaluating U.S. targets should pay close attention to Qualified Small Business Stock (QSBS) under Section 1202 of the Internal Revenue Code, which can allow shareholders to exclude up to 100% of capital gains on eligible shares held for more than five years (with graduated exclusions beginning in year three). The One Big Beautiful Bill Act (OB3) significantly expanded the attractiveness of QSBS and should be a consideration for any searcher; proper structuring at acquisition, including entity conversion, asset thresholds, and original issuance requirements, can materially increase after-tax returns for both searchers and their investors.

Section 1202 After the One Big Beautiful Bill Act: Initial Planning Considerations in a New QSBS Landscape

Congress enacted Section 1202 of the Internal Revenue Code (the Code) in 1993 to encourage investment in domestic C corporations. Code Section 1202 allows eligible noncorporate taxpayers to exclude a significant portion of gain from the sale of qualified small business stock. For more than a decade, Code Section 1202 operated under relatively static rules and imposed a strict five‑year holding period. The enactment of the One Big Beautiful Bill Act, signed into law on July 4, 2025, dramatically changed that framework. The legislation represents the most significant revision to Code Section 1202 since 2010.

A Brief Refresher: Summary of Preexisting QSBS Rules

Before OB3, Code Section 1202 generally allowed a non-corporate taxpayer (such as an individual or trust) to be eligible to exclude capital gains attributable to the disposition of QSBS held for more than five years. Taxpayers could also claim the exclusion for gains realized indirectly through passthrough entities, including partnerships and S corporations, so long as the transaction satisfied statutory and regulatory requirements at both the entity and owner levels.

QSBS is defined as capital stock (common or preferred) of a domestic C corporation that satisfies several corporate‑level requirements.

To qualify as QSBS, a taxpayer must acquire the stock at original issuance, either (i) in exchange for money or other non‑stock property or (ii) as compensation for services performed for the corporation. Stock that a taxpayer acquires by purchase from another shareholder never qualifies, regardless of the holding period. However, there are limited Code Section 1202 statutory carryover situations (e.g., gifts, inheritance, certain Code Section 351 or Code Section 368 exchanges) where QSBS status can be preserved.

In a mergers and acquisitions (M&A) context, if a searcher forms a new C corporation acquisition vehicle to acquire a target’s assets or equity, stock of the acquisition vehicle issued at original issuance to the searcher (and other investors) may qualify for QSBS treatment, provided all other requirements of Code Section 1202 are satisfied. Such M&A transactions may also involve “rollover equity” issued to the sellers of the target. Code Section 1202 in the M&A context will be discussed in greater detail in Article 2.

Code Section 1202 expressly disqualifies certain businesses from issuing QSBS, including enterprises engaged in professional service fields such as health, law, accounting, consulting, banking, insurance, leasing, farming, mineral extraction, and hotel or restaurant operations, among others.

Code Section 1202 generally required a holding period of more than five years before any gain exclusion applied. For stock acquired after September 27, 2010, taxpayers could exclude up to 100% of eligible gain, subject to a cap equal to the greater of $10 million per taxpayer per issuer or ten times the taxpayer’s basis in the stock.

OB3 Key Changes

There are three key changes to the QSBS rules under OB3:

1. Graduated Holding Periods

OB3 fundamentally altered the holding period framework by replacing the single five‑year holding period with a tiered holding‑period regime for QSBS issued after July 4, 2025. Under OB3:

• Stock held for at least three years qualifies for a 50% gain exclusion.
• Stock held for at least four years qualifies for a 75% gain exclusion.
• Stock held for five years or more continues to qualify for a 100% exclusion.

This graduated approach preserves the incentive for long‑term investment while recognizing that earlier exits often prove unavoidable or strategically optimal. From a planning perspective, this change significantly reduces the downside risk associated with missing the five‑year mark and may influence negotiations over exit timing.

2. Increase in Per-Issuer Gain Exclusion

OB3 increased the per‑issuer gain exclusion cap from $10 million to $15 million for QSBS issued after July 4, 2025 (and schedules inflation indexing to begin in 2027). Code Section 1202 retains the alternative 10‑times‑basis limitation, which continues to support planning opportunities for capital‑intensive businesses and founders with substantial sweat equity.

3. Increase in Gross Asset Value Limitation

OB3 raised the aggregate gross‑asset threshold from $50 million to $75 million, significantly expanding the number of corporations that can qualify as QSBS issuers. This change carries particular significance for later‑stage startups and businesses that operate as pass‑through entities during early loss years before converting to C corporation status.

Conclusion

OB3 transformed Code Section 1202 from a powerful (but often rigid) tax incentive into a more flexible and economically meaningful planning tool. Although Code Section 1202 retains its core eligibility requirements, the introduction of (i) graduated holding periods, (ii) higher exclusion caps, and (iii) an expanded asset threshold demands a renewed focus on initial QSBS planning.

These changes materially increase the value of QSBS treatment for investors and emerging company founders. In practice, taxpayers should analyze entity choice, capital structure, equity compensation planning, and add‑on and exit transactions through the lens of maintaining (or intentionally preserving the option for) QSBS qualification. Code Section 1202 has long delivered significant tax benefits to patient and careful taxpayers; OB3 expands those benefits by permitting meaningful exclusions at earlier liquidity events while increasing the potential exclusion amount and broadening issuer eligibility.