Updated September 2026 to reflect the changes Congress made to Section 1202 in the One Big Beautiful Bill Act, signed into law on July 4, 2025.

In the course of Companyon’s fundraising discussions with high-net-worth individuals, angel investors, VCs, and family offices, we’ve been struck by how many sophisticated investors overlook this. Some are unaware of the tax advantages Section 1202 provides. Others know about it but are confused about how the rules actually work, especially around funds. Many are surprised to learn that distributions from early-stage VC funds can also qualify for these tax benefits. Whether they do depends on how the fund made its investments and whether the investment details are shared with its limited partners.

To learn more about this topic, we sat down with Scott Pinarchick, a tax partner at Ropes & Gray in Boston who specializes in private equity, venture capital, and mergers & acquisitions. Scott has been practicing tax law in Boston for more than 25 years. Ropes & Gray is a preeminent global law firm with approximately 1,500 lawyers serving clients in major centers of business, finance, technology, and government.

Note that this article is a high-level summary of only some of the provisions in Section 1202. Section 1202 is a federal provision, and state conformity varies. Since July 2025, the answer to almost every Section 1202 question also depends on when the stock was issued. Always consult your tax advisor about your specific situation before making any investments and related tax planning assumptions.

Background

Angel investors and fund managers often tout the tax advantages of early-stage investing under Section 1202 of the Internal Revenue Code (Qualified Small Business Stock, or QSBS), enacted in 1993 to incentivize small-business growth. As explained here, an investment that qualifies for Section 1202 treatment can be sold without federal capital gains tax. The exclusion covers the greater of $15M or 10x the investor’s cost basis, meaning what they originally paid for the shares.

For shares acquired on or before July 4, 2025, that ceiling is $10M rather than $15M. The cap applies per investor, per company, so someone holding three qualifying companies has three separate caps. For a venture capital fund investor (known as a Limited Partner or LP), the exclusion applies on a per-LP and per-company profit-distribution basis.

What the 2025 tax law changed

This was the most significant expansion of Section 1202 since 2010. Three changes matter most to early-stage investors:

• A shorter path to a tax break. Stock acquired after July 4, 2025 no longer has to be held a full five years to produce any benefit. An investor who holds for at least three years excludes 50% of the gain, at four years 75%, and at five years or more the full 100%.
• A larger cap per company. The maximum gain one investor can shelter from a single company rose from $10M to $15M, or 10x the amount they paid for the shares, whichever is greater. Married taxpayers filing separately are capped at $7.5M. Beginning with tax years after 2026, the $15M figure rises each year with inflation. The 10x test is unchanged, and for investors writing larger checks, it is often the test that actually governs.
• A higher company size limit. The issuing corporation can now have up to $75M in aggregate gross assets, up from $50M. Gross assets mean roughly the company’s cash plus what it paid for what it owns, not what the company is worth on paper, so a startup carrying a $300M valuation can still qualify. Congress also wrote in inflation indexing after 2026, but a drafting glitch has left advisors unsure it works, so nobody should count on that ceiling rising yet. The practical effect is real. A company that has already crossed $50M can issue QSBS in a post-July 2025 round, so long as it remains under $75M. That brings Series B and even Series C checks into range.

There is an important limitation on all of this. These changes apply only to stock acquired or issued after July 4, 2025. Stock acquired on or before that date is subject to the old rules in full: a 5-year holding period, a $10M cap, and a $50M gross asset test. There is no way to move existing shares into the new rules, so most angels and LPs will be tracking two sets of QSBS math side by side for years.

A worked example makes the holding period concrete. Suppose an LP’s share of a portfolio company exit is $2M of gain on shares the fund bought in 2026. Sell at year three, and $1M of that is tax-free, while the other $1M is taxed at 28% plus the 3.8% surtax on investment income, or roughly $318K of federal tax. Hold to year five, and the entire $2M comes through tax-free. Those two extra years are worth about $318K on that single position.

Qualifying criteria

While not a comprehensive list, the most relevant Section 1202 qualifying criteria for most early-stage tech investments are:

• The stock was issued by a domestic C corporation. An investment made in an LLC treated as a partnership for federal income tax purposes or an S corporation does not qualify.
• On the date the stock is issued, both before and immediately after the investment, the issuing corporation’s aggregate gross assets did not exceed the ceiling. That ceiling is $75M for stock issued after July 4, 2025, and $50M for stock issued on or before that date. What matters here is the company’s assets, not its valuation.
• The issuing corporation does not repurchase 5% or more of its own stock (determined by the value of the stock at the beginning of the two-year period) during the two-year period beginning one year before the issue date (certain exceptions apply).
• The issuing corporation does not purchase any of the stock from the investor or a related person during a four-year period beginning two years before the issue date (certain exceptions apply).
• The stock is held for at least 5 years to qualify for a full exclusion. For stock acquired after July 4, 2025, a partial exclusion is available earlier: 50% at three years and 75% at four years.
• The corporation uses its assets in an active qualified business.

Investments in Venture Funds and circumstances around the start of the holding period seem to cause the most confusion, especially when investments are made as convertible notes or SAFEs. The July 4, 2025, dividing line has added a fresh wrinkle. To better understand these topics, I asked Scott some questions about Section 1202 of the Internal Revenue Code.

Venture fund investments

Q: What does the 50% exclusion now available at three years mean in real terms?

The three and four-year tiers are useful, but the portion of the gain you don’t exclude is taxed at a maximum federal rate of 28%, not the 20% rate that normally applies to long-term gains. The 3.8% surtax on investment income still applies on top of that. A three-year exit, therefore, has an effective federal tax rate of 16% of the total gain, and a four-year exit roughly 8%, with zero at five years up to the cap. Gain above the cap is calculated separately, and that portion is taxed at the ordinary 20% plus 3.8%. Where an investor has any control over exit timing, and in a fund, they usually don’t, five years remains the number that matters the most. For an exit inside three years, a Section 1045 rollover is still the better tool, and the new law left it untouched. A rollover lets an investor reinvest the proceeds into another qualifying company and defer the tax. There is also no alternative minimum tax complication on the newer shares.

Q: Many investors assume Section 1202 tax benefits are only available to angels who directly invest in startups. Do the benefits extend to limited partners (LPs) in a venture fund?

Most venture funds are structured as limited partnerships, which are pass-through entities. Fund LPs who are US-taxable individuals or eligible trusts should receive the benefit of Section 1202 directly when their venture fund exits a QSBS investment. The condition is that they are LPs both when the fund makes the investment and when it exits.

Q: Many early-stage funds hold several closings over a year or two. Does it matter which closing an LP comes in on?

An exit by a fund of a QSBS investment will only have Section 1202 tax treatment for LPs who were investors in the fund at the time the qualifying investment was made. LPs who invest in the fund after the fund’s qualifying investment will pay full capital gains from that particular exit.

Q: Most funds now hold investments made both before and after July 4, 2025. What does that mean for an LP?

Each portfolio company investment is evaluated on its own merits. Investments the fund made on or before July 4, 2025, stay under the old rules of five years, a $10M cap, and the $50M gross asset test. Investments made after that date get the tiered holding period, the $15M cap, and the $75M asset ceiling. Investors should not assume that the two caps stack to $25M for a single company. The $15M limit is reduced by the gain the taxpayer previously excluded on that same corporation’s stock, regardless of when the shares were bought, so the order of sales becomes a real dollar decision. Selling the newer shares first can consume the older $10M allowance. There are also unresolved mechanical questions about how the two caps interact when both sets of shares are sold in the same tax year. Treasury has Section 1202 guidance on its list but has not issued it. An LP with meaningful positions on both sides of the date should walk through the numbers with an accountant rather than assume an answer.

Q: In my conversations with potential LPs, many have asked me whether several individuals can pool their capital into an LLC to make a fund investment. Does Section 1202 tax treatment extend to pass-through entities that invest in a fund?

Yes. Individuals who pool capital into a US S corporation, LLC, partnership, trust, or common trust fund that then becomes a partner in the fund should still receive the benefit of Section 1202. Two conditions have to hold. The pooling vehicle must be a flow-through entity for tax purposes, meaning it pays no tax itself and passes its income out to its owners. And the gain must ultimately land with a US taxable individual.

Q: A common strategy for VC fund managers is making one or more company investments before their fund’s first close. General partners either make direct investments using personal funds or create a special purpose vehicle (SPV). Once the VC fund has its first close, these early investments are then transferred into the new fund. Investors call this process “deal warehousing.” Does deal warehousing impact the benefit of Section 1202 for all limited partners?

Transferring an investment or contributing shares to a partnership generally nullifies Section 1202 treatment for all parties involved. If fund managers are trying to maximize the tax benefits of Section 1202 for their LPs, they should avoid warehousing and invest directly from a closed or fertile fund. Pooling the initial investors’ funds into a first “soft” close of the VC fund and making the investment from the fund is a much better way to benefit from Section 1202. As mentioned above, only investors who are in the fund at the time of the investment can benefit from Section 1202 with respect to that investment. The larger exclusion enacted in 2025 raises the stakes for getting this right, since a warehousing mistake now forfeits a larger amount.

Convertible notes

Many investors buy equity in an early-stage company. Others use instruments such as convertible notes that eventually convert into equity. Some notes convert at a near-term round of financing. Others can take years, if the startup delays the funding round or exits before the conversion.

Q: Does the signing date of the convertible note start the holding period to qualify for Section 1202 treatment?

No, the issuance of a convertible note is not the start of the holding period for Section 1202 purposes because a convertible debt instrument is not considered equity. Investors must convert the note into equity to begin the holding period (assuming the company’s stock meets the Section 1202 requirements at the time of conversion).

Q: What about a note signed before July 2025 that converts after July 4, 2025? Which set of rules applies to the resulting stock?

The new rules apply when the stock is acquired, and because a convertible note is debt, that date is the conversion date. A note signed in the first half of 2025 that converts after July 4, 2025 should therefore produce stock in the new regime. That is the prevailing practitioner view rather than a settled one, since the IRS hasn’t confirmed it, and the company still has to pass the gross asset test as of the conversion date. The harder version of this question involves SAFEs, which I’ll come to below.

Suppose investors suspect that a convertible note’s lifetime could be a year or longer. In that case, they might consider negotiating a priced round with the entrepreneur instead of using a debt instrument. The tiered exclusion softens the penalty somewhat. A delayed clock now reaches a 50% exclusion at three years rather than nothing before five. But the opportunity cost of pushing the start date out is still real.

SAFEs

Some startups execute SAFEs (Simple Agreement for Future Equity) as a substitute for an equity round. Other startups use SAFEs as a bridge mechanism while they fundraise or complete a diligence process with a prospective investor.

Q: Does the holding period for Section 1202 treatment start when a SAFE investment is executed or when it converts into equity?

Whether a SAFE investment qualifies for Section 1202 treatment is unclear and depends on its terms. While a SAFE is generally not considered debt, it may be treated differently by tax authorities depending on its terms.

On the one hand, a SAFE can be interpreted as a prepaid forward contract, essentially an advance payment for shares to be delivered later. In that case, a SAFE is not considered equity, and an investor is not treated as an owner until the new stock is issued. Depending on its terms, a SAFE may instead be interpreted as current equity even though it technically becomes a different class of equity in the future. If the SAFE were to qualify as equity pursuant to its terms, the holding period begins at the issue of the SAFE. In my experience, the terms of most SAFEs would not qualify as equity for federal income tax purposes, including Section 1202.

Given the gray area surrounding Section 1202 treatment for SAFEs, investors should tread carefully and seek advice from their tax advisors when classifying SAFE investments. The 2025 dividing line adds a second layer to the problem. Say a SAFE is treated as equity from the date it’s signed. One executed before July 5, 2025, could then be stuck under the old $10M cap and five-year clock, even though the shares are issued much later. Treasury has signaled that SAFEs and convertible notes are on its list for Section 1202 guidance, but nothing has been published yet.

Mergers, acquisitions, and recapitalizations

Q: Do tax-free mergers, acquisitions, and recapitalizations wipe out the Section 1202 benefit?

In general, a recapitalization, meaning a reshuffling of a company’s own share classes with no new money changing hands, should not affect Section 1202 status. Other tax-free exchanges, like stock for stock exchanges or a merger in an acquisition, generally don’t eliminate the benefit of Section 1202, but they can limit the benefit since they’re usually treated as an exchange of stock. As a result of such an exchange, investors need to determine whether their new stock qualifies as qualified small business stock under Section 1202. If the new stock qualifies as Section 1202 stock, the benefits continue on future appreciation. If the new stock does not qualify, the Section 1202 benefits become limited to the stock value on the date of the exchange. Any value increases after this date are then subject to regular tax. The gross asset threshold that the test uses, $75M or $50M, depends on when the replacement stock is issued, though in practice, most acquirers are well past either number.

Venture fund evaluation & reporting

When considering an investment in a Venture Capital Fund, LPs should think about what Section 1202 may do to their after-tax return. Fund performance metrics are usually reported before tax, because different types of LPs, such as individuals, pensions, and endowments, are taxed differently on gains from fund distributions.

Q: What should an LP ask a fund manager about Section 1202 before investing?

LPs should ask fund managers the following questions related to how that fund invests in companies and reports to its limited partners:

• Will the fund purchase any warehoused deals? If so, what % of the invested capital will be warehoused investments vs. direct investments? Depending on how warehoused investments are structured, they may not qualify for benefits under Section 1202.
• Does the fund typically invest its first check in a company as priced equity, convertible notes, or SAFEs? Investments in convertible notes and SAFEs will delay the start of the holding period for Section 1202 benefits, which now also determines which exclusion tier an exit lands in: 50%, 75% or 100%.
• What percentage of investments from the fund will be in secondary purchases or non-US companies? Secondary purchases and non-US investments will not qualify for Section 1202 benefits.
• If the fund is multi-stage, what percentage of investments will be in US C corporations under the gross asset ceiling, meaning $75M for stock issued after July 4, 2025 or $50M for earlier issuances? These investments are most likely to entitle an individual investor to Section 1202 benefits.
• For an existing fund, how many of the portfolio investments were made on or before July 4, 2025? Those shares are locked into the $10M cap and the five-year holding period no matter when the fund exits.
• When distributing cash from portfolio company exits, does the fund manager and its tax firm provide a Section 1202 assessment with the distribution notice and K-1? A useful assessment names the stock issuance date, the fund’s holding period, and the applicable exclusion percentage. Otherwise, it would be difficult for an investor to know whether any gains from one of the fund’s investments qualified for Section 1202 benefits, and at what rate.

What to do about it

For an investor who already holds early-stage positions or fund interests, four things are worth doing this year.

• Find the issuance date for every position you hold. On a direct investment, it is on the stock certificate or the purchase agreement. On a fund interest, ask the manager for the date the fund bought each portfolio company. That single date decides which set of rules applies, and most K-1s do not report it.
• Identify which holdings predate July 5, 2025. Those are capped at $10M and still need the full five years. Nothing can change that, but knowing which positions they are prevents an expensive assumption at exit.
• Do not plan a three-year exit around the 50% tier without running the numbers. The 28% rate on the taxable half means the break is worth less than the headline suggests, and a Section 1045 rollover may serve better.
• If you are negotiating a new investment, ask whether the round is priced equity rather than a SAFE or a note. That choice determines when your holding period starts or is delayed, and it is usually negotiable.

About Ropes & Gray

Ropes & Gray was named both “2022 Law Firm of the Year” and the number one firm on the A-List by The American Lawyer (in both the U.S. and U.K.). A preeminent global law firm, Ropes & Gray has approximately 1,500 lawyers and legal professionals serving clients in major centers of business, finance, technology, and government. The firm has offices in Boston, Chicago, Dublin, Hong Kong, London, Los Angeles, New York, San Francisco, Seoul, Shanghai, Silicon Valley, Tokyo and Washington, D.C. The firm has consistently been recognized for its leading practices in many areas, including private equity, M&A, finance, asset management, real estate, tax, antitrust, life sciences, health care, intellectual property, litigation & enforcement, privacy & cybersecurity, and business restructuring.