A well-run construction project starts with a clear plan for completing the work on schedule and within budget. Business succession deserves the same level of preparation. For construction company owners, one strategy worth evaluating is the qualified small business stock, or QSBS, exclusion under Section 1202 of the Internal Revenue Code.
When the requirements are met, the exclusion may allow an eligible shareholder to exclude some or all of the federal capital gain from selling qualifying stock. Recent changes under the One Big Beautiful Bill Act expanded the potential benefit for certain stock issued after July 4, 2025. However, the rules are detailed, and the exclusion generally requires years of advance planning.
Why entity structure matters
QSBS treatment is available only for stock in a qualifying domestic C corporation. At the entity level, a qualified small business is generally taxed like any other C corporation.
This structure creates both advantages and drawbacks. A C corporation is generally subject to a flat 21% federal corporate income tax rate. However, income may be taxed once at the corporate level and again when shareholders receive taxable dividends, compensation or sale proceeds. This is commonly called double taxation.
Section 1202 may offset part of that disadvantage for eligible shareholders. If the company, stock and shareholder satisfy the applicable requirements, a shareholder may be able to exclude a substantial portion of the gain from a future stock sale. In some cases, the eligible federal gain could be excluded entirely.
Core QSBS eligibility requirements
QSBS eligibility depends on several interrelated requirements. Among other conditions:
- The shares generally must have been acquired at original issuance from the corporation in exchange for money, eligible property or services. Certain gifts and inheritances may also qualify.
- The issuing company must be a qualifying domestic C corporation when the stock is issued and during substantially all of the shareholder’s holding period.
- The corporation must satisfy the applicable gross-assets test at the time of issuance.
- At least 80% of the corporation’s assets generally must be used in the active conduct of one or more qualified trades or businesses during substantially all of the holding period.
- The shareholder must satisfy the applicable holding-period rules.
For qualifying stock issued after July 4, 2025, the corporation’s aggregate gross assets generally cannot exceed $75 million before or immediately after issuance. The previous $50 million threshold generally applies to stock issued on or before July 4, 2025.
Because these tests are highly technical, owners should not assume that C corporation status alone makes their shares eligible.
Holding periods and potential exclusion amounts
For qualifying stock issued after July 4, 2025, the law introduced a tiered exclusion based on how long the shareholder holds the stock:
- At least three years: Up to 50% of eligible gain may be excluded.
- At least four years: Up to 75% of eligible gain may be excluded.
- At least five years: Up to 100% of eligible gain may be excluded.
Different rules apply to stock issued before July 5, 2025. For example, stock acquired after September 27, 2010, generally must be held for more than five years to qualify for a 100% exclusion.
For qualifying stock subject to the new rules, the per-issuer dollar cap was increased from $10 million to $15 million, subject to the statute’s alternative limitation and other requirements. Any gain that is not excluded may be subject to a special 28% federal rate and, when applicable, the 3.8% net investment income tax.
Construction companies may qualify, but service mix matters
Construction is not specifically listed among the excluded fields under Section 1202. Still, engineering, architecture and several other professional service fields are excluded.
This distinction can create uncertainty for design-build contractors and other companies that combine construction with significant engineering or architectural services. Eligibility may depend on the nature of the company’s operations, how its employees generate revenue and which activities account for its assets.
The rules also exclude a business when its principal asset is the reputation or skill of one or more employees. That provision may require added review for very small firms, one-person operations and specialty contractors whose value is closely tied to a particular individual’s expertise.
Watch the active-business test
During substantially all of the shareholder’s holding period, at least 80% of the corporation’s assets generally must support one or more qualified businesses. Only reasonable amounts of working capital count toward this requirement.
A construction company that accumulates substantial excess cash, investment assets or real estate unrelated to its operating activities could put its QSBS status at risk. Owners considering the exclusion should monitor the company’s balance sheet, asset use and business activities throughout the holding period, not only when shares are issued or sold.
Should a pass-through construction business convert?
Many contractors operate as S corporations, partnerships or limited liability companies taxed as partnerships. Interests in those entities do not qualify as QSBS. An owner may therefore consider converting the business to a C corporation and receiving newly issued shares.
That decision should not be based on the potential exclusion alone. A conversion may cause the owner to lose access to the qualified business income deduction, which can be worth up to 20% of qualified business income when the applicable requirements are met. C corporation double taxation, state taxes, transaction structure, cash-flow needs and the expected timing of an exit should also be modeled.
Just as important, the QSBS holding period generally begins when qualifying stock is issued. A conversion shortly before a sale is unlikely to produce the intended benefit.
Stock sale versus asset sale
The Section 1202 exclusion generally applies when an eligible shareholder sells qualifying stock. It does not ordinarily protect gain recognized by the corporation when the company sells its assets.
This difference can be decisive because buyers often prefer asset purchases, while sellers may prefer stock sales. Owners considering QSBS should evaluate the likely transaction structure well before going to market and should recognize that the final deal terms may affect the available tax benefit.
Start planning early
The QSBS exclusion can be a valuable component of a construction business owner’s exit strategy, but it is not a last-minute tax tactic. Entity selection, stock issuance, asset composition, service mix, holding period and transaction structure all influence whether the exclusion is available.
A tax advisor and legal counsel can help determine whether the potential federal tax savings justify the costs and trade-offs of operating as a C corporation. They can also help establish documentation and monitoring procedures designed to support eligibility throughout the holding period. Contact us for help with this process.
Frequently Asked Questions
What is the qualified small business stock exclusion?
The qualified small business stock exclusion is a federal tax benefit under Section 1202. When the shareholder, stock and issuing C corporation meet the applicable requirements, the shareholder may exclude some or all of the eligible federal capital gain from selling the stock, subject to holding periods, dollar limits and other restrictions.
Can a construction company qualify for QSBS treatment?
Potentially. Construction is not specifically listed as an excluded business under Section 1202. However, engineering, architecture and certain professional service businesses are excluded. Contractors that provide substantial design, engineering or architectural services should obtain a detailed analysis of their operations before relying on QSBS treatment.
How long must QSBS be held before it can qualify for an exclusion?
For qualifying stock issued after July 4, 2025, a shareholder may be eligible for a 50% exclusion after at least three years, a 75% exclusion after at least four years and a 100% exclusion after at least five years. Different rules apply to earlier stock, so the issuance and acquisition dates should be reviewed carefully.
Do S corporation or LLC ownership interests qualify as QSBS?
No. QSBS must be stock in a qualifying domestic C corporation. An S corporation, partnership or LLC taxed as a partnership may consider a conversion, but the tax consequences, holding-period rules, loss of pass-through benefits and expected exit structure should be evaluated before making that decision.
Does the QSBS exclusion apply to an asset sale?
Generally, no. Section 1202 generally benefits an eligible shareholder who sells qualifying stock. It does not ordinarily exclude gain recognized by the corporation from selling its assets. Because buyers and sellers may prefer different transaction structures, the anticipated form of a future sale should be considered early in the planning process.
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