On July 4, 2025, President Trump signed into law the One Big Beautiful Bill Act (the “OBBBA”). Among other things, the OBBBA makes permanent many provisions of the 2017 Tax Cuts and Jobs Act (the “TCJA”) that otherwise would have expired at the end of 2025. The OBBBA contains a wide range of provisions that affect nearly every sector of the economy and every type of taxpayer, but the changes to the qualified small-business stock (“QSBS”) and research and development (“R&D”) expenditure deduction rules are particularly relevant for venture capital investors and venture-backed companies.
Qualified Small-Business Stock
As many venture investors know, the QSBS provisions in Section 1202 of the Internal Revenue Code (the “Code”) allow a noncorporate taxpayer to potentially exclude up to 100% of the amount of eligible gain realized from the sale or exchange of QSBS. The potential benefits of Section 1202 do not directly apply to equity interests in “pass-through” entities, such as “S-corporations” or partnerships (or LLCs taxed as partnerships). However, an individual taxpayer’s allocable share of gain attributable to a sale of QSBS by, for example, a venture capital fund structured as a pass-through entity, may potentially qualify as gain eligible for the Section 1202 exclusion, provided that the individual taxpayer held an interest in the fund entity at the time the shares that qualify for QSBS treatment were originally issued and acquired by the fund.
Even before enactment of the OBBBA, the QSBS rules provided significant potential federal income tax savings for venture capital investors. The OBBBA introduces a number of taxpayer-friendly changes to the QSBS rules that result in even greater potential benefits. The OBBBA significantly increases the amount of gain that taxpayers can exclude from federal income tax upon the sale of shares that qualify for QSBS treatment, provides potential tax benefits earlier in an investor’s holding period, and expands the eligibility criteria for a corporation to be a valid issuer of shares that qualify for QSBS treatment.
To qualify for the benefits of Section 1202, a noncorporate taxpayer must acquire and hold stock in an entity treated as a C-corporation for federal income tax purposes. Once that hurdle has been cleared, there are five main requirements that must generally be satisfied before gain on the sale of stock is potentially eligible for the exclusion under Section 1202: (i) The issuing corporation must be a “qualified small business” (often referred to as the “gross-assets test”); (ii) the taxpayer must satisfy certain holding period requirements; (iii) the stock must be acquired directly from the relevant corporation at the time of its original issuance in exchange for money or property (not including stock) or as compensation for services; (iv) the issuing corporation must satisfy the “active business requirement” during substantially all of the taxpayer’s holding period; and (v) the issuing corporation must not have made certain redemptions of its stock within specified time periods before and after the issuance of the stock. The OBBBA eases the first two of these requirements for stock issued after July 4, 2025 (the date of enactment of the OBBBA).
For stock issued on or prior to the enactment of the OBBBA to qualify for QSBS treatment, the issuer could not exceed $50 million in aggregate gross assets at any time prior to or immediately following the issuance. For this purpose, aggregate gross assets generally means the amount of cash and the aggregate adjusted tax bases of other property held by the corporation. For stock issued after the enactment of the OBBBA, however, the $50 million gross-assets limitation is increased to $75 million and is thereafter indexed to inflation.
In addition, stock issued on or prior to the enactment of the OBBBA had to be held for at least five years before a shareholder could qualify for the 100% QSBS gain exclusion. However, stock issued after the enactment of the OBBBA and held for only three years can now qualify for a 50% exclusion, and stock held for four years can qualify for a 75% exclusion, while stock held for five years remains eligible for the full 100% exclusion (in each case, subject to the limitations described below).
The final, and perhaps most impactful, change to Section 1202 significantly increases the per-issuer limitation on QSBS gain exclusion. For stock issued prior to the enactment of the OBBBA, the amount of gain that is eligible for exclusion by a taxpayer with respect to shares that qualify for QSBS treatment of a particular issuer is subject to an annual limitation equal to the greater of (i) $10 million (reduced by the aggregate amount of eligible gain taken into account by the taxpayer in prior taxable years with respect to dispositions of shares that qualify for QSBS treatment of the issuer) or (ii) ten times the aggregate adjusted basis of QSBS issued by the issuer and disposed of by the taxpayer during the taxable year. For stock issued after the enactment of the OBBBA, the $10 million limitation is increased to $15 million. The $15 million limitation is also indexed to inflation going forward.
The takeaways for venture capital funds and their investors are that (i) expanded eligibility requirements will lead to more portfolio companies being eligible issuers of shares that qualify for QSBS treatment, and (ii) exclusion limitation and holding period changes will permit investors to enjoy larger QSBS benefits, and to potentially enjoy them sooner, than they would have under prior law. Venture capital funds and their investors should consider these new QSBS rules carefully when acquiring or disposing of portfolio company stock.
Research and Development Expenditure Deductions
Since 2022, as a result of the TCJA’s changes to Section 174 of the Code, taxpayers have generally not been permitted to deduct R&D expenditures in the year incurred. Instead, taxpayers have been required to capitalize those expenditures and amortize them over a period of five years (in the case of domestic R&D expenses) or 15 years (in the case of foreign R&D expenses). For startup and early-stage companies with significant R&D expenditures, the TCJA rules could result in increased tax liabilities and potentially have a negative impact on a corporation’s ability to pass the QSBS gross-assets test described above.
The OBBBA changes the rule for domestic R&D expenditures so that, for tax years beginning on or after January 1, 2025, taxpayers may (but are not required to) deduct the full amount of domestic R&D expenditures in the year incurred (foreign R&D expenditures must still be capitalized and amortized over 15 years). The OBBBA and subsequent Internal Revenue Service guidance also provide a set of transition rules that give taxpayers a few different options when it comes to the treatment of domestic R&D expenditures that were previously capitalized under prior law. Those transition rules permit any taxpayer to choose to (i) deduct the full amount of capitalized and unamortized domestic R&D expenditures in the 2025 tax year or (ii) split the deduction 50/50 between the 2025 tax year and the 2026 tax year.
A separate election is available for certain small businesses that meet a gross-receipts test. To qualify, the average annual gross receipts of the taxpayer for the three-taxable-year period ending with the 2024 taxable year must not exceed $31 million. Eligible taxpayers may elect to treat January 1, 2022 (as opposed to January 1, 2025) as the effective date of the OBBBA R&D expenditure changes. The election must be made on or before July 6, 2026. Electing taxpayers must amend their federal income tax returns for the 2022, 2023, and 2024 tax years to deduct the full amount of domestic R&D expenditures in those years, which could result in tax refunds or increased net operating losses for such periods. Alternatively, a taxpayer that is eligible for the small-business election described above may choose to implement the election by way of a change in method of accounting for purposes of Section 481 of the Code.
The OBBBA’s restoration of current deductions for domestic R&D expenditures is generally a win for venture-backed companies and their investors. However, taxpayers, particularly early-stage companies that may be eligible for the small-business election, should carefully consider their options when it comes to the treatment of previously capitalized R&D expenditures. The facts of a taxpayer’s specific situation (with respect to its net operating loss position, whether it has experienced any changes in ownership under Section 382 of the Code, and other factors) will dictate which transition election provides the most tax benefit to the taxpayer. In addition, to the extent that previously capitalized R&D expenditures may have prevented a taxpayer from satisfying the $50 million aggregate gross-assets test described above in relation to potential QSBS status, a retroactive deduction of those expenses may also enable QSBS qualification for any stock issuances made during the 2022, 2023 and 2024 tax years. As a result, taxpayers should consult with their tax advisors regarding the new R&D expense deduction rules and other provisions of the OBBBA that may impact their business.
