Founders and Investors May Face New Illinois Tax on QSBS Gains
Beginning with tax years ending on or after December 31, 2026, Illinois will require taxpayers to add back gains excluded from federal gross income under Section 1202 of the Internal Revenue Code when calculating Illinois taxable income. In other words, a gain that remains tax-free for federal purposes may now be taxable in Illinois.
What Is QSBS?
Qualified Small Business Stock, or QSBS, is a federal tax incentive designed to encourage investment in qualifying small businesses.
Under Section 1202 of the Internal Revenue Code, taxpayers who meet certain requirements may be exclude a portion—or potentially all—of the gain recognized on the sale of qualifying stock. Recent changes to federal law also expanded the availability of the exclusion, allowing certain taxpayers who hold Qualified Small Business Stock for more than three years to qualify for a partial federal income tax exclusion, with larger benefits available for longer holding periods.
For founders and investors, these federal changes have made Section 1202 an even more valuable planning tool by expanding the potential tax benefits associated with future business sales, liquidity events, and other stock dispositions.
Illinois, however, is taking a different approach.
What Is Changing?
Illinois is decoupling from the federal treatment of QSBS gains, and is not the first state to do so.
Several states already do not fully conform to Section 1202, meaning taxpayers may receive favorable federal treatment while receiving reduced, or no, state tax benefit.
What Should Taxpayers Do Now?
While the change does not take effect until tax years ending on or after December 31, 2026, taxpayers who may qualify for QSBS treatment should begin evaluating how it could affect long-term planning.
Areas worth reviewing may include:
- Future exit strategies
- Transaction modeling
- State residency considerations
- Projected after-tax proceeds from a future sale
- Existing assumptions regarding QSBS benefits
Because Illinois is creating a distinction between federal and state treatment, modeling both outcomes may become increasingly important when evaluating future transactions.
The federal benefits associated with Section 1202 remain intact. However, Illinois’ decision to decouple from the federal exclusion creates a new layer of complexity for founders and investors planning future transactions.
Understanding the difference between federal and Illinois treatment may become increasingly important as taxpayers evaluate investment opportunities, succession plans, and exit strategies.
If you have questions about how Illinois’ new treatment of Qualified Small Business Stock may affect your business, investment strategy, or future sale transaction, contact FGMK. Our team can help evaluate the potential impact and identify planning opportunities based on your specific circumstances.