Qualified small business stock (QSBS) under Section 1202 has long been a powerful tax incentive available to small- and midsized business owners, including startup founders and early-stage investors, if statutory requirements are met. Under federal law, eligible shareholders may exclude up to 100% of gain from the sale of qualifying stock, potentially eliminating millions of dollars of federal income tax on a successful exit if certain eligibility requirements are met. The One, Big, Beautiful Bill Act (OBBBA) expanded QSBS benefits for qualified stock issued after July 4, 2025.
However, Illinois recently enacted legislation that significantly changes the state tax treatment of QSBS gains. Beginning with 2026 tax year, Illinois will require taxpayers to add back any gain excluded under Section 1202. Several states have taken similar actions while others have legislative proposals following a similar path. Further, states that have not yet fully conformed to recent federal law changes might not provide the expanded QSBS benefits. As a result, taxpayers may continue to enjoy substantial federal tax savings while owing state income tax on the same gain to Illinois and other states. Still, this also adds another layer of potential tax planning opportunity for those who look far enough ahead.
Illinois decouples from federal treatment
As part of its 2026 revenue legislation, S.B. 3019, Illinois adopted a decoupling provision that requires taxpayers to add back gains excluded under Section 1202 when determining Illinois taxable income starting for 2026 tax years. Prior to this change, Illinois conformed to the federal treatment of QSBS gains. The decoupling isn’t dependent on when the stock was issued, so even stock issued before this law was enacted will be subject to Illinois tax when sold. Further, the law is retroactive to the beginning of the year, so even sales of QSBS that occurred early in 2026, before the law changed, will be retroactively subject to tax.
With an individual income tax rate of 4.95%, the impact can be significant. For example, an Illinois resident realizing a QSBS gain of $10 million could face approximately $495,000 of state income taxes solely as a result of the state’s decoupling from Section 1202. The federal tax savings of $2,380,000 in this example are still substantial, but the increase in state tax may take some Illinoisans by surprise.
Other states’ recent changes to Section 1202 treatment
Most states are reviewing their conformity to the federal tax law changes in OBBBA, which have tended to significantly decrease state income tax revenues for those who conform. This is causing many states to not conform to certain elements of OBBBA. However, Illinois’ decision to decouple from the entirety of Section 1202, rather than just the changes made by OBBBA, is part of a broader trend in which states are reassessing the fiscal impact of the entirety of the QSBS exclusion. Several states have recently modified their treatment of Section 1202 gains, creating an increasingly fragmented state tax landscape.
Maine, Vermont, and Oregon have each decoupled from the federal treatment of Section 1202 to eliminate the state-level benefit of the federal QSBS exclusion. Oregon’s legislature specifically cited concerns regarding the cost of the expanded federal exclusion and took the larger step to decouple from the QSBS exclusion that Oregon residents have enjoyed for decades. A number of other states are currently debating legislation that would provide similar treatment.
In contrast, New Jersey moved in the opposite direction. Historically, New Jersey was one of the few states that didn’t conform to the federal gain exclusion. However, beginning in 2026, New Jersey will conform to the federal gain exclusion. This makes New Jersey one of the few states that recently expanded, rather than restricted, the availability of QSBS benefits. The change was intended to encourage investment and improve New Jersey’s competitiveness for founders, investors, and emerging businesses.
California, Alabama, Mississippi, and Pennsylvania have decoupled from the QSBS exclusion in the past, and none of those states appear to be revisiting that policy. Similarly, Hawaii residents are only able to claim a 50% exclusion, even if the federal exclusion is larger.
Planning ahead
At the federal level, Section 1202 is now more valuable than ever, offering earlier access to exclusions, larger gain limitations, and broader eligibility standards. At the same time, Illinois’ decision to tax federally excluded QSBS gains reduces the overall benefit available to the state’s residents and introduces a new element of state tax planning.
When looking ahead to the sale of a business, it has long been the case that a change in residence to a state with a lower tax burden, such as Florida or Texas which impose no income tax whatsoever, could result in substantial tax savings. In states that impose tax on QSBS, a change in residence even to a neighboring state has the potential to result in similar tax savings. For example, a taxpayer that moves 15 miles from Chicago, Ill., to Indiana not only reduces their overall state tax rate from 4.95% to 2.95%, but they would also eliminate all state tax on QSBS. While any change in state residency requires a lot of forethought and active changes in an individual’s daily habits, that style of move might be more palatable than the cross-country version. For those who are hoping to avoid hiring movers altogether, other state tax planning surrounding the sale of a business, such as the use of trusts with a different state of tax residence than the grantor, also have the potential to result in QSBS state tax savings as well. However, this strategy depends on the state’s taxation of out-of-state trusts, which is particularly challenging in Illinois.
Founders, investors, and business owners expecting future liquidity events should evaluate the impact of both developments well before a transaction occurs. As QSBS continues to play an increasingly important role in startup and private company exits, understanding the interaction between federal incentives and state conformity rules will be critical to maximizing after-tax results.
Key takeaways
- Illinois will tax federally excluded QSBS gains beginning in 2026. Taxpayers must add back Section 1202 gains when calculating Illinois taxable income, even if the gains remain fully excluded for federal purposes.
- The change applies broadly and retroactively. Illinois’ decoupling isn’t limited to newly issued stock and applies retroactively to 2026 transactions, including sales completed before the law was enacted.
- State conformity is becoming increasingly fragmented. While Illinois, Oregon, Maine, and Vermont have moved away from federal Section 1202 treatment, New Jersey is moving toward conformity, creating a more complex state tax landscape.
- Advance planning is more important than ever. Founders, investors, and business owners should evaluate residency, trust, and other state tax planning strategies well before a liquidity event to help maximize after-tax proceeds.
