Tax
Your Fund Just Exited a QSBS Position. Your Second-Close LPs Get Nothing.
Section 1202(g) gives the QSBS exclusion only to LPs who held an interest the day your fund bought the stock. What that means for second closes and K-1s.
By 409.AI Team - 2026-10-06
# Your Fund Just Exited a QSBS Position. Your Second-Close LPs Get Nothing.
Five years after the check cleared, the exit lands. Your fund put $3 million into a portfolio company and the position returns $48 million. Someone on the team has already done the back-of-envelope and told the LPs the gain is QSBS, so it comes out federally tax-free.
Then the K-1s go out, and they don't all say the same thing.
The LP who came in at your first close excludes their entire share. The LP admitted six months later, at the second close, pays long-term capital gains on every dollar of theirs. Same fund, same position, same exit, same five years. The only difference is a date, and the statute cares about it more than anything else in the file.
Almost everything written about Section 1202 is written for founders and employees holding shares directly. This is the other side of it: the shareholder of record is a venture fund, and the people who claim the exclusion are its partners. If you run finance at a fund, one rule decides who gets the benefit and another decides whether you can still prove the company ever qualified.
The two conditions nobody reads until exit
Section 1202(g) lets gain flow through a partnership and keep its character. It's short, and both of its conditions are easy to fail.
The first is about the stock. Under [26 U.S.C. 1202(g)(2)(A)](https://www.law.cornell.edu/uscode/text/26/1202), the gain has to be attributable to the sale of stock that is qualified small business stock "in the hands of such entity (determined by treating such entity as an individual)" and that the entity held "for at least 3 years (more than 5 years in the case of stock acquired on or before the applicable date)." The fund is tested as if it were a person. Its purchase has to have been an original issuance, and its holding period is the one that counts.
The second is about the partner, and it's the one that surprises people. Subparagraph (B) requires that the amount be includible in the partner's income by reason of holding an interest in the entity "which was held by the taxpayer on the date on which such pass-thru entity acquired such stock and at all times thereafter before the disposition of such stock by such pass-thru entity."
Read that twice. Not "held an interest in the fund." Held an interest on the day the fund bought that specific stock, and continuously from then until the fund sold it.
Eligibility, then, isn't a property of the LP, or of the fund, or even of the position. It belongs to the pairing: this LP, this stock, this purchase date. A fund with 22 companies bought over a four-year investment period has 22 partner rosters that matter, and they aren't the same roster.
What that does to a subsequent closing
Funds hold closings over months. The statute doesn't adjust for that.
Say Brightwater Ventures is raising a $50 million Fund I. The first close lands in March 2026 at $30 million. In May 2026 the fund leads a round in Tessel Robotics, buying newly issued preferred for $3 million. The second close comes in September 2026 and brings total commitments to $50 million.
Harper committed $6 million at the first close, so Harper held 20% of the fund on the day it bought Tessel. Calder committed $5 million at the second close, four months later.
In 2031 Tessel is acquired and the fund books a $45 million gain on the position.
Harper is fine. Harper held an interest on the acquisition date and never stopped, so Harper's distributive share is Section 1202 gain. The second close diluted Harper to 12%, putting that share at $5.4 million. The fund held the stock more than five years and bought it after July 4, 2025, so the exclusion is 100%, and Harper's per-issuer cap is the greater of $15 million or ten times Harper's share of basis. A $5.4 million share is comfortably under either one, so Harper pays nothing.
Calder's share of the same gain is $4.5 million, and none of it is Section 1202 gain. Calder didn't hold an interest in the fund on the day it bought Tessel. It's a long-term capital gain like any other, so at 20% plus the 3.8% net investment income tax, Calder owes roughly $1.07 million on the same five-year hold that cost Harper nothing.
Nothing fixes this after the fact. The subsequent-close mechanics that make later LPs economically whole, the catch-up contribution with interest, none of it makes them partners on a date that has already passed. Holland & Knight's analysis of [QSBS in pooled investment fund partnerships](https://www.hklaw.com/en/insights/publications/2025/08/special-qualified-small-business-stock-issues-applicable) puts the result bluntly: a partner admitted after the fund acquires QSBS "will not be able to qualify for a future exclusion."
The practical consequence is a scheduling question, not a tax one. If your fund is between closes and about to wire into a company you think issues QSBS, the order of those two events is worth real money to everyone who hasn't signed yet.
The ceiling set on day one
There's a second limit for partners whose stake grew. Section 1202(g)(3) caps the exclusion at what it would have been "if such amount were determined by reference to the interest the taxpayer held in the pass-thru entity on the date the qualified small business stock was acquired."
Mercer held 10% of Brightwater when it bought Tessel, then picked up a departing LP's interest and got to 18%. At exit Mercer's distributive share of the $45 million is $8.1 million, but the QSBS portion is capped at the 10% Mercer held in May 2026, so $4.5 million. The remaining $3.6 million is ordinary long-term capital gain.
Note which way this runs. Dilution doesn't hurt you: you receive a smaller allocation and all of it qualifies. Accretion is what gets capped. The acquisition-date percentage is a ceiling, never a floor.
Each LP has their own cap
Here's the part that makes fund-held QSBS more valuable than it first looks. Under 1202(g)(1)(B), the pass-through amount is treated as gain from a disposition of stock in the issuing corporation for purposes of applying subsection (b), which is the per-issuer limitation.
That limitation lives with the taxpayer, not the fund. BDO's analysis of QSBS for private equity and venture investors states it directly: the dollar and ten-times-basis limits "are applied at the level of the individual owner," and [each investor has a separate cap per issuer](https://www.bdo.com/insights/industries/private-equity/qualified-small-business-stock-can-provide-a-strategic-advantage-to-private-equity-groups-and-ventur).
So a fund with thirty qualifying LPs isn't working against one $15 million ceiling on a position. Each eligible partner brings their own, measured against their own share. A $200 million gain on a single name can come out almost entirely excluded across the partner group, where one founder with the same economics would hit the cap and stop.
The ten-times-basis prong also does more work for funds than for founders, who usually have close to zero basis. A fund that paid $3 million hands its partners real basis to multiply: an LP whose share of it is $600,000 carries a $6 million alternative cap. That's below the flat $15 million here, though on a large early position it won't always be. The current tiers and dollar amounts, and which stock they apply to, are in our walkthrough of [what the One Big Beautiful Bill Act changed about Section 1202](https://409.ai/articles/qsbs-one-big-beautiful-bill-act-section-1202-changes), and the $75 million ceiling [starts indexing in 2027](https://409.ai/articles/qsbs-75-million-ceiling-inflation-indexing-2027).
Worth flagging without overstating: whether gain attributable to the GP's carried interest qualifies is unsettled. Holland & Knight argues there's a good position that it does, while noting the regulations under Section 1045 point the other way. If your carry on a QSBS name is material, raise it with tax counsel before the exit.
Three years, or nothing
The exclusion percentages for stock acquired after July 4, 2025 step up at three, four and five years, and below three there's no partial credit. Section 1202(g)(2)(A) sets the floor at three years of holding by the entity, so a fund that exits a strong position at 30 months hands its LPs ordinary long-term capital gain and nothing else.
That's a live tension in a fast acquisition, and one of the few places the tax tail belongs in the room. Where the timing can't move, [Section 1045 lets a qualifying gain roll into replacement QSBS](https://409.ai/articles/section-1045-qsbs-rollover-defer-gain-early-sale) and preserve the holding period, under its own rules about who elects and at which level.
What the fund has to prove about the day it bought
The partner conditions decide who gets the exclusion. The issuer conditions decide whether there's one to get, and here the fund is the only party holding the evidence.
Two of these are facts about the moment of purchase. Under 1202(c)(1)(B), the stock has to be acquired at original issue, so the fund buying newly issued preferred qualifies and the fund buying existing shares from a founder in a secondary does not. We've covered [what a secondary purchase does to QSBS status](https://409.ai/articles/secondary-sale-startup-shares-qsbs-tax-treatment) and the narrow transfers that carry it over. Under 1202(d)(1), the company's aggregate gross assets must not have exceeded the ceiling at any point before the issuance, or immediately after it counting the money you just wired. That's $75 million for stock issued after July 4, 2025 and $50 million for earlier stock, and it's measured on tax basis rather than valuation, which is [why a post-money number tells you nothing](https://409.ai/articles/qsbs-gross-assets-test-section-174a-capitalized-rd) about whether the test is met.
The third one isn't a closing-day fact at all, and it's commonly described as though it were. Section 1202(c)(2)(A) requires that "during substantially all of the taxpayer's holding period," the corporation meets the active business requirements of subsection (e), which is the 80% by value test, and remains a C corporation. That's a condition running the entire five years. A company that pivots into an excluded line of business, or parks a large round in investments rather than operations, can break it long after the fund could do anything about it. The categories that never qualified in the first place are in our piece on [the consulting test](https://409.ai/articles/qsbs-qualified-trade-or-business-consulting-test-section-1202), and a company-level buyback in the wrong window can [disqualify stock issued around it](https://409.ai/articles/qsbs-redemption-rules-stock-buybacks-section-1202) without anyone at the fund hearing about it.
The diligence has a shelf life, and closing is when to do it, while you still have negotiating room and the company still has its records. In practice: a representation in the purchase agreement that the company is a qualified small business as of the issuance, a tax basis balance sheet dated the closing, a covenant to notify you of a redemption, and contemporaneous support for the gross assets figure rather than someone's recollection of it. A [QSBS attestation](https://409.ai/products/qsbs) obtained at investment is the version of that evidence your LPs' accountants will accept in year six, when the founding CFO has moved on and the company belongs to someone else.
The record your administrator should already be keeping
Eligibility is partner-specific and position-specific, which makes it a records problem before it's a tax problem. The fund reports Section 1202 gain on the K-1s, and the fund is the only party that can say which partners were in on which acquisition date, at what percentage.
Build that table at each investment closing rather than reconstructing it in the year of the exit. For every position: the acquisition date, whether it was an original issuance, the gross assets support, and the partner roster with percentages as of that date. Twenty minutes per deal at the time, close to unrecoverable five years later.
An LP who loses a seven-figure exclusion because nobody could evidence the company's basis in 2026 doesn't write it off as bad luck. They read it as a fund that didn't know what its own records were for, and they remember it while you're raising Fund II.