July 1, 2025
While IRC § 1202 offers one of the most powerful federal tax incentives available—a potential 100% exclusion of capital gains up to significant limits—these three states stand in stark contrast. They do not conform to this federal provision and subject all QSBS gains to their respective income tax rates, some of which are among the highest in the nation.
This disparity between federal and state law creates a critical planning challenge for the states' founders, employees, and investors, who may face a federal tax rate of 0% on a successful exit, only to be met with a significant state tax liability on the very same gain. The origins of this anomaly vary: California's is rooted in a pivotal 2012 court decision (Cutler v. Franchise Tax Board); New Jersey's stems from the unique structure of its Gross Income Tax Act; and Pennsylvania's is a result of its specific statutory decoupling from the federal provision.
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