For more than three decades, Section 1202 of the Internal Revenue Code has offered one of the most significant tax benefits available to startup founders and early-stage investors: a complete exclusion from federal income tax on gains from the sale of Qualified Small Business Stock held for at least five years. For stock acquired after September 27, 2010, the exclusion is 100% of the gain, with a per-issuer cap of the greater of $10 million or ten times the taxpayer's adjusted basis. The provision was enacted to incentivize capital formation in small businesses, and it has become a central feature of startup exit planning.
New York has, until now, conformed to Section 1202. If your QSBS gain was excluded federally, it was excluded at the state level too. That conformity is now under direct threat.
The Proposal
New York's State Senate has incorporated into its one-house budget proposal for fiscal year 2026–2027 a provision that would decouple New York personal income tax from the federal QSBS exclusion under Section 1202. If enacted, taxpayers who exclude QSBS gains from federal adjusted gross income would be required to add those gains back when computing New York taxable income. The state-level benefit would be eliminated entirely.
The effective date is retroactive to January 1, 2025. This is not a prospective change. Founders who sold QSBS in calendar year 2025 and filed New York returns relying on the exclusion would face a recomputation of their state tax liability.
The retroactive effective date is the most aggressive feature of the proposal. Taxpayers who structured exits and made residency decisions in 2025 based on the existing law would find the ground shifted beneath them after the fact.
The proposal was advanced in the State Senate's budget resolution. Whether the Assembly or the Governor will adopt it remains uncertain. Final budget negotiations are expected before the April 1, 2026 statutory deadline. The provision may survive intact, be modified, or be dropped entirely during negotiations.
Why This Matters for Founders
The math is straightforward and the numbers are large. New York's top marginal income tax rate is 10.9%. New York City adds an additional 3.876%. A founder residing in New York City who sells QSBS with $10 million in gain currently pays zero federal tax and zero state tax on that gain. Under the proposed decoupling, the same founder would owe approximately $1.48 million in combined state and city tax on income that remains fully excluded federally.
For larger exits, the exposure scales proportionally. A $50 million gain — not unusual in a successful Series B or later exit — would generate roughly $7.4 million in New York state and city tax liability that does not exist under current law. This is not a marginal adjustment. It is a material change to the after-tax economics of building a company in New York.
The policy also creates asymmetric incentives. The federal QSBS exclusion was designed to encourage investment in domestic small businesses. New York's decoupling would tell founders that the federal government will reward them for building a qualifying small business, but New York will not. The natural consequence is that founders with imminent liquidity events — and the flexibility to relocate — will consider doing so.
The Retroactivity Problem
Retroactive tax legislation is not unconmon, and courts have generally upheld it where the retroactive period is modest and the legislative purpose is legitimate. But retroactivity in this context raises distinct concerns.
A founder who sold QSBS in March 2025, filed a New York return excluding the gain in conformity with then-existing law, and made financial commitments based on the after-tax proceeds would now face an unexpected state tax bill that could be seven figures. The transaction is closed. The proceeds may be deployed. The reliance on existing law was reasonable and, at the time, legally correct.
Whether retroactive application of this provision would survive a constitutional challenge under the Due Process Clause is an open question. The Supreme Court's framework, established in United States v. Carlton (1994), requires a rational legislative purpose and a "modest" period of retroactivity. A retroactive reach of fifteen months — from January 2025 to an enactment date in spring 2026 — is at the outer boundary of what courts have historically tolerated at the federal level. New York courts applying the state constitution's due process protections may evaluate the question differently.
Planning Considerations
Residency and Domicile
New York taxes residents on worldwide income. It taxes nonresidents only on income sourced to New York. QSBS gain is generally sourced to the taxpayer's state of residence, not to the state where the issuing company is located. A founder who is not a New York resident at the time of sale would not owe New York tax on QSBS gain, regardless of whether the company was formed or headquartered in New York.
This makes residency planning the most direct response to the proposal. But it must be done carefully. New York's Department of Taxation and Finance conducts aggressive residency audits, particularly for high-income individuals who change domicile around a liquidity event. A change of domicile requires more than filing a declaration — it requires a genuine, permanent relocation supported by objective factors: sale or lease termination of the New York residence, driver's license change, voter registration, relocation of personal effects, and primary presence in the new state. Partial moves and maintained ties to New York invite audit challenges that can take years to resolve.
Trust Planning
New York's tax code provides that certain trusts — commonly referred to as exempt resident trusts — are not subject to New York income tax on gains from intangible property, provided specific conditions are met. The trust must have no New York trustees, hold no New York real property, and have no New York-source income. A founder who transfers QSBS to a properly structured exempt resident trust before a sale could potentially shield the gain from the proposed add-back, because the gain would be realized by the trust rather than by the individual.
This strategy requires advance planning and careful execution. The transfer must precede the sale. The trust must satisfy all statutory requirements at the time the gain is realized. The IRS's rules on incomplete gift trusts and grantor trust status add additional complexity. This is not a last-minute solution.
Timing
Founders with pending exits should monitor the budget negotiation process closely. If the provision appears likely to be enacted, the retroactive effective date means that waiting provides no benefit — the exposure already exists for 2025 transactions. The planning window is now, not after enactment.
The Broader Signal
New York is not the first state to consider decoupling from Section 1202. California has never conformed to the federal QSBS exclusion and taxes these gains at ordinary income rates. Massachusetts, New Jersey, and Pennsylvania each have their own approaches, ranging from partial conformity to full taxation. But New York's proposal is notable for its retroactive reach and for the signal it sends at a moment when the state is competing with Florida, Texas, and other no-income-tax jurisdictions for startup talent and capital.
The federal QSBS exclusion exists because Congress concluded that preferential tax treatment for small business equity encourages risk-taking and job creation. Whether one agrees with that policy judgment or not, New York's decision to decouple from it is a choice to impose a cost on exactly the economic activity the federal provision was designed to encourage. Founders evaluating where to build their next company will notice.
The budget negotiations are ongoing. The provision may be adopted, modified, or abandoned. We will update this analysis as the situation develops.
This article is for informational purposes only and does not constitute legal advice. Reading this content does not create an attorney-client relationship. Laws and regulations change; readers should not rely on this content as a substitute for qualified legal counsel specific to their circumstances. Attorney Advertising.