Illinois has enacted legislation that decouples the state’s income tax from the federal exclusion for gain from the sale of Qualified Small Business Stock (QSBS). Effective for tax years ending on or after Dec. 31, 2026, taxpayers subject to Illinois income tax must add back to their Illinois base income any gain excluded from federal gross income under IRS Code Section 1202. This change was enacted as part of the state’s fiscal year 2027 budget bill, signed by Governor J.B. Pritzker on June 16, 2026. The change will primarily affect Illinois resident taxpayers.

Background: The Federal Section 1202 Exclusion

Code Section 1202 provides a generous federal tax incentive to encourage investment in early-stage companies. Under Section 1202, eligible taxpayers – including individuals, estates and trusts, and passthrough entities in some instances – may exclude some or all of the capital gain recognized on a sale of QSBS. To qualify for the exclusion, stock generally must satisfy the following requirements:

• Issued by a domestic C corporation (S corporations and other passthroughs do not qualify);
• Acquired by the taxpayer at original issuance (or in certain tax-free exchanges) after Aug. 10, 1993;
• Received by the taxpayer in exchange for cash, property, or services;
• Issued when the corporation’s aggregate gross assets did not exceed the applicable threshold (see below);
• Held throughout a period when the corporation satisfies qualifying and active business requirements; and
• Held by the taxpayer for the applicable minimum holding period.

Federal Exclusion Amounts

For QSBS issued on or before July 4, 2025, the exclusion amount is the greater of (i) $10 million, or (ii) 10 times the taxpayer’s adjusted basis in the stock. For QSBS issued after July 4, 2025, the One Big Beautiful Bill Act (OBBBA) introduced a tiered holding period and increased the exclusion amount:

Holding Period	Exclusion Percentage
At least three years but less than four years…	50%
At least four years but less than five years…	75%
Five years or more…	100%

Additional OBBBA enhancements applicable to post-July 4, 2025 stock include:

• Increased per-issuer exclusion: raised from $10 million to $15 million (indexed for inflation beginning in 2027), or 10 times adjusted basis, whichever is greater;
• Increased gross assets threshold: the corporation’s aggregate gross assets at the time of issuance may not exceed $75 million, indexed for inflation (increased from $50 million).

Illinois Prior Treatment: Rolling Conformity

As a rolling conformity state, Illinois historically incorporated changes to the Internal Revenue Code automatically, including the gain exclusion under Section 1202. As a result, Illinois taxpayers who qualified for the federal QSBS exclusion generally paid no Illinois income tax on the excluded gain, either.

The Change: Illinois SB 3019

Through Senate Bill 3019, Illinois amended 35 Ill. Comp. Stat. § 5/203 to require an addback to Illinois base income. Specifically, for tax years ending on or after Dec. 31, 2026, Illinois taxpayers must include: “an amount equal to the amount of gain excluded from gross income under Section 1202 of the Internal Revenue Code.”

In practical terms, even if a taxpayer qualifies for the federal QSBS exclusion in full, that gain will now be subject to Illinois income tax at the flat rate of 4.95% for individuals.

Illinois joins a growing list of states – including California, Alabama, Mississippi, Pennsylvania, Oregon, and the District of Columbia – that have decoupled from the federal Section 1202 exclusion.

Practical Impact and Considerations

Increased State Tax Liability on Exit Events

For Illinois residents holding QSBS in portfolio companies, any gain on a liquidity event (sale, merger, or other disposition) occurring in a tax year ending on or after Dec. 31, 2026, will be subject to Illinois income tax to the extent the gain was excluded at the federal level. The change is expected to generate more than $60 million in additional state tax revenue annually.

Effect on Startup and Venture Investment Ecosystem

The QSBS exclusion serves as a meaningful offset to the risk inherent in investing in early-stage companies. Illinois’ decoupling may have unintended consequences for the state’s startup community and investment climate generally:

• Investor behavior: Investors may seek larger equity positions to compensate for the lost state tax advantage;
• Exit timing: Existing QSBS shareholders may need to reevaluate exit timelines and structures to mitigate Illinois tax exposure; and
• Negotiating dynamics: Deal terms may shift as buyers and sellers factor in the incremental state tax cost.

Interaction with OBBBA Expansions
The timing of Illinois’ decoupling is particularly significant in light of the federal expansion of Section 1202 benefits. While federal law now makes QSBS more attractive, Illinois residents will not benefit from the expanded state-level exclusions, though they will still enjoy the federal exclusion.

Action Items

Clients with potential exposure to Illinois income tax on QSBS – i.e., Illinois residents who have invested or are considering investing in qualified small business corporations – should consider the following steps:

1. Review current QSBS holdings. Identify any positions in QSBS that may be subject to a liquidity event in 2026 or beyond. Determine the Illinois tax exposure based on the anticipated Section 1202 exclusion.
2. Model after-tax returns. For pending or anticipated transactions, recalculate net after-tax returns factoring in Illinois income tax on the previously excludable gain.
3. Evaluate domicile considerations. For individual investors, review whether a change in state residency prior to a significant exit event may be appropriate or desirable, given the incremental Illinois tax cost and the treatment in other conforming states.
4. Review partnership and operating documents. Passthrough entity stakeholders should assess how the addback affects economic arrangements among partners and whether existing tax distribution provisions adequately address this new state-level liability.