For founders, early employees and investors, a successful Section 1202 analysis can produce an extraordinary federal tax result. But federal qualification is increasingly only one part of the exit calculation. Several states do not recognize the federal Qualified Small Business Stock exclusion, and two significant additions joined that group in 2026: Illinois and Oregon.
For taxpayers preparing for a liquidity event, the planning question is no longer simply, “Do my shares qualify as QSBS?” It also needs to include, “Where will this gain be taxed when I sell?”
Illinois and Oregon changed the 2026 QSBS landscape
Illinois enacted a significant change as part of its fiscal year 2027 legislation. Under Illinois Department of Revenue guidance, taxpayers must add federally excluded Section 1202 gain back into Illinois base income for tax years ending on or after December 31, 2026.
For a calendar-year taxpayer, that can reach transactions completed earlier in 2026, even if the sale occurred before the legislation was enacted. A founder who completed a qualifying QSBS sale in February 2026, for example, may still face the Illinois addback on the 2026 return.
Oregon made a similar move. Senate Bill 1507 fully disconnects Oregon from the federal QSBS gain exclusion for tax years beginning on or after January 1, 2026. Federally excluded Section 1202 gain must therefore be added back for Oregon purposes.
Which states do not follow federal Section 1202 treatment?
As of September 2026, six states do not generally carry the federal Section 1202 exclusion through to their personal income tax calculation:
Alabama: Alabama does not tie its treatment of QSBS gain to the federal Section 1202 exclusion. The Alabama Department of Revenue also identifies the federal 2025 expansion of Section 1202 as not tied to Alabama law.
California: California has long been the most familiar QSBS nonconformity state for startup founders. The Franchise Tax Board confirms that California does not conform to Section 1202, including the federal expansion enacted in 2025.
Illinois: Beginning with tax years ending on or after December 31, 2026, federally excluded QSBS gain is added back to Illinois income.
Mississippi: Mississippi does not simply adopt the federal Section 1202 exclusion. However, Mississippi has an important state-specific rule: its law can separately exclude gain from certain shares in Mississippi domestic corporations and other specified Mississippi entities held for more than one year. That means a transaction may receive favorable Mississippi treatment for reasons independent of federal QSBS qualification.
Oregon: Oregon fully disconnected from the federal Section 1202 exclusion for tax years beginning in 2026.
Pennsylvania: Pennsylvania does not recognize the federal QSBS exclusion. Pennsylvania Department of Revenue guidance states that gain from the sale of stock remains taxable even when the federal Section 1202 exclusion applies.
District of Columbia: While not a state, Washington D.C. also now requires attention. Current D.C. law requires individuals, estates and trusts to include gain excluded federally under Section 1202 in District gross income.
Hawaii and Massachusetts require separate treatment
Hawaii and Massachusetts do not fit neatly into either the fully conforming or fully nonconforming category.
Under Hawaii law, Section 1202 remains operative in the form that existed as of December 31, 2024, but with important modifications. Hawaii specifically does not apply the federal provisions that increased the QSBS exclusion from 50% to 75% and then 100%. As a result, a shareholder who qualifies for a 100% federal QSBS exclusion should not assume the same gain will be fully excluded for Hawaii purposes. Hawaii also does not adopt the expanded Section 1202 rules enacted under the OBBBA.
Massachusetts takes a similar approach. Massachusetts generally conforms to Section 1202 based on the Internal Revenue Code as amended and in effect on January 1, 2024. That allows the 100% exclusion for qualifying QSBS held for more than five years under the pre-OBBBA rules. However, Massachusetts does not currently adopt the federal Section 1202 changes enacted in 2025. Massachusetts Department of Revenue guidance confirms that the state generally remains tied to its January 1, 2024 conformity date for personal income tax purposes.
For Massachusetts taxpayers, that means the pre-OBBBA Section 1202 framework continues to apply. The corporation generally must satisfy the $50 million gross-assets threshold, and the stock must be held for more than five years to receive the 100% exclusion. Massachusetts has not adopted the newer federal $75 million gross-assets threshold, the 50% exclusion after three years, the 75% exclusion after four years, or the increased federal gain limitation enacted by the OBBBA.
For founders and investors with Massachusetts exposure, this can create a split result. Stock issued after July 4, 2025 may qualify for favorable federal treatment under the expanded OBBBA rules while failing to qualify, or qualifying for less favorable treatment, under Massachusetts law.
The trend is moving in both directions
There are signs that states are looking more closely at federal tax benefits as they manage their own budgets.
Oregon provides the clearest example. Legislative materials surrounding SB 1507 expressly connected selective federal tax decoupling with the revenue effects of H.R. 1 and pressure on Oregon’s General Fund. Illinois enacted its QSBS addback within its fiscal year 2027 budget package. The District of Columbia has also addressed Section 1202 through budget legislation.
That does not mean every state is moving toward decoupling. New Jersey went the other way. Under legislation effective for tax years beginning January 1, 2026, New Jersey now excludes QSBS gain to the extent it is excluded federally.
Washington also considered legislation in 2026 that would have pulled federally excluded QSBS gain into its capital gains tax base. That proposal was not enacted, and the Washington Department of Revenue currently confirms that federally excluded Section 1202 gain is not subject to Washington’s capital gains tax.
For founders, that legislative activity is a reason to treat state conformity as a live planning variable rather than a permanent assumption.
Your QSBS opinion is not a state tax opinion
A federal QSBS analysis typically focuses on original issuance, qualified-small-business status, active-business requirements, holding periods and the shareholder’s exclusion limitation. Aura discusses those federal requirements in more depth in QSBS Just Got a Makeover: What the OBBBA Means for Startup Investors and Founders.
That analysis does not determine where the shareholder will be a resident at closing, whether another state can source the gain, how a trust will be taxed, or whether a state has modified Section 1202 between the date the stock was acquired and the date it is sold.
Founders considering relocation should model those questions well before signing a transaction. Establishing domicile involves more than changing an address, and moving shortly before a sale may create residency, sourcing or documentation issues that need to be evaluated based on the taxpayer’s facts.
How Aura Advisors can help with state QSBS planning
QSBS planning before an exit should connect the federal qualification analysis with the taxpayer’s expected state filing position. That means confirming the federal Section 1202 benefit, identifying every jurisdiction that could have a claim to the gain, reviewing current conformity rules, modeling the state tax cost and evaluating whether a contemplated move or ownership change actually improves the result.
For founders with a transaction on the horizon, the strongest planning window is generally before the deal structure and closing timeline become fixed. Aura Advisors can help build a federal and multistate QSBS analysis around the shareholder’s actual stock history, residence, transaction structure and documentation so that the expected tax result is both efficient and defensible.
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