Illinois business owners and investors are facing new tax considerations following the passage of the state's fiscal year 2027 budget. Signed into law by Governor J.B. Pritzker, the budget contains several new revenue-generating measures targeting businesses. One such provision concerns the state's tax treatment of qualified small business stock (QSBS).
Illinois is now decoupling its tax code from federal law and will begin to tax capital gains from the sale of qualifying small business stock, which were previously excluded at the state level.
As a rolling conformity state, Illinois automatically incorporates changes to the federal Internal Revenue Code (IRC). This includes the longstanding federal incentive found under IRC code Section 1202, which allows eligible taxpayers to exclude significant capital gain from income when selling qualified small business stock.
At the federal level, the One Big Beautiful Bill Act (OBBBA) significantly expanded the tax benefits offered under Section 1202. Most notably, the recent changes introduced phased-in exclusion holding periods (offering a benefit for holding periods as short as 3 years compared to the prior 5-year requirement), as well as increases in gross asset thresholds and maximum excludable gains for issuers.
As part of the state's recent enacted budget, Illinois investors will no longer be able to benefit from these federal changes as the state has now decoupled from the federal treatment under Section 1202. Beginning with tax years ending on, or after, December 31st, 2026, any QSBS capital gain excluded from income on your federal tax return must be added back to your Illinois base income.
Illinois now joins a handful of other states that have decoupled from the federal gain exclusion under Section 1202. The state’s shift in policy will diminish some of the financial reward for Illinois residents who have taken on the risk of investing in early-stage businesses.
Founders and investors have relied upon these incentives to offset some of the risk embedded in the investment of startups, which generally carry a high probability of total capital loss. By taxing the gains of those who invest in these companies, Illinois may inadvertently disrupt part of its valuable startup ecosystem.
Investors may now demand larger equity stakes to compensate for the lost tax advantages, or they may choose to shift their capital and invest in startups in other states with more advantageous tax policies or different investment opportunities altogether. For existing shareholders, this change likely will require a re-evaluation of exit timelines to minimize the potential state-level tax hit for Illinois.
As Illinois moves away from federal conformity on Section 1202, business owners and investors should reassess both current holdings and future investment strategies with this new state-level tax cost in mind. The loss of the QSBS exclusion at the state level introduces a meaningful shift in after-tax return calculations, particularly for those considering liquidity events in the near to medium term, as the tax change will go into effect for tax year 2026.
If you believe the changes noted above may affect your current or anticipated investments, we suggest consulting with your tax advisor, such as one at Founder's CPA, to review the potential impact and how this will affect your overall tax strategy.