Quick Summary: Qualified Small Business Stock (QSBS) under Section 1202 allows founders and investors to exclude up to 100% of capital gains from federal taxes when selling startup stock, saving up to 23.8% on gains reaching $15 million per company (increased from $10 million for stock issued after July 4). This requires holding C-corporation stock for 3 to 5 years, company assets staying under $75 million at issuance, and meeting specific business activity requirements.
Quick Facts About QSBS Tax Exclusion
| Category | Details |
|---|---|
| Tax Code Section | IRC Section 1202 |
| Maximum Exclusion | $15 million per company (stock issued after July 4) |
| Previous Cap | $10 million (stock issued before July 5) |
| Holding Period (New) | 3 years (50%), 4 years (75%), 5+ years (100%) |
| Traditional Holding | 5+ years required for stock issued before July 5 |
| Tax Savings | Up to 23.8% (20% capital gains + 3.8% NIIT) |
| Asset Threshold | $75 million maximum at issuance (up from $50M) |
| Entity Required | Domestic C-corporation only |
| Alternative Option | Section 1045 rollover after 6 months |
What Is QSBS and Section 1202?
Qualified Small Business Stock (QSBS) is stock in specific C-corporations that qualifies for complete federal capital gains tax exclusion when sold, potentially saving sellers millions in taxes. Section 1202 of the Internal Revenue Code created this tax benefit in 1993 to encourage investment in early-stage American businesses.
The numbers tell a powerful story. Without QSBS, selling startup stock worth $15 million with a $1 million cost basis triggers $14 million in capital gains. Federal taxes consume $3,332,000 (23.8% rate including net investment income tax). Many states add another 5% to 13.3%, pushing total tax to $4 million or more.
With QSBS qualification, you pay $0 federal tax on that same $14 million gain. Zero. Nothing. The entire $15 million goes into your pocket before state taxes. This represents one of the most valuable tax incentives in the entire tax code.
Recent legislative changes through the One Big Beautiful Bill Act made QSBS even more attractive. For stock issued after July 4, the gain exclusion cap increased from $10 million to $15 million per company. The gross asset threshold jumped from $50 million to $75 million. The holding period decreased to 3 years minimum with graduated exclusions (50% at 3 years, 75% at 4 years, 100% at 5+ years).
These changes opened QSBS benefits to more companies and accelerated when founders can access tax-free gains. A founder who invested $2 million and sold for $17 million after 5 years realizes $15 million in excludable gains, saving $3,570,000 in federal taxes alone.
Who Qualifies for QSBS Benefits?
Both the shareholder and the issuing company must meet specific requirements for QSBS treatment. Missing even one requirement disqualifies the entire tax benefit.
Eligible Shareholders
Individuals owning stock directly qualify for QSBS exclusion. This includes founders, angel investors, venture capital fund partners (on their pro-rata share), and employees receiving stock or options.
Trusts and estates can claim QSBS benefits on qualifying stock they hold. This matters for estate planning and wealth transfer strategies.
Pass-through entities like partnerships (including LLCs) and S-corporations can hold QSBS. The tax benefits pass through to individual partners or shareholders proportionally. However, tracking ownership interests through pass-throughs creates complexity when ownership percentages shift over time.
C-corporations cannot claim QSBS benefits. If a C-corporation owns startup stock, its shareholders don’t get Section 1202 exclusions when the C-corporation eventually sells the stock. This restriction makes entity structure critical for tax planning.
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Original Issuance Requirement
You must acquire stock directly from the issuing corporation, not from another shareholder. Stock purchased in secondary transactions from existing stockholders doesn’t qualify for QSBS treatment regardless of other factors.
Exceptions exist for certain transfers that preserve QSBS status:
- Inheritance from someone who acquired stock as original issuance
- Gifts from original purchasers
- Distributions from partnerships to partners
- Certain tax-free reorganizations and conversions
Stock received through option or warrant exercise counts as original issuance. The holding period begins when you exercise, not when options were granted
Company Qualification Requirements
The issuing company must meet stringent requirements both when issuing stock and throughout substantially all of your holding period. Losing qualification during your holding period disqualifies the tax benefit entirely.
C-Corporation Structure
Only domestic C-corporations qualify. S-corporations, LLCs, partnerships, and foreign corporations cannot issue QSBS regardless of other factors.
Companies organized as non-C-corporations can convert to C-corporation status. Stock issued after conversion qualifies as QSBS if all other requirements are met. However, value appreciation before conversion doesn’t qualify. Only gains accruing after becoming a C-corporation and meeting all requirements get QSBS treatment.
Gross Assets Test
Company assets cannot exceed $75 million immediately before and immediately after stock issuance (for stock issued after July 4). This threshold was $50 million for stock issued earlier.
“Gross assets” means cash plus the adjusted basis of all other assets. Contributed property counts at its fair market value when contributed, not the company’s basis.
Example: A startup raises $60 million Series B funding. Assets before funding: $20 million. After funding: $80 million. Stock issued during this raise doesn’t qualify as QSBS because post-issuance assets exceed $75 million.
Planning opportunity: Companies approaching $75 million in assets should carefully time additional fundraising rounds to preserve QSBS status for existing stockholders.
The $75 million threshold will adjust for inflation starting in 2027, gradually increasing the allowable asset level.
Active Business Requirement
At least 80% of company assets (measured by value) must be used in active conduct of qualified trades or businesses during substantially all of your holding period.
Qualified businesses include most operating companies. Manufacturing, software development, consulting, retail, and services generally qualify.
Excluded businesses that disqualify QSBS status:
- Professional services (health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage)
- Banking, insurance, financing, leasing
- Farming
- Hotels, motels, restaurants
- Mining or production of products eligible for percentage depletion
- Any business where principal asset is reputation or skill of employees
The professional services exclusion creates traps. A software company primarily selling products qualifies. A software company primarily providing consulting services doesn’t qualify. The distinction matters enormously.
Safe harbor exception: Even excluded service businesses qualify if the business requires substantial capital investment beyond employee compensation. A medical practice won’t qualify, but a hospital with significant equipment and facilities might.
Holding Period Rules After Recent Changes
New graduated exclusion rates create flexibility while rewarding longer holding periods. These rules apply only to stock issued after July 4. Earlier-issued stock still requires the full 5-year holding period for any exclusion.
Graduated Exclusion Rates
| Holding Period | Exclusion Percentage | Effective Tax Rate | Tax on $10M Gain |
|---|---|---|---|
| 3+ years | 50% | 11.9% | $1,190,000 |
| 4+ years | 75% | 6.0% | $600,000 |
| 5+ years | 100% | 0% | $0 |
| Under 3 years | 0% | 23.8% | $2,380,000 |
The 3-year minimum represents a significant acceleration. Founders can now exit with substantial tax benefits two years faster than previously required.
However, the non-excluded portion faces a 28% federal capital gains rate (not the usual 15% or 20% rate) plus 3.8% NIIT, totaling 31.8%. This higher rate on non-excluded gains means the effective rates aren’t simple percentages of the normal 23.8% rate.
Calculating Your Holding Period
Your holding period begins when stock is issued to you, not when you signed a purchase agreement or received options. For stock from option exercise, the holding period starts on exercise date.
Tacking: Certain transactions let you “tack” prior holding periods onto newly received stock:
- Converting debt to equity
- Stock-for-stock exchanges in tax-free reorganizations
- Gifts (recipient adds donor’s holding period)
- Inheritance (generally receives automatic long-term holding status)
Hedging restrictions: Entering into certain hedging positions (short sales against the box, options limiting upside, or other transactions reducing risk) can stop your holding period clock or disqualify stock entirely from QSBS treatment.
Practical Examples Showing Tax Savings
Real calculations demonstrate QSBS’s power in typical startup exit scenarios. These examples use stock issued after July 4 with the new $15 million cap.
Example 1: Founder with 3-Year Hold
Sarah founded a B2B SaaS company in early 2023. She invested $500,000 and received 5 million shares. In 2026, after 3 years, an acquisition valued her shares at $8 million.
Without QSBS:
- Capital gain: $7.5 million
- Federal tax (23.8%): $1,785,000
- Net proceeds: $6,215,000
With QSBS (50% exclusion at 3 years):
- Capital gain: $7.5 million
- Excluded amount: $3.75 million
- Taxable amount: $3.75 million
- Federal tax (31.8% on unexcluded): $1,192,500
- Net proceeds: $6,807,500
- Tax savings: $592,500
Example 2: Investor with 5+ Year Hold
David invested $2 million in a biotech startup in 2019. In 2024, the company goes public and he sells his shares for $22 million after holding 5+ years.
Capital gain breakdown:
- Sale price: $22 million
- Cost basis: $2 million
- Total gain: $20 million
- QSBS exclusion cap: $15 million (greater of $15M or 10x basis)
- Excluded gain: $15 million
- Taxable gain: $5 million
Tax calculation:
- Tax on $5 million (23.8%): $1,190,000
- Net after-tax proceeds: $20,810,000
Without QSBS:
- Tax on $20 million (23.8%): $4,760,000
- Net after-tax proceeds: $17,240,000
- Tax savings: $3,570,000
Example 3: Multiple Company Strategy
Jennifer invested in three startups, each issuing qualifying QSBS:
- Company A: $15 million gain (100% excluded)
- Company B: $12 million gain (100% excluded)
- Company C: $8 million gain (100% excluded)
Total excluded gains: $35 million across three companies Total tax savings: $8,330,000 in federal taxes
The per-company cap means sophisticated investors can exclude $15 million from each qualifying company. Diversifying across multiple QSBS-qualifying startups multiplies the total tax benefit.
Section 1045: QSBS Rollover Option
If you need to sell before the full holding period, Section 1045 provides an alternative that preserves eventual tax-free treatment. This rollover provision works like a 1031 exchange for QSBS.
How Section 1045 Works
After holding QSBS for at least 6 months, you can sell it and defer recognizing gain by rolling proceeds into replacement QSBS within 60 days.
Qualification requirements:
- Original stock held over 6 months
- Proceeds reinvested in new QSBS within 60 days
- Replacement stock must be QSBS at purchase
- Must purchase from issuing corporation (not secondary market)
Tax treatment: You recognize gain only to the extent sale proceeds exceed the amount reinvested in replacement QSBS.
Example: You sell QSBS for $5 million with $1 million basis, realizing $4 million gain. You reinvest $4.5 million in new QSBS within 60 days. Taxable gain: $500,000 (proceeds exceeding reinvestment).
Your basis in the replacement QSBS equals your basis in the original stock ($1 million) reduced by the gain not recognized ($3.5 million), plus any gain recognized ($500,000), equaling a $1 million basis carried forward.
Holding period: Your holding period for Section 1202 exclusion purposes starts fresh with the replacement QSBS. You must hold it another 3 to 5 years from the purchase date to qualify for graduated exclusions.
Strategic use: Section 1045 lets founders and investors move capital between startups while deferring taxes. Sell from a moderating company and reinvest in a higher-growth opportunity without paying immediate taxes.
Common QSBS Disqualification Traps
Several common mistakes destroy QSBS status even when everything else checks out. Knowing these traps helps you preserve valuable tax benefits.
Excessive Stock Redemptions
If the company redeems more than 5% of its stock value (measured by value, not shares) during a 2-year window (1 year before and 1 year after your stock issuance), your stock may lose QSBS status.
Example: A company redeems $4 million in stock from a departing founder. Six months later, it issues you $10 million in new stock. The redemption exceeds 5% of combined equity value ($14 million), potentially disqualifying your newly issued stock.
Exception: Redemptions don’t disqualify QSBS when purchasing stock from departing employees or for death or disability.
Portfolio Stock Traps
Holding excess passive assets disqualifies QSBS. The company must use at least 80% of assets in active business operations.
Problematic scenarios:
- Keeping excess cash in corporate bonds or stocks beyond operating needs
- Significant real estate holdings not used in business operations
- Lending money rather than operating a business
Safe harbor: Cash and short-term instruments (under 24-month maturity) held to meet working capital needs don’t count against the 80% active business test. Specify working capital needs in board resolutions documenting business requirements.
Business Model Changes
If your company changes to an excluded service business during your holding period, QSBS status disappears for substantially all of that period.
Example: A software product company shifts to primarily consulting services. This transition disqualifies existing QSBS even though stock was issued when operating as a qualified business.
Protection: Monitor business model evolution. If services become significant revenue, restructure operations through separate entities to preserve QSBS in the product-focused C-corporation.
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Asset Threshold Crossing
Raising new funding that pushes gross assets above $75 million disqualifies stock issued in that round from QSBS treatment. However, previously issued stock remains qualified.
Planning: Stage fundraising to keep capital raises below thresholds. A company with $60 million in assets should consider raising $14 million rather than $20 million to preserve QSBS status for new investors.
Can I claim QSBS on stock options or RSUs?
You can claim QSBS on stock received from exercising stock options, but RSUs don’t qualify because they’re not original issuances from the corporation. For stock options, your holding period starts when you exercise (not when granted), and you must hold the resulting stock for 3 to 5 additional years. Early exercise strategies help because they start the QSBS holding period clock sooner. RSUs represent compensation, not purchases from the corporation, so they fundamentally don’t qualify as QSBS regardless of timing.
Do all states recognize QSBS exclusions?
No, state treatment varies significantly. States like California, New Jersey, Massachusetts, Pennsylvania, Alabama, and Mississippi don’t fully conform to federal QSBS exclusions, potentially taxing gains that are federal tax-free. California especially taxes the full gain at 13.3% for high earners despite federal exclusion. Some states follow federal treatment but cap the exclusion at lower amounts. Check your specific state’s conformity to Section 1202 before assuming complete tax-free treatment. This makes domicile planning important for founders anticipating large QSBS gains.
What happens if my company gets acquired by another company?
The outcome depends on deal structure. In stock-for-stock tax-free reorganizations, your holding period generally carries over (tacks) to the acquiring company’s stock, though you must verify the acquirer’s stock qualifies as QSBS. Cash buyouts trigger immediate tax liability, though Section 1045 rollover within 60 days preserves tax deferral. Asset sales often disqualify QSBS treatment. Structure matters enormously, so negotiate tax-efficient deal terms early. Request stock consideration over cash when possible to preserve QSBS benefits.
Can I combine QSBS exclusion with other tax strategies?
Yes, QSBS stacks favorably with other tax planning. Gifting QSBS to family members or trusts preserves their QSBS status, and the recipient’s holding period includes your holding period for Section 1202 purposes. Donating QSBS to charity gives you a fair market value deduction without recognizing capital gains. The NIIT exemption means QSBS gains don’t count toward the $200,000/$250,000 modified AGI threshold for Medicare surtax. Estate planning using GRATs, CLATs, or QPRTs can multiply QSBS benefits across generations.
What if I sold my stock before meeting the holding period?
If you sold after 6 months, Section 1045 rollover lets you defer gain by reinvesting proceeds in new QSBS within 60 days. The replacement stock begins a fresh holding period toward eventual Section 1202 exclusion. If you sold before 6 months, you face ordinary income or short-term capital gains tax with no QSBS benefit available. The gain becomes taxed at up to 37% federal plus state taxes and 3.8% NIIT. No retroactive claiming of QSBS benefits exists, making premature sales costly mistakes.
Qualified Small Business Stock exclusions under Section 1202 represent the most valuable tax benefit available to startup founders and early-stage investors. Recent legislative changes expanding the exclusion cap to $15 million per company, reducing the minimum holding period to 3 years, and increasing the gross asset threshold to $75 million made QSBS more accessible and valuable than ever.
The tax savings are staggering. Excluding $15 million in capital gains saves $3,570,000 in federal taxes. Sophisticated investors using QSBS across multiple companies can save tens of millions through proper tax planning. Even with graduated exclusions at 3 or 4 years, founders save six-figure amounts compared to ordinary capital gains treatment.
However, qualifying for QSBS requires meticulous attention to detail. The company must be a domestic C-corporation, maintain assets under $75 million at issuance, use at least 80% of assets in qualified active businesses, and avoid excluded service industries. Shareholders must acquire stock directly from the corporation and hold it for minimum periods. One misstep disqualifies the entire benefit.
Start QSBS planning early. Review company structure at formation, not before exit. C-corporation status from day one preserves all appreciation for QSBS treatment. Converting from LLC or S-corporation later limits benefits to appreciation after conversion. Document compliance continuously through board resolutions, attestation letters, and annual audits of gross assets and active business percentages.
Work with qualified tax advisors experienced in QSBS planning. The complexity of requirements, interactions with other tax provisions, and state conformity variations make professional guidance essential. The cost of expert advice pales compared to losing multimillion-dollar tax benefits through technical missteps.
Consider Section 1045 rollovers strategically. If you must exit before full holding periods, reinvesting in replacement QSBS within 60 days preserves eventual tax-free treatment while deploying capital into new opportunities. This flexibility adds significant value beyond static hold-to-maturity strategies.
The QSBS exclusion fundamentally changes startup economics. Founders can build and sell businesses knowing they keep substantially all proceeds after state taxes. This drives risk-taking, entrepreneurship, and innovation exactly as Congress intended when creating Section 1202. Use it wisely.
