Qualified Small Business Stock (QSBS) is one of the most powerful tax benefits in the tax code. If you hold qualifying stock for more than five years, you can exclude up to $10 million (or 10x your basis) in gains from federal income tax. For startup founders and early employees, this can mean millions in tax savings.
What Is QSBS?
QSBS is stock in a qualified small business (C-corporation) that meets specific requirements. When you sell QSBS after holding it 5+ years, you can exclude capital gains from federal income tax.
The potential benefit:
- Stock purchased for $100,000
- Sold for $10,100,000
- Gain: $10,000,000
- Federal tax normally: ~$2,380,000 (at 23.8%)
- Federal tax with QSBS exclusion: $0
Requirements for QSBS
1. C-Corporation
The company must be a domestic C-corporation. LLCs, S-corps, and partnerships don't qualify (though can convert).
2. Active Business
At least 80% of assets must be used in active conduct of a qualified trade or business.
Qualified businesses include:
- Technology companies
- Manufacturing
- Retail
- Consulting
- Most operating businesses
Excluded businesses:
- Professional services (law, medicine, accounting)
- Financial services (banking, lending)
- Hospitality (hotels, restaurants)
- Farming
- Mining and extraction
- Real estate (in most cases)
3. $50 Million Gross Assets Test
At the time stock is issued AND immediately after, the corporation's gross assets must be $50 million or less.
Once qualified, the company can grow past $50M—the test is at issuance.
4. Original Issuance
Stock must be acquired at original issuance from the company in exchange for:
- Money
- Property (not including stock)
- Services
Stock purchased on secondary market generally doesn't qualify.
5. Held 5+ Years
Must hold the stock for more than five years to get the exclusion.
The Exclusion Amounts
Section 1202 Exclusion (Post-2010 Stock)
100% exclusion of gain, up to the greater of:
- $10 million, OR
- 10x your original basis
Example:
- Paid $500,000 for stock
- Sold for $15,000,000
- Gain: $14,500,000
- Excluded: $10,000,000 (greater of $10M or 10 × $500K)
- Taxable gain: $4,500,000
Per-Issuer Limit
The $10 million limit is per issuer, per taxpayer. Married couples filing jointly can each exclude $10 million from the same company = $20 million household exclusion.
Older Stock (Historical Rates)
Stock acquired before September 28, 2010 may only have 50% or 75% exclusion depending on acquisition date.
QSBS Strategies
1. Meet the 5-Year Hold Requirement
No shortcuts. You must hold for 5+ years. Plan accordingly around liquidity events.
2. Section 1045 Rollover
If you need to sell before 5 years, you can roll QSBS gains into new QSBS within 60 days and continue the holding period.
Use case: Company gets acquired before your 5 years. Roll proceeds into new QSBS investment.
3. Gift to Family Members
Each family member has their own $10M exclusion. Gifting QSBS before sale can multiply exclusions.
Example:
- Parent owns $30M in QSBS
- Gifts $10M to spouse, $10M to child
- Each person sells $10M → $30M excluded vs. $10M
Caution: Gift and estate tax rules apply. Children must actually own the stock.
4. Charitable Giving
Donate QSBS to charity → avoid all capital gains tax AND get charitable deduction for full fair market value.
5. Basis Planning
Higher basis = higher 10x limit. Consider paying fair value for founders' stock rather than nominal amounts.
Documentation Requirements
What to Document
- Company's C-corp status at issuance
- Gross assets at time of issuance
- Active business qualification
- Original issuance documentation
- Your basis and holding period
Why It Matters
IRS can challenge QSBS treatment years later. Burden is on taxpayer to prove qualification.
Keep records forever (or at least 7 years after sale).
State Tax Treatment
States That Follow Federal QSBS Treatment
- Most states follow federal rules partially or fully
- Some significant exclusions
States That Don't Recognize QSBS
- California (big one—state tax applies even if federal excluded)
- Pennsylvania
- Alabama
- Mississippi
California impact:
- Federal: $0 tax on $10M gain
- California: ~13.3% tax on gain
- Total tax on $10M gain: ~$1.33M (vs. ~$2.38M without federal exclusion)
Planning for State Taxes
- Consider residency planning if large QSBS sale expected
- Move to tax-friendly state before sale (careful—states scrutinize)
- Factor state taxes into financial planning
Common QSBS Issues
1. Professional Services Disqualification
Lawyers, doctors, consultants often discover their company doesn't qualify. Plan early.
2. LLC/S-Corp Structure
Many startups start as LLCs or S-corps. Must convert to C-corp to have QSBS-eligible stock. Conversion itself can trigger tax events.
3. Stock Options vs. QSBS
Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs) have different QSBS implications:
- Stock from exercised options CAN qualify for QSBS
- Holding period starts at exercise, not grant
4. Gross Assets Test Failures
Fast-growing companies may exceed $50M before issuing employee stock. Later grants may not qualify.
5. Redemptions
Certain stock redemptions can disqualify QSBS. Buybacks require careful structuring.
The Strategic Picture
For Founders
- Structure as C-corp from the start if QSBS is goal
- Document everything
- Understand state tax implications
- Plan for 5-year hold
For Employees with Equity
- Ask if company stock is QSBS-eligible
- Understand your exercise prices and holding periods
- Factor QSBS into exercise decisions (especially for ISOs)
For Investors
- QSBS is a major benefit for angel investing
- $10M exclusion per company is significant
- Can make early-stage investing more attractive on after-tax basis
The Bottom Line
QSBS is one of the most valuable tax benefits available—potentially worth millions for startup founders, employees, and investors. Requirements are specific, documentation is essential, and state taxes may still apply. Work with a tax professional who understands QSBS when approaching liquidity events.