Primer on Qualified Small Business Stock (QSBS)

March 17, 2025  |  By

Since 1993, the U.S. tax code has provided startup founders, early employees, and investors a tremendous tax benefit through the qualified small business stock (“QSBS”) federal income tax exclusion. Upon exit—most often an acquisition or IPO—taxpayers can potentially exclude from their federal taxable income up to 100% of capital gain from the sale of stock in certain small businesses. In effect, a founder selling QSBS worth $10M in gain would save $2.38M, or 23.8%, in federal taxes by excluding income that would otherwise be recognized as capital gain.[1]

Virtually all new business ventures require capital to grow, and founders generally only have three options: (1) self-fund or “bootstrap” the company, (2) borrow money (“venture debt”), or (3) receive direct investment from outside investors in exchange for ownership or the promise of future ownership. Of course, option #3 is often the only practical, or possible, option for startup founders. However, because venture investing primarily deals with one of the highest-risk asset classes, it typically only attracts institutional investors and high-net-worth individuals. To improve access to capital and facilitate investment, Congress enacted Section 1202 of the Internal Revenue Code (I.R.C.) to incentivize a broader tax base to invest in startups, with the goal of increasing innovation and maintaining the U.S.’s position as one of the top technology ecosystems in the world.

Benefiting from the tax exclusion is a multi-step process. And unlike most other tax benefits provided by the I.R.C., there are no special filings or elections to be made upon acquiring QSBS to be eligible for the income exclusion.[2] Instead, if (i) the company meets the requirements to issue stock deemed QSBS, (ii) the stockholder is an eligible recipient, and (iii) the stockholder maintains eligibility through exit, then the stockholder can exclude from their income most, if not all, of their gain, subject to the dollar limitations discussed below.

Qualifying for QSBS: Issuer Requirements

First, the requirements to issue QSBS-eligible shares to a stockholder are specific to the company-issuer. This eligibility is measured at the time of issuance, meaning a company can issue shares that qualify for QSBS in the first three years of existence, for example, but may no longer be eligible at the start of year four. In this instance, shares held by a stockholder originally issued as QSBS will remain QSBS—so long as the stockholder complies with the stockholder-taxpayer requirements outlined in the following section.

  1. Original Issuance: The stock must be acquired directly from the company for cash, property, or services. “Property” may include non-cash consideration and intellectual property, which is common for startup founders.[3]
  2. Entity: The company must be a domestic C corporation, and the company must retain such tax status from the date of stock issuance to the date of stock sale.[4]
  3. Asset Limitation: The company’s “aggregate gross assets” must not exceed $50,000,000 at any time from incorporation up to immediately after the stock is issued. The I.R.C. places the burden on the stockholder to prove this test is satisfied, which can produce a high bar for investors or employees who purchase QSBS shares many years after a company’s formation.[5]
  4. Qualified Trade or Business: During the stockholder’s holding period, the company must be (i) engaged in a “qualified trade or business” (“QTB”) and (ii) use 80% of its assets in the active conduct of one or more qualified trades or businesses.[6] Note that while a company’s initial principal business may be a bona fide QTB, the company must continuously satisfy the 80% active conduct requirement so long as the stockholder holds QSBS. The improper co-mingling of assets is a common pitfall that can impair QSBS status.

Defining “Qualified Trade or Business”

The Code defines a “qualified trade or business” as any trade or business other than the following:

  • Services businesses: any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services
  • Reputation or skill of individuals: any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees
  • Other excluded businesses:
    • banking, insurance, financing, leasing, investing, or similar businesses,
    • farming businesses,
    • mining, oil, or gas businesses,
    • Operations of a hotel, motel, restaurant, or similar business

The statute also limits companies from holding too much cash or investment assets. A business can’t be a “qualified trade or business” if stock held in other corporations (other than subsidiaries) exceeds more than 10% of the total value of the company’s assets. A similar rule applies to real estate holdings: the value of any real property that is not used in the company’s QTB cannot exceed more than 10% of the total value of the company’s assets. In short, the Code tries to ensure that eligible startups derive value from their own active business operations, rather than through passive investments—which fall more in line with the business models of holding companies and investment funds.

Qualifying for QSBS: Stockholder Requirements

Once shares of QSBS are properly issued, stockholder-taxpayers must follow additional requirements to remain eligible for the income exclusion upon the sale of QSBS. There is no election or IRS filing to be made at the time of purchase in order for shares to be deemed QSBS. Instead, stockholders must claim the exclusion on Form 8949 in the year of sale.

  1. Eligible Stockholder: Any stockholder other than a corporation is eligible for the exclusion. Individuals, trusts, estates, and pass-through entities (e.g., partnerships, S corporations, and common trust funds) may claim the exclusion, so long as the stock passes through to an ultimate QSBS-eligible stockholder.
  2. Minimum Holding Period: The stockholder must hold the QSBS for more than five years for capital gain to qualify as “Eligible Gain” upon sale. If the startup is tremendously successful early on, and the founder sells the company within a few short years, Section 1045 allows the stockholder to reinvest the sale proceeds into another qualified small business within a certain timeframe, and tack the holding period in order to meet the five-year minimum (I.R.C. § 1045).
  3. Start of Holding Period: Founders often receive their initial shares in a startup in exchange for their services, and typically, the shares are issued in the form of restricted stock. Consequently, the rules surrounding I.R.C. Section 83 generally apply to the tax treatment of their stock. As it applies to QSBS, whether a founder files an 83(b) election determines when her holding period starts for the purposes of Section 1202. Meaning, if a founder fails to file an election and thus recognizes income at each vesting event, her holding period for each share of QSBS only begins once each share is vested. Conversely, if a founder files an 83(b) election within 30 days of “transfer,” she will recognize income immediately and begin her Section 1202 holding period in the same year the restricted stock was issued (I.R.C. § 83(b)).
  4. Eligible Securities: In addition to requiring an original issuance from a domestic C corporation, stockholders must purchase or receive “stock,” as defined in the Code. This includes shares of common and preferred stock, as well as voting and non-voting classes. However, employees or service providers who receive options or warrants don’t hold QSBS until they exercise their option to purchase stock. Similarly, the vast majority of convertible note investors don’t start their 1202 holding period until the debt converts into stock.[7]

Calculating the Tax Exclusion

For founders and investors who successfully receive QSBS shares from a qualified small business and maintain eligibility through the five-year holding period, Section 1202 provides two formulas for calculating the income exclusion. Upon sale, stockholders may exclude from their income capital gain equal to the greater of: (a) $10 million, or (b) 10 times aggregated adjusted basis of the QSBS (the “10X Cap”). These amounts are determined on a per-issuer, per-taxpayer basis—meaning a single company can issue QSBS to an unlimited number of co-founders or investors, and a single stockholder can hold QSBS from an unlimited amount of qualified small businesses—all while treating the exclusion limitation separately for each transaction.

The $10 million limitation, while invoked more often, caps each taxpayer’s exclusion to $10 million across all aggregate sales of QSBS by such taxpayer for each company. Thus, if Founder X holds $15 million worth of QSBS and decides to sell $7 million worth in a given year, she may only exclude $3 million more in any future sales. The remaining $5 million would then be subject to non-section 1202 gain and likely be characterized as long-term capital gain.

On the other hand, the 10X Cap is measured during the tax year of the sale, and thus it can be re-tested every subsequent year. Under these rules, a strategic founder can apply the 10X Cap every year after year 5, until she exhausts all of her QSBS. In addition, certain strategies allow stockholders to increase the “aggregate adjusted basis” of their shares (aka “pack” the basis) such that the 10X Cap can provide a nine-figure tax exclusion.

Section 1202 can provide a tremendous tax benefit to founders, employees, and investors upon exit. While these requirements may seem simple to follow, there are a number of pitfalls that can impair QSBS treatment.

[1] Assumes 20% long term capital gains rate for the sale of stock and a 3.8% NIIT.

[2] Stockholders must make an election to apply the rollover rules § 1045.

[3] I.R.C. § 1202(h) provides certain carve-outs, including the transfer of QSBS by gift, which makes advanced tax planning strategies possible, such as “stacking”.

[4] The term “domestic corporation” includes LLCs and non-corporate entities that elect corporate tax treatment under check-the-box regulations. See § 7701.

[5] See, e.g., Ju v. United States, No. 22-1815 (Mar. 18, 2024).

[6] The 80% requirement is calculated by value and excludes assets used in non-qualifying activities, investment assets, non-qualifying real-estate and cash not required for working capital needs (§ 1202(e)(2)).

[7] Courts apply a multi-factor test to determine whether instruments should be characterized as debt or equity. The majority of convertible notes we come across in practice don’t have a strong argument to be characterized as equity. But of course, form isn’t determinative and when drafted with certain terms, notes—and even highly customized Safes—can provide equity-like characteristics.

Posted in: Tax, Funding & Capital Raising

About the Author(s)

Bobby Gojuangco

Bobby Gojuangco is an attorney at Vela Wood. He focuses his practice in the areas of venture financing, M&A, and taxation.

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