Qualified Small Business Stock (QSBS): What Founders, Investors, Contractors, and Employees Need to Know

What Is Qualified Small Business Stock (QSBS)?

Qualified Small Business Stock, or QSBS, refers to shares issued by a U.S. C corporation that meet the requirements of Section 1202 of the Internal Revenue Code. Under these rules, founders, investors, contractors and employees who receive stock directly from the company and hold it for more than five years can potentially exclude up to $15 million of capital gain — or in some cases even more, if ten times their basis is larger — from federal income tax when they sell.

To qualify as QSBS, the stock generally must:

• Be originally issued by a U.S. C corporation (not an LLC or S corporation).
• Be issued after August 10, 1993 (and for the $15 million exclusion, after July 4, 2025).
• Belong to a company engaged in an active trade or business (not an excluded industry such as professional services, finance or hospitality).
• Be acquired in exchange for money, property (other than stock), or as compensation for services.
• Be held for more than five years before sale.

Why QSBS Benefits Matter — Now More Than Ever

Recent changes enacted on July 4, 2025 increased the per‑issuer gain exclusion cap under Section 1202 from $10 million to $15 million for stock acquired after that date. The new law also introduced a tiered system that allows partial exclusions after shorter holding periods: 50 % of gain after three years and 75 % after four years, with the full 100 % exclusion still available after five years. In addition, the asset threshold for a corporation to qualify as a “qualified small business” increased from $50 million to $75 million.

These enhancements make Section 1202 more attractive to early‑stage companies and their stakeholders by expanding eligibility and increasing the potential tax savings.

The One Mistake That Will Kill QSBS Eligibility

In my experience, the most costly mistake founders can make is electing to be taxed as an S corporation. Stock issued by an S corporation can never qualify as QSBS. Even if you later revoke the S election and operate as a C corporation, any shares issued while the S election was in effect remain permanently disqualified.

Other Common Pitfalls

While the S election is the biggest trap, several other missteps can undermine QSBS eligibility:

• Starting as an LLC or other non‑corporate entity. If you form as an LLC taxed as a partnership and later convert to a C corporation, the five‑year holding period doesn’t begin until after the conversion, which can delay or reduce the benefit.
• Engaging in disqualified business activities. Certain industries — including professional services, finance, hospitality and a few others — are excluded from QSBS. Pivoting into one of these areas may jeopardize eligibility.
• Exceeding the $75 million gross asset limit. To qualify, a company’s gross assets must not exceed $75 million at the time stock is issued.
• Not devoting substantially all of the company's assets to the qualified trade or business. Section 1202 requires that at least 80% of the corporation's assets be used for the qualified trade or business; falling short of this threshold can jeopardize QSBS eligibility.
• Poor recordkeeping. Years down the road, you’ll need to document how and when stock was issued and that the company qualified at the time. Without clear records, it can be difficult or impossible to substantiate the exclusion.
• Making certain types of redemptions. Some redemptions or repurchases of stock can disqualify what would be QSBS, so companies need to understand and comply with the redemption rules.

Conclusion

• Section 1202 offers one of the most powerful tax incentives available to startups and their stakeholders, especially after the $15 million cap and related enhancements enacted in July 2025. But securing these benefits requires careful planning at formation and during financings. A single early decision — such as electing S corporation status — can foreclose the opportunity forever. Early guidance can ensure your company stays on the right side of the QSBS rules and preserves the opportunity for substantial tax‑free gains at exit.