What Is QSBS?

Qualified Small Business Stock (QSBS) refers to shares issued by a U.S. C corporation that meet the requirements of Section 1202 of the Internal Revenue Code. If you hold QSBS for long enough and sell it, you can exclude a substantial amount of capital gain — potentially all of it — from federal income tax.

This is, by a wide margin, the most significant tax benefit available to startup founders and early-stage investors. On a successful exit, the difference between qualifying for the Section 1202 exclusion and not qualifying can be measured in millions of dollars.

The basic idea is simple: Congress wants to encourage investment in small businesses, so it created a powerful incentive. If you acquire stock directly from a qualifying C corporation, hold it for at least five years, and the company meets certain requirements during that time, you pay zero federal income tax on the gain when you sell — up to a generous cap.

The details, as with most things in the tax code, are where it gets complicated. This guide walks through each requirement and the planning considerations that matter most in practice.

What Changed Under the Big Beautiful Bill (2025)

On July 4, 2025, President Trump signed the One Big Beautiful Bill Act (OBBBA), which made the most significant changes to Section 1202 in over a decade. These changes apply only to stock issued after July 4, 2025 — pre-existing QSBS is still governed by the old rules.

Qualification Requirements

Not every share of stock qualifies for the Section 1202 exclusion. There are requirements at both the company level and the shareholder level, and all of them must be satisfied.

Company-Level Requirements

• Domestic C corporation. The issuing company must be a U.S. C corporation at the time of issuance — not an S corp, not an LLC, not a partnership.
• Gross asset test. The corporation's aggregate gross assets cannot exceed $50 million (pre-OBBBA) or $75 million (post-OBBBA) at any time before or immediately after the stock issuance.
• Active business requirement. At least 80% of the corporation's assets must be used in the active conduct of one or more qualified trades or businesses during substantially all of the taxpayer's holding period.
• Qualified trade or business. The business must not be in an excluded category — certain service industries, banking, insurance, farming, mining, and hospitality are disqualified.

Shareholder-Level Requirements

• Original issuance. The stock must be acquired directly from the corporation in exchange for money, property (other than stock), or services. Buying shares on the secondary market does not qualify.
• Non-corporate taxpayer. The exclusion is available to individuals, trusts, estates, and pass-through entities (partnerships and LLCs taxed as partnerships). C corporations cannot claim the Section 1202 exclusion.
• Holding period. The stock must be held for more than five years for the full exclusion (or three to four years for the new partial exclusions on post-OBBBA stock).

Excluded Businesses

The following types of businesses cannot issue QSBS, regardless of size or structure:

• Professional services (health, law, engineering, accounting, consulting, financial services, performing arts, athletics)
• Banking, insurance, financing, leasing, or investing
• Farming (including raising or harvesting timber)
• Mining, oil, gas, or other extractive industries
• Hotels, motels, and restaurants

Who Benefits — Founders, Investors & Employees

The Section 1202 exclusion is a per-taxpayer, per-issuer benefit. That means each person who holds qualifying stock in a given company gets their own exclusion. This is powerful because it means founders, angel investors, seed-round participants, and early employees who receive stock can each independently exclude up to $10 million (pre-OBBBA) or $15 million (post-OBBBA) of gain from the same company.

Founders

If you form a C corporation and acquire your founder shares at par value, you have the maximum potential exclusion available — your basis is near zero, so nearly all of your exit proceeds are gain, and the exclusion shelters up to $15 million of it (or 10× your basis, whichever is greater). For most founders paying a fraction of a penny per share, the flat cap will be the binding constraint.

Angel Investors

Angels who write checks directly to the company in exchange for stock at original issuance qualify. The 10× basis alternative can be especially valuable here: an investor who puts in $2 million gets at least a $20 million exclusion, which can exceed the flat $15 million cap.

Employees & Contractors

Stock received for services — including through the exercise of stock options — can qualify as QSBS. The key is that the employee acquires the stock directly from the corporation. For options, the QSBS clock generally starts when the option is exercised, not when it's granted.

Entity Structure: Why Only C-Corps Qualify

This is the single most important structural decision for QSBS purposes, and it's also the one that's most frequently gotten wrong. Only stock issued by a C corporation can be QSBS. Not an LLC. Not an S corporation. Not a partnership.

If you form as an S corp, your founder shares will never qualify — even if you later revoke the S election, stock issued while the election was in effect is permanently disqualified. If you form as an LLC, your membership interests don't qualify, but you can convert to a C corporation and start the clock from the date of conversion.

The Holding Period & Tiered Exclusion

Under the pre-OBBBA rules (stock issued on or before July 4, 2025), the holding period is binary: hold for more than five years and get the 100% exclusion, or don't and get nothing (unless you do a Section 1045 rollover).

The OBBBA introduced a tiered structure for stock issued after July 4, 2025:

The Exclusion Cap: $10M vs. $15M

The Section 1202 exclusion is not unlimited. There are two caps, and you get the benefit of whichever is larger:

The flat cap: $10 million per issuer for pre-OBBBA stock, or $15 million per issuer for post-OBBBA stock (with inflation adjustments starting in 2027).

The basis multiplier: 10 times the taxpayer's adjusted basis in the stock. This is where investors with larger check sizes can significantly exceed the flat cap.

These caps are per issuer and per taxpayer. A married couple filing jointly who each independently acquired QSBS can each claim their own exclusion on the same company's stock. Similarly, gifting QSBS to family members (in certain circumstances) or using trusts can multiply the number of available exclusions — but the rules here are technical and require careful planning.

Section 1045 Rollovers

What happens if you need to sell your QSBS before the five-year mark? Section 1045 provides an escape valve: if you've held the stock for more than six months, you can defer the gain by reinvesting the proceeds into new QSBS within 60 days.

Unlike Section 1202, the 1045 rollover has no dollar cap on the amount of gain that can be deferred. And the holding period of the original stock tacks onto the replacement stock, so you can still reach the five-year mark for a full 1202 exclusion on the replacement shares.

Key Requirements

The original stock must be QSBS that you've held for more than six months. The replacement stock must be newly issued QSBS — you can't buy it on a secondary market. The reinvestment must happen within 60 days of the sale. And the replacement corporation must meet the active business test for at least six months after issuance.

QSBS and Trusts & Estates

Trust and estate planning is one of the most powerful — and most technical — dimensions of QSBS strategy. Done right, trusts can multiply the number of available exclusions within a family. Done wrong, they can destroy QSBS status entirely.

Grantor Trusts

A grantor trust is disregarded for income tax purposes — the grantor is treated as the owner of the trust's assets. This means QSBS held by a grantor trust is treated as held by the grantor, and the grantor claims the exclusion. Transferring QSBS to a grantor trust is generally safe and does not restart the holding period or trigger a disqualifying event.

Non-Grantor Trusts

This is where it gets complicated. A non-grantor trust is a separate taxpayer, which means it gets its own Section 1202 exclusion — but the trust must have acquired the stock at original issuance (or through a qualifying transfer) to claim it. Transferring QSBS to a non-grantor trust can be a powerful exclusion-multiplication strategy, but the transfer must be structured correctly to avoid losing the benefit.

Gifting QSBS

Gifting QSBS to family members or trusts can create additional exclusions, but the rules are nuanced. The recipient generally inherits the donor's holding period and basis, and must independently meet the requirements. Gifts to non-grantor trusts for the benefit of multiple beneficiaries can potentially multiply exclusions, but this area requires careful coordination between startup counsel and estate planning attorneys.

Estates and Inherited QSBS

QSBS that passes through an estate at death can retain its QSBS character. The heir inherits the decedent's holding period (but not a stepped-up basis for Section 1202 purposes — this is an important distinction). Estate planning around QSBS often involves deciding whether to gift shares during life (to multiply exclusions) or hold them until death (to get a stepped-up basis for non-1202 purposes).

State-by-State Conformity

The Section 1202 exclusion is a federal benefit. Whether your state respects it is a separate question — and the answer varies significantly.

Most states conform to Section 1202, meaning if your gain is excluded federally, it's also excluded at the state level. But several important states do not:

Common Pitfalls That Blow the Exclusion

The Section 1202 exclusion is generous, but it's also fragile. There are several common mistakes that can disqualify stock — and most of them are avoidable with proper planning.

Wrong Entity at Formation

Forming as an S corp or LLC when a C corp was the right choice. S corp shares are permanently disqualified. LLC interests don't qualify, though you can convert and start the clock from that date.

Exceeding the Gross Asset Threshold

If the company's gross assets exceed $50 million (pre-OBBBA) or $75 million (post-OBBBA) at any time before or immediately after issuance, the stock doesn't qualify. Large fundraising rounds can push a company over this limit.

Redemptions and Repurchases

Section 1202 contains anti-abuse rules around stock redemptions. Significant redemptions within certain windows around the stock's issuance date can disqualify the stock — even if the redemption involves different shareholders.

Trying to "Reset" or "Refresh" QSBS

Exchanging old QSBS for newly issued shares to get the OBBBA's better terms does not work. Unless the exchange falls into a narrow statutory exception (like a tax-free reorganization under Section 368), you'll lose QSBS status entirely.

Failing the Active Business Test

The company must use at least 80% of its assets in an active qualified business during substantially all of the holding period. Companies that accumulate too much cash or investment assets relative to operating assets can fail this test.

Poor Record-Keeping

There is no QSBS "certificate." Qualification is determined by facts and circumstances, and the burden of proof is on the taxpayer. If you can't document that every requirement was met at the relevant times, you may not be able to claim the exclusion even if the stock technically qualified.

Attestation Letters & Documentation

There is no formal IRS process for certifying that stock is QSBS. Unlike an 83(b) election, there's no form to file at the time of issuance. QSBS status is determined based on whether the requirements were met — and the taxpayer bears the burden of proof.

This makes documentation critical. Best practice is for the issuing company to provide shareholders with a QSBS attestation letter at the time of issuance confirming that, based on the company's knowledge, the stock meets the Section 1202 requirements. The letter should cover the company's gross assets, its C corporation status, the nature of its business, and the terms of the issuance.

These letters aren't legally required, but they're enormously helpful in three situations: when the shareholder files their tax return claiming the exclusion, if the IRS audits the exclusion, and during due diligence for a sale or acquisition. Companies that don't issue attestation letters are doing their shareholders a disservice.