Qualified Small Business Stock (QSBS) can be one of the most powerful tax planning tools available to entrepreneurs and early employees. If you’re a founder navigating startup growth, the QSBS exclusion may allow you to completely sidestep federal capital gains tax—up to $10 million per issuer, or 10× your original investment, whichever is greater.
Below is a breakdown of QSBS tailored for entrepreneurs, with key eligibility requirements, pitfalls to avoid, and actionable planning tips.
What is QSBS?
Qualified Small Business Stock (QSBS) refers to shares in a C-corporation that meet specific Internal Revenue Code Section 1202 requirements. If held for at least five years and meeting certain criteria, gains from the sale of these shares may be excluded from federal income tax.
Tax Benefit: For shares acquired after September 27, 2010, founders may qualify for a 100% capital gains exclusion (subject to a cap), making QSBS a potentially life-changing financial tool. Earlier acquisition periods may qualify for 50% or 75% exclusion depending on the date and are still taxed at favorable rates.
See the IRS QSBS Overview for official guidance.
What is the tax exemption amount under QSBS?
For stock acquired between August 11, 1993, and February 17, 2009, only 50 percent of the gain can be excluded, and any remaining gain is taxed at a maximum 28 percent federal rate, with a dollar cap equal to the greater of $10 million or ten times the shareholder’s basis. The exclusion percentage rises to 75 percent for shares purchased from February 18 2009 through September 27 2010, but the residual gain is still subject to the 28 percent rate and the same dollar cap. Purchases made on or after September 28 2010 enjoy a full 100 percent exclusion—meaning the federal income-tax rate on qualifying gain drops to zero—while the cap remains the greater of $10 million or ten-times basis. In every period, any portion of the gain that is excluded under these rules also avoids the 3.8 percent net-investment-income tax.
How to qualify for QSBS?
To qualify for the QSBS exclusion, the stock must be issued by a C-corporation and acquired directly from the company, so any secondary-market purchases are automatically disqualified. The corporation’s aggregate gross assets cannot exceed $50 million immediately before and immediately after each issuance, which means founders must monitor the balance sheet—especially after large funding rounds, SAFE conversions, or in-kind asset contributions that could push the total over the limit. Throughout substantially all of the shareholder’s holding period, at least 80 percent of the company’s assets by value must be devoted to an active, qualified trade or business; professional-service sectors such as health, law, consulting, or financial services generally fail this test, and while cash counts as working capital for up to two years after a financing, it cannot exceed 50 percent of total assets thereafter. In addition, the shareholder must hold the stock for more than five years, with the clock starting on the issuance date—or, for options and restricted stock, on the option-exercise or § 83(b) election date. Finally, significant redemptions by the company—typically those exceeding two percent of outstanding shares or $10,000—during certain look-back and look-forward windows can taint otherwise eligible stock, so founders should structure repurchase programs and tender offers with care.
Checklist for the aforementioned eligibility requirements
- C-Corporation stock, acquired at original issuance.
- Secondary-market purchases do not qualify.
- Gross-assets test: company’s aggregate assets must be ≤ $50 million both immediately before and after each share issuance. Keep an eye on large funding rounds, SAFE conversions, and asset contributions that could push you over.
- “Active business” test: at least 80 % of assets (by value) used in a qualified trade or business during substantially all of your holding period.
- Disfavored fields (health, law, consulting, finance, etc.) generally fail the test.
- Cash counts as “active” working capital for up to two years after a funding round, but only up to 50 % of total assets thereafter.
- Five-year holding period. Clock starts when the share is issued (option exercise date for ISOs/NSOs; § 83(b) election date for restricted stock).
- No tainting redemptions. Significant buy-backs (generally > 2 % or > $10k) by the company within certain windows can disqualify the new shares. Plan repurchases and tender offers carefully
What are some special situations under the QSBS framework?
- Special rules allow partnerships or S-corporations to pass QSBS benefits through to their owners, although only with respect to the percentage interest each owner held when the partnership acquired the stock, and later transfers of partnership interests do not carry QSBS treatment.
- Gifts, bequests, and certain partnership distributions let the recipient “step into the shoes” of the original holder, enabling estate-planning strategies.
- Companies heavy in passive real estate may fail the 80 percent active-business test unless property is spun off or leased back. In practice, founders maximize the benefit by maintaining clear capitalization and asset records, modeling the impact of future financings on QSBS eligibility, coordinating any stock repurchases with tax counsel, and documenting the corporation’s compliance so that investors, auditors, and eventual buyers can easily verify the exemption when it matters most.
What should founders do?
Founders who hope to claim the QSBS exclusion should begin by rigorously documenting C-corporation status and the company’s capitalization table at every stock issuance, tracking how much of each round counts as paid-in capital versus increases in asset value.
They should also model anticipated fundraising to forecast when aggregate assets will exceed the $50 million ceiling so they can alert incoming investors that shares issued after that point will lose QSBS eligibility.
Repurchase programs require close coordination with tax counsel to avoid redemption “taint” that could disqualify otherwise eligible stock.
Furthermore, because employees and early angel investors often overlook QSBS, founders should proactively educate them on how exercising options or holding founder shares for the full five-year period can turn an eventual exit into a tax-free gain.
In Conclusion
For founders and early employees, the Qualified Small Business Stock (QSBS) exemption isn’t just a tax perk—it’s a strategic advantage that can transform a successful exit into a life-changing, tax-free event. But to capitalize on this benefit, companies must plan ahead: maintain C-corporation status, track asset thresholds, document all issuances meticulously, and structure redemptions with care.
As someone who has worked closely with startups and high-growth companies navigating the complexities of equity, fundraising, and regulatory compliance, I’ve seen how early planning around QSBS can significantly shape long-term outcomes. If you’re building something big, make sure you’re building it smart—with the right tax strategies in place from day one.
Have questions about your company’s QSBS eligibility or need help structuring future rounds? Reach out to Montague Law for strategic legal counsel tailored to startups and founders.
Written by: Yufan Cao (Legal Intern, Montague Law)
