Startups are risky by nature, but they can also reap immense rewards. The IRS offers tax incentives to encourage the entrepreneurial spirit behind these innovative enterprises. The qualified small business stock (QSBS) exclusion is a tax advantage that benefits eligible shareholders in qualified small businesses (QSBs).
Turn to trusted business law firm Allegis Law to explore qualified small business stock and other tax-saving strategies that could save you millions.
The QSBS tax exclusion established by Internal Revenue Code Section 1202 provides shareholders a break on capital gains tax when they sell or exchange qualified stock. The tax break can go all the way up to 100 percent, which makes exploring your eligibility with a business and tax attorney well worth the investment.
Eligibility as a qualified small business in relation to the QSBS tax exclusion comes with each of the following requirements:
If you intend to sell your business, consider reorganizing it as a corporation well in advance. By structuring your company for QSBS eligibility, you’ll be set up to maximize tax benefits when it comes time to sell. For an LLC, this often means contributing the business to a new C corporation under IRC Section 351. For an S corporation, revoking the S election alone does not turn existing shares into QSBS. Qualifying stock generally comes from a new issuance of C corporation stock, often through a restructuring. Gain built up before the conversion generally does not qualify, so an earlier conversion leaves more of the company’s future growth eligible.
By planning for a QSBS sale transaction in advance, you can reduce or eliminate capital gains tax on the increase in value of your qualified small business stock under IRC Section 1202, or reinvest the proceeds into new qualified small business stock within 60 days to defer capital gains tax on the gain under IRC Section 1045.
QSBS planning works best when it starts before a financing round, a restructuring, or a sale. The services below cover the points where Section 1202 eligibility can be preserved or lost. Each links to a dedicated page with detailed guidance.
Gifts of stock to properly structured non-grantor trusts, each of which may claim its own Section 1202 exclusion. Timing matters, since gifts made after a sale is substantially negotiated can draw IRS scrutiny.
Conversion timing and structure for S corporations and LLCs. Only C corporation stock can qualify, and the QSBS holding period generally starts at conversion.
Section 355 and Section 1202 analyzed together before a business line is separated. A tax-free separation does not automatically preserve QSBS treatment.
Gain deferral for QSBS held more than six months, when sale proceeds are reinvested in replacement QSBS within 60 days.
Cap table, financing, and redemption review to confirm each shareholder acquired stock directly from the corporation. Secondary purchases and poorly timed buybacks can disqualify otherwise eligible shares.
Section 1202 does not require a QSBS attestation letter. Shareholders often request one from the company because it documents that the company met the qualified small business requirements when their shares were issued. That record supports the exclusion if the IRS later questions it, and buyers and investors often ask for it during due diligence.
Certain actions can disqualify a company from status as a QSB, which can directly affect its shareholders’ eligibility for the QSBS tax exclusion.
Stock buybacks can disqualify newly issued stock. If the company redeems more than 5 percent of the value of its stock during the two-year window that begins one year before an issuance, stock issued in that window does not qualify. Redemptions from the shareholder or a related person within two years before or after an issuance can also disqualify that shareholder’s stock. Small redemptions may fall under de minimis exceptions.
A company that qualified as a QSB prior to changing its business model to the provision of services that are outside eligibility for QSBS can lose its qualification.
Cash and investments count toward the 80 percent active use requirement only in limited cases. Assets held for reasonably required working capital, or expected to be used within two years for research or working capital, can count as active. Once the company is at least two years old, no more than 50 percent of its assets can qualify under that rule. A company also fails the test for any period in which more than 10 percent of its assets, net of liabilities, consist of stock or securities in corporations that are not its subsidiaries.
The gross assets test applies when shares are issued and immediately after. For stock issued on or before July 4, 2025, the company's aggregate gross assets cannot exceed $50 million at that point. For stock issued after July 4, 2025, the OBBBA raised the threshold to $75 million, indexed for inflation beginning in 2027. Shares issued while the company was under the threshold keep their status if the company later grows past it. Once gross assets exceed the threshold, stock the company issues afterward does not qualify, even if assets later fall back under the limit.
Stock options and warrants are not QSBS. A shareholder’s securities become eligible only after the shareholder exercises the option and receives actual shares, and the holding period starts at exercise. Shareholders should also confirm the company’s QSB status when their shares are issued. Only noncorporate taxpayers, such as individuals, trusts, and estates, can claim the exclusion. Owners of a partnership or S corporation that sells QSBS may also qualify under the pass-through rules.
For stock issued on or before July 4, 2025, the stock must be held for more than five years before the QSBS tax benefit applies. Selling shares prior to the completion of the holding period can lead to tax liabilities. Once the five-year holding period ends, the stockholder can sell their qualified stock, and as long as all required conditions are met, the gain can be excluded from federal income tax up to the per-issuer cap. For stock issued after July 4, 2025, partial exclusions of 50 or 75 percent are available at the three- and four-year marks, respectively, with the full 100 percent exclusion available at five years.
Section 1202 limits the gain a shareholder can exclude for each issuer to the greater of a dollar cap or 10 times the shareholder's adjusted basis in the stock sold. For stock issued on or before July 4, 2025, the dollar cap is $10 million. For stock issued after July 4, 2025, the OBBBA raised it to $15 million, indexed for inflation beginning in 2027. Gain excluded in earlier years counts against the dollar cap. Because the 10-times-basis limit has no fixed ceiling, investors who paid cash for their shares may be able to exclude more than the dollar cap.
Investors have a stake in whether the companies they back protect QSBS eligibility. Investor rights agreements often include terms like the following:
The selling of shares generally comes with either short-term or long-term capital gains tax rates, which can be exceptionally high. For example, short-term rates can top out at 37 percent while long-term rates can be as high as 20 percent, each of which can take a serious bite out of earnings. QSBS status can exclude up to 100 percent of qualifying gain from federal income tax, depending on when the shares were acquired.
The exclusion percentage for pre-July 4, 2025, issuances depends on when the stock was acquired:
For stock issued after July 4, 2025, the OBBBA introduced a tiered exclusion structure based on holding period:
Shareholders can sell QSBS in one year or across several years, and the dollar cap applies to the total gain excluded for each company. When a shareholder holds QSBS in more than one qualifying company, the cap applies separately to each company.
QSBS rules are complex and change with new legislation, so review your position with a business and tax attorney before a sale.
Once shares qualify as QSBS at issuance, some later events do not affect their status, and others can:
If the company merges or is acquired, shareholders may have these options:
Many states follow the federal QSBS exclusion, but some do not. Residents of the following states do not receive the full benefit at the state level:
Maine adds back the exclusion for stock acquired after July 4, 2025. New Jersey adopted the federal QSBS exclusion for tax years beginning on or after January 1, 2026. The District of Columbia also decoupled from Section 1202 beginning with the 2025 tax year.
Both Massachusetts and Hawaii partially conform to the federal QSBS tax exclusion. State rules on QSBS change often, so confirm current treatment before a sale.
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