The Powerful Tax Savings of "Qualified Small Business Stock"

IRC Section 1202 provides one of the most powerful tax benefits in the U.S. Internal Revenue Code (IRC) to entrepreneurs and investors. Section 1202 provides an exclusion from taxation to a qualified investor of up to $10-15 million of capital gain or 10 times the stockholder’s adjusted cost basis, whichever is greater, upon the sale of Qualified Small Business Stock (QSBS). Why is the range of potentially excluded capital gain between $10-15 million? A look back at past and more recent legislative history provides some insight.

Section 1202 was originally enacted as part of the Budget Reconciliation Act of 1993 and meant to encourage private investment into small companies that have difficulty raising private capital. Three events in the last two decades have increased its popularity:

• First, the tax benefits applicable to sales of QSBS were made more generous in September 2010, exempting 100% of an eligible investor’s gain – up to the greater of $10 million (per-issuer limit) or a 10-times basis limit.
  
  • Prior to 2010, gain exclusion had been limited to 50-75% of the total eligible gain, depending on the date of the stock sale.
  • This more generous exclusion was made permanent in 2015.
• Second, the TCJA of 2017 lowered corporate income tax rates from 35% to a flat 21%, enticing more company founders to consider choosing or converting to a C-corporation for their company structure, a key requirement for stock to qualify as QSBS.
• Third, the One Big Beautiful Bill Act (OBBBA) passed in 2025 made the 21% C-corp tax rate permanent and added three (3) key changes to the 1202 rules applicable only to stock issued after July 4th, 2025:
  
  • Per-issuer capital gain exclusion limit increased from $10 million to $15 million
  • Partial holding period allowed of 3-years (50% gain exclusion) and 4-years (75% gain exclusion)
  • Company asset threshold increased from $50 million to $75 million.

The issuance date of the stock is a critical starting point; for stock issued on or prior to July 4th, 2025, the “old” rules will continue to apply. More on what those rules are to follow.

Tax Benefits of Section 1202 Exclusion - An Example

First, consider a concrete example of the potential value of Section 1202. Susan received 1,000 shares of QSBS stock as compensation worth $3 million in 2017. In 2024, she sells all her shares for $33 million, realizing a $30 million gain.

Under normal taxation rules, Susan would owe federal (and any state) taxes on the $30 million capital gain, paying $7.14 million in federal taxes assuming a top capital gains rate of 20%, plus the additional Net Investment Income (NII) tax of 3.8% (state taxes may also apply, depending on jurisdiction).

Because the stock qualified as QSBS – it was issued in 2017 and held for more than 5 years - Susan’s capital gain can be excluded up to the greater of $10 million or 10 times her cost basis of $3 million, which is $30 million in this case. As a result, Susan’s entire capital gain from the QSBS sale is excluded from taxation.  See below for a summary table:

If the sale price was higher and Susan realized any capital gain in the year of sale above the maximum $30 million exclusion amount, that gain would be taxed at 28% under QSBS rules (but exempt from the NII tax).

Corporate Requirements for QSBS Treatment

Given the large tax benefit available, Congress imposed a number of requirements a company must meet in order to qualify as a Qualified Small Business (QSB). Though there are additional important nuances, the main corporate requirements are:

1. The company must be organized as a C-corporation at the time of original stock issuance and during substantially all the shareholders’ holding period.
   
   • S-corporations do not qualify, and pass-through entities (partnerships, LLCs) must convert to a C-corp before the stock is issued.
2. Gross assets cannot exceed $50-75 million prior to or immediately after issuing stock, depending on the issuance date. The OBBBA legislation increased the gross asset threshold to $75 million, applicable only to stock issued after July 4, 2025. To clarify, the maximum gross assets based on issuance date are:
   
   • On/prior to July 4th, 2025: $50 million
   • After July 4th, 2025: $75 million
     
     • Note - inflation adjustments to the $75 million begin in 2027.
     • For the purposes of this test, assets other than cash are valued based upon their adjusted basis rather than fair market value.
3. The corporation must use 80% of its assets in the active conduct of one or more “qualified trade or businesses” as defined in IRC Section 1202(e)(3). Assets for the purposes of this test are valued based upon their fair market value. This requirement must be satisfied through substantially all of the shareholders’ holding period.
4. The corporation must be a “qualified trade or business” defined as any business not specifically excluded in IRC Section 1202(e)(3) and summarized in the table below:

Investor Requirements for QSBS Treatment

In addition to the requirements above at the corporate level, there are specific investor requirements to be met as well:

1. The investor must be an individual, trust, or pass-through entity (to the extent their owners are eligible). Corporate investors (C-Corps) do not qualify.
2. The stock must be acquired at original issuance directly from the corporation, either as compensation or in exchange for cash or property. Stock acquired through the secondary market does not qualify.
   
   • Options, restricted stock, and convertible debt are considered original issuance.
3. The investor must hold the stock for 3-5 years or longer, depending on when the QSBS was issued. OBBBA added new partial exclusions for shorter holding periods, applicable only to stock issued after July 4, 2025. To clarify, the required holding period is:

Common Real-Life Issues for QSBS Investors

Holding Period

A common question that arises and can cause significant confusion pertains to when the holding period for an investor of QSBS begins. While straightforward for normal stock purchases (the purchase date is the beginning of the holding period), shares acquired via other methods require close attention. The table below summarizes the holding period “trigger” for restricted stock, options, warrants, restricted stock units (RSUs), and convertible debt.

Consider John, who received restricted stock as compensation from a QSBS-eligible company in 2019 with a four-year cliff vesting schedule. Since John did not file an 83(b) election within 30 days of the grant date, his QSBS holding period only began when the shares fully vested in 2023! For founders and early employees, making an early 83(b) election, when appropriate, can be critical to start the holding period earlier and maximize QSBS tax advantages.

Acquisition by a Non-QSB Company

Suppose you’ve held QSBS for nearly 4 years, and your company is acquired by a public company that is not a qualified small business. In the acquisition, your QSBS is exchanged for shares of the acquiring public company in a tax-free reorganization. Is all hope of QSBS treatment lost? Fortunately, no — under §1202(h), your shares can still partially qualify for the QSBS exclusion.

Continuing the previous example, assume John’s company is acquired by a non-QSB eligible public company in 2027 (4 years after his restricted stock vested in 2023). The shares are worth $5 per share at the time of acquisition. John holds the public company stock one more year and sells the public company’s shares for $10 per share. John’s gain on the sale qualifies for the QSBS exclusion, but only up to the $5 per share value at the acquisition date. He owes capital gains taxes on the additional $5 gain. 

Redemptions of QSB Stock

Exercise caution before allowing redemptions of QSBS from existing shareholders — or their family members. Certain redemptions can jeopardize the QSBS eligibility of the redeemed shares or even the entire stock issuance. Under §1202(c)(3), stock may be disqualified from QSBS treatment if:

1. The company redeems more than 5% of its stock within one year before or after the issuance date; or
2. The company makes more than de minimis (~2%) redemptions from related parties (e.g., the issuing shareholder or their family members) within two years before or after issuance.

These redemption rules are designed to prevent companies from issuing QSBS with one hand while simultaneously returning capital with the other.

There are exceptions for redemptions triggered by death, disability, divorce, or termination of employment, but they are narrowly applied. In practice, even routine buybacks or restructuring transactions can inadvertently run afoul of these rules — so it is critical to consult tax counsel before any redemptions are made near an issuance.

Pass Through Entities (VC & PE Investors)

The QSBS tax exclusion is available to investors who hold qualified stock through pass-through entities, such as partnerships, S-corporations, or LLCs taxed as partnerships. §1202(g) permits this treatment, provided that both the corporate-level requirements and investor-level requirements are satisfied. Specifically:

1. The pass-through entity must acquire the stock at original issuance and hold it for at least 5 years (or at least 3 years if the stock was issued after July 4th 2025).
2. The stock must meet all corporate-level QSBS requirements throughout the entity's holding period.
3. Each individual investor must have been a partner, member, or shareholder of the pass-through entity at the time the QSBS was acquired, and they must remain an owner through the entity’s sale of the stock.

If these conditions are met, the gain flows through to the individual, who may claim an exclusion on their pro-rata share, subject to their own applicable gain limitation (e.g., $10-15M or 10× basis).

Qualified Team and Documentation

This post offers an in-depth primer on QSBS but is not an exhaustive guide to every requirement or potential pitfall. Given what is at stake, it’s essential to build a team that works collaboratively — including a financial advisor, tax professional, and attorney well-versed in Section 1202 planning. In this area, good advice is well worth the cost.

Keeping clear documentation, especially across multiple financing rounds, is also critical — and often easier said than done. This is where having a thoughtful, detail-oriented team makes a real difference. At Wealthspire, we help clients stay organized and coordinated across all moving parts of their financial lives, so they are positioned to fully realize opportunities like QSBS.

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