Summary: Qualified small business stock (QSBS) is stock in a domestic C corporation that meets the requirements of Section 1202 of the tax code. If your shares qualify, you can exclude 100% of the gain from federal capital gains tax when you sell. The QSBS exemption is one of the most valuable tax breaks for founders, early employees, investors, and business owners, but the rules are strict and some changed for stock acquired after July 4, 2025.
Key QSBS rules at a glance:
- Tax benefit: up to 100% of the gain excluded from federal tax, per taxpayer, per company
- Exclusion cap: the greater of $10 million ($15 million for stock acquired after July 4, 2025 – adjusted annually for inflation) or 10x your cost basis
- Holding period: 5 years for stock acquired on or before July 4, 2025. Newer stock earns a 50% exclusion at 3 years, 75% at 4 years, and 100% at 5 years
- Company size: gross assets of $50 million or less when the stock was issued ($75 million after July 4, 2025)
- Other requirements: C corporation, original issuance, a qualified active business (the 80% test), and no disqualifying stock redemptions
- State tax: not every state follows the federal rules, including California and Pennsylvania, and Massachusetts doesn’t recognize the 2025 changes
- Planning: QSBS trusts, gifting, and Section 1045 rollovers can multiply or preserve the exclusion
So if you invested in a startup or small business (founders, employee exercise of stock options, business owner), you need to know about qualified small business stock (also called QSBS or section 1202). QSBS has the potential to save millions (even tens of millions) in taxes. But before you can claim a capital gains exclusion on section 1202 stock, you must understand eligibility requirements and be able to support it.
What is Qualified Small Business Stock?
Qualified small business stock is stock acquired directly from a qualified small business (a domestic C corporation with gross assets under the Section 1202 limit) in exchange for cash, property, or services. Section 1202 small business stock gets special 1202 tax treatment: if all the requirements are met, some or all of the gain on a sale is excluded from federal income tax, including the 3.8% net investment income tax.
This article is meant to be an easily-digestible introduction to QSBS. It is not personal legal/tax/financial advice or an exhaustive discussion of the exclusion.
Old vs. New QSBS Rules (Before and After July 4, 2025)
The One Big Beautiful Bill (OBBB) significantly expands the benefits of Qualified Small Business Stock (QSBS) through three key provisions. However, these expanded benefits apply only to taxpayers who acquire shares after the bill’s enactment date.
Old vs. New QSBS Rules and Limits
| Rule | Old rulesStock acquired on or before July 4, 2025 | New rulesStock acquired after July 4, 2025 |
|---|---|---|
| Holding period and exclusion | 5+ years: 100% exclusion (stock acquired after Sept. 27, 2010). Under 5 years: no exclusion | 3 years: 50% exclusion; 4 years: 75%; 5+ years: 100% |
| Per-company gain cap | Greater of $10 million or 10x basis | Greater of $15 million or 10x basis ($15.48 million for 2027) |
| Gross asset test | $50 million | $75 million ($77.39 million for 2027) |
| Inflation adjustment | None | Annually, starting in 2027 |
| Tax on gain not excluded | Gain above the cap: regular capital gains rates plus 3.8% NIIT | Unexcluded portion at 3 or 4 years: 28% plus 3.8% NIIT. Gain above the cap: regular capital gains rates plus 3.8% NIIT |
| AMT | No AMT preference (stock acquired after Sept. 27, 2010) | No AMT preference |
| Other requirements | C corporation, original issuance, active business (80% test), redemption rules | Same |
Source: Darrow Wealth Management, November 2026. Not tax or legal advice.
Effective Date: These provisions apply to QSBS issued after July 4, 2025 (including qualifying new exercises and stock purchases).
Important Note: Stock acquired before the OBBB enactment date remains subject to the original QSBS rules, as outlined throughout this article.
The $15 million cap and $75 million asset test are indexed for inflation starting in 2027. For 2027, the IRS set them at $15.48 million and $77.39 million (Rev. Proc. 2026-35). The $10 million cap on older stock is not indexed.
QSBS Qualification: How Do You Qualify for QSBS?
Qualified Small Business Stock Requirements
To qualify for the small business capital gain exclusion, the following key requirements must be met:
QSBS Qualification Rules
To qualify for the Section 1202 small business capital gain exclusion, the following key requirements must be met:
-
Issuance and type
- Shares of a domestic C corporation, acquired at original issuance (directly from the company) on or after August 11, 1993.
- Shares must be exchanged for money, property (excluding stock), or services.
- Held by an individual, trust, estate, or pass-through entity. C corporations can’t claim the exclusion.
-
Gross asset test
- Aggregate gross assets (generally cash and adjusted tax basis of property) must be $50 million or less immediately before and after the stock issuance.1
- Threshold is $75 million for stock acquired after July 4, 2025 ($77.39 million for stock issued in 2027).
-
Holding period
- At least 5 years for stock acquired on or before July 4, 2025.
- Stock acquired after July 4, 2025: 3 years for a 50% exclusion, 4 years for 75%, 5 years for 100%.
- Clock starts on the exercise date for stock options.
- Generally, the original purchaser of QSBS must be the seller claiming the Section 1202 exclusion.2
-
Active business
- At least 80% of assets (by value) must be used in the active conduct of a qualified trade or business during substantially all of your holding period (the 80% rule).
- Excludes businesses where the principal asset is the reputation or skill of one or more employees, such as professional services, consulting, law, health, and financial services, plus farming, banking, insurance, hotels and restaurants, and others.
- Excessive non-operating real estate, cash, or portfolio assets can disqualify stock.
-
Stock buybacks
- No significant stock redemptions by the company. They can disqualify shares.
- No buybacks from the shareholder or a related party 2 years before or after issuance; no significant buybacks from any shareholder 1 year before or after issuance.3
Updated November 2026. Other rules apply; not tax or legal advice.
Other rules apply; not tax or legal advice
This list is only a summary of the primary elements.
For more detailed information on qualifying, refer to this article. Given the complexities, consult with your CPA to discuss your specific circumstances. Careful structuring of transactions and planning for capital gains exclusions related to QSBS are crucial for federal income tax purposes.
QSBS Tax Benefits and 1202 Tax Treatment
For those holding Section 1202 shares, the amount of gain eligible for exclusion from federal long-term capital gains tax on the sale of qualified small business stock depends on the gain itself, how long you held the shares, and the stock’s acquisition date. If you got shares from stock options, the exercise date is considered the acquisition date.
Video: Qualified Small Business Stock (QSBS): Founder Qualification and Exemption
Gain Exclusion: The Greater of $10 Million ($15 Million) or 10x Basis
Each year, a taxpayer holding Section 1202 shares can exclude the greater of the following two amounts:
- $10 Million Cap: This is a lifetime limit, reduced each year by any previous QSBS sales from the same issuer where this $10 million cap was used. (Note: The OBBB raised this to $15 million for acquisitions after July 4, 2025, indexed for inflation starting in 2027.)__
- 10x Basis: Calculated annually when QSBS is sold, per taxpayer, per issuer. This is ten times the stock’s adjusted basis.
Example (stock acquired before July 4, 2025):
Jack acquired QSBS-eligible stock in 2011 with a total fair market value of $15 million. This year, he sells enough stock to reach the $10 million gain exclusion cap. Next year, he sells an additional $2 million worth of stock with an aggregate adjusted basis of $5,000. His gain exclusion will be $50,000 ($5,000 x 10). The remaining gain from that sale will be subject to long-term capital gains taxes.
Example (stock acquired after July 4, 2025):
Maria exercises stock options in August 2025 and sells the shares in September 2029, just over four years later, for a $12 million gain. Because she held the stock at least four years but less than five, 75% of the gain ($9 million) is excluded. The remaining $3 million is taxed at 28% plus the 3.8% net investment income tax. Had she waited until the five-year mark, the entire gain would have been excluded.
Percentage Limitations for Stock Issued Before September 28, 2010
In addition to the limits above, the exclusion may be further reduced depending on the stock’s acquisition date:
- August 11, 1993 – February 17, 2009: 50% exclusion
- February 18, 2009 – September 27, 2010: 75% exclusion
- After September 27, 2010: 100% exclusion
Stock not eligible for the 100% exclusion will have slightly different tax treatment. The portion of the gain that is taxable due to these percentage limitations is subject to a 28% tax rate and the 3.8% net investment income tax (Medicare). Furthermore, 7% of the excluded amount is considered a preference item for the alternative minimum tax (AMT).
Remember, this is a summary of the tax implications for section 1202 of the tax code; it’s not tax advice! Discuss your situation with a tax advisor.
QSBS Trusts And Gifting: Gains Over the Exemption
The Section 1202 gain exclusion is per taxpayer. To maximize tax benefits beyond the 10x/$10M/$15M limits, explore strategies such as gifting stock to family members, as each taxpayer has their own individual limits. Consult with an attorney regarding tax planning strategies involving QSBS and trusts.
Gifting QSBS outright to children or family, or more commonly, using trusts, is another way to maximize the tax-free nature of QSBS shares. Putting shares into a trust for the benefit of another taxpayer (not a spouse) can create new $10M ($15M for newer stock) tax-free caps. Gifted shares generally keep the donor’s original issuance status and holding period.
For a QSBS trust to qualify for the exclusion, it must be an irrevocable non-grantor trust. Mistakes with drafting, beneficiaries, or even roles and responsibilities can invalidate the trust. Work with an estate planning attorney who has done this before.
Prior to gifting shares, make sure you can support your lifestyle and income needs. Gifting and trust stacking becomes much more difficult after the company has met success, given the lifetime gifting limits.
Another strategy involves structuring sales of Section 1202 stock to first sell low-basis stock (up to the $10M/$15M cap), followed by high-basis stock (to utilize the annual 10x basis limit). Additional strategies may be available depending on your specific circumstances.
Additional Section 1202 Tax Planning Considerations for Founders
Disqualifying Qualified Small Business Stock
Certain company actions can jeopardize its QSBS status, thereby affecting shareholders’ ability to claim the QSBS tax exclusion. For example, even investing business assets in money market funds can impact QSBS eligibility.
Other actions that could disqualify QSBS include company share buybacks exceeding a certain threshold or surpassing the $50 million ($75 million for stock issued after July 4, 2025) gross asset threshold through fundraising or inventory. Companies should regularly monitor their QSBS eligibility to avoid inadvertent disqualification and consult with corporate legal and tax advisors to ensure compliance.
QSBS and Stock Options
Founders and early startup employees often hold shares that could qualify for QSBS if properly managed. To help ensure eligibility for these small business stock tax benefits, consider purchasing restricted stock or exercising stock options early on, even before the shares vest.
QSBS in Massachusetts
Massachusetts previously had its own QSBS rules, but sales after January 1, 2022, now conform to the federal rules on a rolling basis. The Commonwealth also enacted a “millionaire tax,” which adds a 4% surtax to taxable income exceeding $1 million (indexed for inflation), even for one-time wealth events.
C Corporation Conversions
In certain situations, converting an S corporation to a C corporation and issuing new stock may be beneficial. Other entity structures may also qualify newly issued stock for Section 1202 benefits. However, this approach can be complex. More established companies may struggle to meet the gross asset requirements when issuing new shares. Like other advanced strategies discussed here, this method can be difficult and costly to implement (or even impossible), so consult with an attorney and tax advisor.
Understanding Hedging Restrictions
Taking an “offsetting short position” during the initial five-year holding period can disqualify stock from QSBS treatment. This includes actions such as buying a put option, writing a call option, or shorting the stock.
Documenting a Claim: QSBS Attestation Letter
While no specific IRS guidelines or documentation is required when initially filing a QSBS gain exclusion claim, taxpayers must be able to substantiate their claim in the event of an audit. The sale is reported on Form 8949 and Schedule D (with adjustment code Q), but no supporting documentation is attached to the return.
One common challenge is that stockholders often don’t realize they could have QSBS at the time of issuance, or they may be unaware of QSBS benefits altogether. We have identified QSBS eligibility for clients in numerous instances, resulting in significant tax savings. It’s a real benefit!
Ultimately, securing the substantial tax advantages of qualified small business stock may depend on maintaining thorough records and retaining those documents for several years. Stockholders are responsible for keeping documentation that proves their QSBS eligibility in case of an IRS audit. At a minimum, Jeff Krueger, CPA, of Seaport Financial Partners in Boston, recommends retaining records of:
- Balance sheets before and after issuance (ideally, reviewed or audited financial statements);
- A copy of the capitalization table showing changes over time to confirm no redemptions; and
- Articles of incorporation and bylaws.
- Stock certificates, purchase agreements, and 83(b) elections;
Ideally, Krueger suggests that companies obtain an opinion letter from a reputable firm (perhaps a Big 4 accounting firm) after reaching the asset threshold and distribute it to employees. Other helpful records include a QSBS eligibility checklist (signed by the CFO) and corporate tax returns coinciding with stock purchases. Employees should proactively gather documentation whenever possible.
Navigating Early Startup Acquisitions
Most successful startups are acquired rather than going public through a traditional IPO. What happens if you haven’t met the holding period requirements, or the acquisition involves stock of the acquiring company? Depending on the deal terms and the goals of major shareholders, there may be unique planning opportunities. While many factors and structuring options exist, here are two ways founders can potentially extend their 1202 runway during an acquisition:
Section 1045: QSBS Rollover and Reinvestment
Krueger, who specializes in equity compensation for founders and employees, suggests considering a tax-free rollover into replacement QSBS under Section 1045. He notes that serial entrepreneurs often use QSBS rollovers to defer taxes and extend the holding period to meet the requirements.
Under Section 1045, investors can transfer their original QSBS holding period to replacement stock by reinvesting in a company that currently meets the QSBS criteria within 60 days. To use a QSBS rollover, you must have held the original stock for more than six months.
While finding suitable replacement QSBS investments can be challenging, this approach offers flexibility in determining the amount to defer and the specific investment. Deferred gains reduce the cost basis in the replacement QSBS. If the rollover stock later meets Section 1202 requirements, it may be fully tax-free, subject to the limits. Otherwise, the taxpayer would pay tax at capital gains tax rates or consider another 1045 QSBS reinvestment.
QSBS Exchange
Another method for extending the holding period of original QSBS involves a Section 351 exchange or a Section 368 reorganization. These options can potentially retain the tax benefits of Section 1202 and provide for tax deferral (either full or partial) upon completion of the buyout. Krueger emphasizes that these strategies must be evaluated by the deal team, including corporate lawyers and accountants. It’s common for company acquisitions to require a certain amount of rollover equity, particularly for founders and key shareholders.
Essentially, when properly executed and all conditions are met, these avenues have the potential to preserve the full gain exclusion under Section 1202 if the buyer’s stock qualifies as QSBS. If it doesn’t, the exclusion can still apply when the shares are ultimately sold, but only on the gain that was deferred at the time of the exchange.
M&A transactions are highly complex and require guidance from both corporate and personal advisors. While exploring your options with your team, remember to consider the present value of the deal. Businesses can fail, and sometimes it’s best to accept the payout and pay the tax.
Financial Advisor Who Understands Founder Equity
As evidenced by the length of this summary on the qualified small business stock exclusion from capital gains, the subject matter is complex. You may never have QSBS, and if you do, you may not be fortunate enough to qualify more than once. Strongly consider engaging a personal team of tax and financial advisors to help guide you through the process.
Darrow Wealth Management is a Boston-based financial fiduciary and fee-only registered investment advisor. We specialize in financial planning for an IPO, acquisition, or sale of a private business. By now you know we don’t provide legal or tax advice, but we do help clients build a team of tax/legal specialists to tackle issues around company stock. Through ongoing financial advice and asset management, we aim to help our clients make the most of a sudden wealth event.
Let’s Talk About Your Equity.
If a liquidity event is on the horizon and you want an advisor in your corner for the long haul — let’s talk.
Frequently Asked Questions About QSBS
Individuals, trusts, and estates that acquire qualified small business stock at original issuance and meet the holding period can qualify. That typically includes founders, early employees who exercise stock options, angel and venture investors, and business owners whose company is a C corporation. Owners of pass-through entities (partnerships, LLCs taxed as partnerships, and S corporations) can share in QSBS gains when the entity held the stock, subject to additional rules. C corporations can’t claim the exclusion.
Start by asking the company. Many startups track QSBS status, and some provide a QSBS attestation or representation letter. Your stock may qualify if you received it directly from a U.S. C corporation (not on the secondary market), the company’s gross assets were $50 million or less when it was issued ($75 million after July 4, 2025), the company operates in a qualifying industry, and there were no disqualifying redemptions. Stock options aren’t QSBS until you exercise them, and the holding period starts at exercise.
Every year, you can exclude the greater of (a) $10 million ($15 million for shares acquired after July 4, 2025, adjusted by inflation starting in 2027) as a lifetime cap per issuer, or (b) 10 times your adjusted cost basis in the stock. This limit applies on a per-taxpayer basis, so it’s possible to achieve even greater tax savings by gifting shares or putting stock in irrevocable trusts.
For stock acquired after July 4, 2025, you can exclude the greater of $15 million or 10 times your basis, per company. The $15 million cap is indexed for inflation starting in 2027, when it rises to $15.48 million. Stock acquired on or before July 4, 2025 keeps the old $10 million cap, which isn’t indexed. Any exclusion you’ve already used for a company counts against the cap.
Your QSBS holding period starts on your exercise date, not your grant date. For stock acquired after July 4, 2025, partial exclusions begin at three years. Employees and founders at early-stage startups should consider exercising or early exercising unvested stock options while the company still meets the gross asset test.
At least 80% of the company’s assets, by value, must be used in the active conduct of a qualified trade or business during substantially all of the time you hold the stock. Too much cash, investment portfolio assets, or real estate not used in the business can cause a company to fail the test. Cash held for reasonable working capital needs or near-term research can count as active, within limits.
Section 1202 excludes businesses where the principal asset is the reputation or skill of employees, including health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage. Banking, insurance, financing, leasing, investing, farming, mining and oil and gas, and hotels and restaurants are also excluded. Most software, technology, biotech, and manufacturing companies can qualify, but there are gray areas like health tech and fintech.
QSBS only applies to shares of a domestic C corporation. LLCs, S corporations, partnerships, and other pass-through entities are not eligible. Although it’s possible to consider various strategies to convert the entity to a C corporation, this is complex and requires legal and tax guidance.
Yes. A trust can hold QSBS and claim the exclusion. An irrevocable non-grantor trust is generally treated as a separate taxpayer with its own $10M/$15M cap, which is why QSBS trusts are used to multiply the exclusion. A revocable or other grantor trust uses the grantor’s cap. Shares gifted to a trust generally keep the donor’s holding period, but drafting matters and multiple trusts for the same beneficiaries can be challenged, so work with an experienced estate planning attorney.
Footnotes
¹ Property contributed to the corporation is based on the fair market value when contributed. Certain related subsidiaries (controlled group) will count towards the $50M/$75M minimum. There are other considerations to discuss with your tax professional and/or tax attorney.
² There are some exceptions to this rule for QSBS acquired by gift, at death or as a distribution from a pass-through entity (partnerships, S corporations, regulated investment companies or common trust funds).
³ Consult a tax advisor as previously mentioned to discuss your situation. Calculating this is often tricky. Significant generally means an amount greater than 5% of the value of the stock. There are also certain purchases than may be disregarded including ‘de minimis’ redemptions.
Information in this article is for informational purposes only and should not be misinterpreted as personalized advice of any kind or a recommendation for any specific investment product, financial or tax strategy. This is a general communication should not be used as the basis for making any type of tax, financial, legal, or investment decision.
[Last reviewed November 2026]
