The Qualified Small Business Stock (QSBS) exemption under Section 1202 of the Internal Revenue Code offers a powerful tax break for startup founders, early employees, and investors. If you meet certain QSBS eligibility criteria—including the 5-year holding period and other exclusion requirements—you could potentially exclude up to 100% of capital gains from federal taxes.
In this guide, we’ll break down how to qualify for QSBS, who it applies to, and why understanding the requirements early can save you millions down the line.
What Is QSBS?
Qualified Small Business Stock (QSBS) refers to shares in a C-corporation that meet specific criteria outlined in Section 1202 of the Internal Revenue Code. When those shares are sold after being held for at least 5 years, a significant portion of the capital gains may be excluded from federal income tax.
This tax benefit is designed to encourage investment in early-stage companies.
Who Is Eligible for QSBS?
To qualify for the QSBS tax exemption, both the stock and the shareholder must meet certain requirements. Here's a breakdown:
QSBS Eligibility Criteria for the Stock:
Issued by a U.S. C-Corporation (not an LLC or S-Corp)
Gross assets <$50 million at the time of issuance
Active business requirement: At least 80% of the company's assets must be used in an active trade or business (non-service-based in most cases)
Original issuance: Shares must be acquired directly from the company, not from a secondary sale
QSBS Requirements for Founders and Investors:
Must be individuals (not entities) or certain trusts
Must have received the shares in exchange for money, property, or services
Must hold the stock for at least 5 years to qualify for full exclusion
The QSBS 5-Year Rule
The most important rule to qualify for the tax exemption is the 5-year holding period. Here’s what you need to know:
The 5-year clock starts on the date the stock is issued to you
Even if your company is acquired, you may be able to tack on holding periods if the acquirer provides stock in exchange
If you sell before 5 years, you may qualify for a QSBS rollover under Section 1045, deferring gains instead of excluding them
Pro tip:Keep clear records of your stock issuance date. It’s crucial for proving QSBS eligibility later.
Section 1202 Exclusion Limits
Depending on when the stock was acquired, you may be eligible for 50%, 75%, or 100% capital gains exclusion, up to $10 million or 10x your basis, whichever is greater.
| Date Acquired | Exclusion Percentage |
|---|---|
| Before 2/18/2009 | 50% |
| 2/18/2009 to 9/27/2010 | 75% |
| After 9/27/2010 | 100% |
Common QSBS Disqualifiers (Exclusion Requirements)
Certain businesses and actions can disqualify your stock from being considered QSBS:
The company operates in a service-based field (e.g., law, accounting, health, finance)
The company buys back stock from you within 2 years of issuance
You acquired the stock via secondary purchase, not original issuance
You converted from an LLC or S-Corp and didn’t meet QSBS rules post-conversion
How to Qualify for QSBS: Step-by-Step
Confirm C-Corp Status: Make sure the company is structured as a U.S. C-corporation
Check Gross Assets: Verify that total assets were under $50M at the time of issuance
Understand Industry Limits: Ensure the company doesn’t fall under excluded service industries
Get It in Writing: Keep documentation showing you acquired shares at original issuance
Track Holding Period: Monitor when your 5-year QSBS clock starts and any rollover activity
Real-World Example: QSBS for Founders
A founder receives 1M shares in a Delaware C-Corp valued at <$5M at incorporation. After building the company for 6 years, it sells for $20M. The founder excludes up to $10M of capital gains from federal tax due to QSBS.
FAQ
What is QSBS?
QSBS stands for Qualified Small Business Stock. It allows certain shareholders to exclude capital gains from federal income tax if specific IRS rules are met.
What are the QSBS eligibility criteria?
To qualify, the stock must be issued by a C-Corp with under $50M in assets, be acquired at original issuance, and held for 5 years.
How do founders qualify for QSBS?
Founders must receive original-issue C-Corp stock, ensure their company meets asset and industry rules, and hold the stock for at least 5 years.
What is the Section 1202 qualified small business stock rule?
Section 1202 of the IRS code allows up to 100% capital gains exclusion on QSBS if conditions are met.
Are there QSBS exclusion requirements?
Yes. Stocks from service-based businesses, secondary purchases, or with asset levels above $50M at issuance are not eligible.
Final Thoughts: Plan Early
The QSBS tax benefit is one of the most powerful incentives for startup equity holders, but qualification is not automatic. Founders and investors should understand QSBS requirements early and structure their equity accordingly.
Looking for an accountant to help you navigate QSBS?
👉Browse startup accountants who help with QSBS planning on Sam’s List
Author: Kimi, Co-founder of Sam’s List
Kimi writes about what she’s learning while building Sam’s List and shares honest takeaways from her conversations with accountants and financial advisors across the country. None of this is financial advice—just the stuff most people wish someone told them sooner.
