The magic is in Section 1202 of the IRS code. It is tested, legitimate and frequently employed. I’ve used it numerous times myself. It’s called Qualified Small Business Stock (QSBS) and it can provide a massive tax advantage to investors and employees of high-growth companies.

There are numerous requirements and conditions to qualify for QSBS treatment. That is what this post is about. But first, what are the tax benefits? 

If you hold your stock for at least five years, you can exclude up to $15 million of your capital gains from taxation when you sell your shares. 

For shares acquired on or before July 4, 2025, the exclusion amount is only $10 million and must be held for five years (still pretty sweet), but new legislation has increased that amount to $15 million and added partial eligibility at shorter holding periods:

• Hold for at least 3 years and exclude 50% of your gain
• Hold for at least 4 years and exclude 75% of your gain 
• Hold for at least 5 years and exclude 100% of your gain 

For cash investors, the exclusion amount is actually the greater of $15 million and 10 times the amount you invested (your cost basis). If you invested $2 million, you can exclude the first $20 million of gain. There is no upper limit.

Let’s take an example. Without QSBS, if you purchased shares in a young business today for $2 million and sold them five years from now for $25 million, at the 23.8% maximum federal tax rate on capital gains you would pay $5.5 million in taxes (the $23 million gain times 23.8%).

However, if you qualified for QSBS, you could exclude $20 million of that gain from federal taxation. As a result, you would pay only $0.7 million in taxes and could put an additional $4.8 million in your pocket.

• Your gain is $23 million ($25 million minus $2 million)
• Your exclusion is $20 million (the greater of $15 million and 10 x $2 million)
• Your taxable gain is $3 million ($23 million minus $20 million)
• Your tax is $0.7 million ($3 million times 23.8% federal tax)

Of course, if you sold for less than $22 million, you would pay 0% federal tax.  

The Rules. In addition to the holding period, what are the most notable requirements to qualify for QSBS?

• You must own the stock itself. Options don’t count until you exercise the options and your holding period begins.
• You must acquire the stock directly from your company and not purchase secondary shares from someone else.
• Your company must be a regular US corporation (a “C corporation”), not an S corporation, LLC, partnership, sole proprietorship or foreign corporation.
• Your company must use at least 80% of its assets in an active trade or business.
• Your company must have less than $75 million in gross assets when and immediately after you acquire your shares. (For shares acquired on or before July 4, 2025, the amount is only $50 million.)
• Your company must not be a personal services business or operate in the hospitality, mining, health, financial services or certain other fields. This determination is complicated and has exceptions, so please see the discussion below.

Please remember that this post is for educational purposes and is not personalized tax or investment advice. If you are considering making a significant decision, you should definitely consult with a tax advisor. 

Unsurprisingly, the reality is more complicated than the prior paragraphs would suggest. If you’re still interested, read on.

QSBS Rules for You

‍Holding Period. You must hold the QSBS shares for an uninterrupted period of at least three years after the date you acquire the stock. 

• Hold for at least 3 years and exclude 50% of your gain up to $7.5 million
• Hold for at least 4 years and exclude 75% of your gain up to $11.25 million
• Hold for at least 5 years and exclude 100% of your gain up to $15 million

If you purchased your QSBS shares for cash, the exclusion amount is the greater of $15 million and ten times your cost basis. The exclusion is calculated per-owner and per-issuer, so that if you have shares in two QSBS eligible companies you get a separate $15 million exclusion for each one.

If you acquire shares more than once, each purchase must be independently qualified. For instance, if you buy shares now and buy shares again a year from now, each holding period starts on its own date of purchase. Your company must also be independently qualified for each individual holding period.

For shares acquired on or before July 4, 2025, the holding period is the full five years and the gain exclusion varies by the date the shares were acquired. 

• 100% exclusion from September 28, 2010, through July 4, 2025
• 75% exclusion from February 18, 2009, to September 27, 2010
• 50% exclusion from August 10, 1993, to February 17, 2009 

‍

Options and RSUs. A common misunderstanding is that the holding period starts when an option or RSU is granted. This is not correct. 

• Option grant – this date is not relevant 
• Option vesting – this date is not relevant 
• Option exercise – you purchase the shares the holding period starts
• Final sale – you sell the shares and the holding period ends

Some options and restricted stock (an RSA rather than an RSU) allow early exercise of unvested shares using an “83b election” at the time of the initial grant or thereafter. In this case, your holding period starts on the date of the early exercise, even for shares that are not yet vested. 

Shares from RSUs, which are delivered and taxed at the time of vesting, are only eligible for QSBS treatment if you subsequently hold the shares for at least three to five years. 

• RSU grant – this date is irrelevant
• RSU vesting – you acquire the shares and the holding period starts
• Final sale – you sell the shares and the holding period stops

Many RSUs deliver the cash-equivalent value upon vesting rather than delivering the stock itself, in which case QSBS does not apply because there is no holding period..

‍Original Issuance. Whether purchased or acquired through an exercise of options, to qualify for QSBS treatment you must acquire new shares issued by your company and acquire them directly from your company. If you purchase or receive shares from someone other than your company (a “secondary sale”), these shares are not eligible for QSBS. 

‍Owner. You, the owner of the shares, can be an individual, S-corp, LLC, partnership or trust, but you cannot be a C-corp. During the holding period, your company must be a C-Corp and you must not.

If a single owner acquires multiple blocks of shares in the same company at different times, the caps on gain exclusion (currently the greater of $15 million or ten times the cost basis) apply to the aggregate of all the blocks acquired by that owner.

‍Redemptions. QSBS treatment is disallowed if any shares you own (beyond a de minimis amount) are redeemed or bought back by your company during the period starting two years before you acquire a group of shares and ending two years afterwards. Redemptions related to termination of employment, death, disability, or divorce do not count against this rule. Secondary sales between you and parties other than the company itself are not disqualifying. There are also redemption rules that apply to your company (see below).    

‍State Taxes. Most states and municipalities follow the federal Section 1202 rules and similarly exclude QSBS gain from taxable income or they have no state income tax at all. Massachusetts adopted the federal QSBS as of the 2020 tax year, New Jersey is scheduled to adopt QSBS as of the 2026 tax year, and Hawaii has partially adopted it. The states that do not offer any QSBS exclusion are California, Pennsylvania, Alabama and Mississippi. 

‍Maximum Capital Gains Tax Rates With and Without QSBS

‍

* New York: 10.9% applies for single taxpayers with taxable income over $5 million and 6.85% applies for taxable income over $214,401. California: 13.3% applies for single taxpayers with taxable income over $1 million and 10.3% applies for taxable income over $349,137.
‍

For QSBS and all capital gains taxes, you are subject to state and local taxes in the state where you reside at the time of the sale, not of the purchase. If you live in a state like California which has not adopted QSBS, you may be able to set up an irrevocable trust in a different state and receive the QSBS exclusion there.

‍Inheritance. In the event of your death, ownership of the QSBS shares pass through to your estate and then to your heirs without causing any change in their QSBS characteristics. For instance, if you were to die two years after purchasing QSBS eligible shares, your holding period would pass to whomever inherited the shares. It is worth noting that, upon your death, the cost basis of the shares would be stepped up to their then-current fair market value, allowing your heirs to sell the shares tax-free at that time, unrelated to QSBS eligibility or rules.

‍Gifting and Stacking. You can gift or transfer your shares tax-free to your children, another individual, a trust or a business entity that is not a C corporation without causing any change in their QSBS characteristics. In this case, the new owner “steps into the shoes” of the previous owner. 

You can “stack” your QSBS shares across multiple owners and receive multiple $15 million exclusions. For instance, if you gifted one third of your shares to your son and one third of your shares to your daughter prior to selling the shares, then you and your children would have an aggregate gain exclusion of $45 million. You could give the shares directly or put them in individual trusts for your children but, in either case, you would no longer own the shares.

‍Rollovers. Under a Section 1045 of the IRS code, after you sell your QSBS shares you can roll over any portion of the value into another QSBS eligible company. To qualify, you must have held the shares in the first QSBS company for at least six months and purchase the shares in the second QSBS company within 60 days of the sale. In this case, the shares in the second company retain the original holding period commencement date of the shares in the first company.

This is valuable (1) if your holding period in the first company was less than five years or (2) if you sell the shares in the second company less than five years after acquiring them.

‍Documentation. In case the IRS audits a QSBS transaction, it is valuable to maintain comprehensive records including Stock Purchase Agreements, Stock Option Plans, option exercise documents, 83b elections, sale documents, tax returns and bank statements. These documents are easily mislaid over the period of many years.

QSBS Rules for Your Company

‍Qualified Business Test. To be eligible for QSBS treatment, your company must have at least 80% of its assets used in a “qualified trade or business” during substantially all of the period during which you hold your stock. Section 1202 defines a qualified trade or business by exclusion. The following types of business may NOT be qualified.

• Personal services firms “where the principal asset of such trade or business is the reputation or skill of one or more of its employees”, such as in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services.
• Businesses in the fields of banking, insurance, financing, leasing, investing, farming, hospitality and real estate.

This is the most nuanced provision of Section 1202. If your business is directly or indirectly related to these fields, it is important to get specific advice from a tax professional. In particular, IRS Private Letter Rulings have distinguished between (a) companies that perform services, which are generally not qualified, and (b) companies that manufacture products or create software or intellectual property, which may be qualified.

For instance, a company in the health field that employs doctors to provide professional medical services would generally not be qualified. A company that designs medical programs, manufactures medical equipment or develops medical software may be qualified.

‍Corporate Entity Test. At the time you acquire your shares your company must be a C corporation and must remain a C corporation during substantially all of your holding period (generally at least 80%). 

If your company is an S corporation, it can generally convert to a C corporation and subsequently issue shares that are eligible for QSBS treatment, provided all other conditions are met. Under certain limited circumstances, shares issued prior to becoming a C corporation can be qualified, however the holding period still begins at the date the C corporation is established.

‍Active Business Test. The active business test requires that during substantially all of the taxpayer's holding period (generally at least 80%), the corporation must use at least 80% of the value of its assets in the active conduct of a qualified trades or businesses. This means:

• Cash and passive investments generally don't count toward the 80%
• Working capital can count if held for specific business needs and follows the safe harbor rules
• Assets used in operating the business (equipment, inventory, intellectual property being developed/used) typically qualify

‍Gross Assets Test. At the time you acquire your shares and immediately thereafter (in other words, after your funds and any other funds invested at the same time have been received by the company), the company must have less than $75 million in aggregate gross assets. For shares acquired on or before July 4, 2025, the gross asset must be less than $50 million.

The gross assets test is designed to limit QSBS to companies conforming to this definition of a small business. However, this test is only applied at the time of the acquisition of the shares. If your company subsequently exceeds the gross assets test during your holding period, those shares are still eligible for QSBS treatment.  

‍Redemptions. QSBS treatment is disallowed if your company redeems or buys back shares from any and all shareholders (beyond specified amounts) during the period starting one year before you acquire a group of shares and ending one year afterwards. Secondary sales between parties other than the company itself are not disqualifying. There are also redemption rules that apply to you (see above).    

‍Documentation. Your company should retain thorough documentation in the event that the IRS audits the company or any of its shareholders who claim QSBS treatment. This includes documents related to corporate formation and governance, stock and option issuance, and financial records and statements.

Because this documentation resides with the corporation and may not be available to you, you should confirm as much of the information as possible including a letter or attestation directly from the company or its officers.  

Why Congress Enacted QSBS

Congress enacted and has maintained the Section 1202 Qualified Small Business Stock provisions for several public-policy reasons. They incentivize risk-taking, capital formation, longer-term investing, innovation and job creation in smaller American businesses by offering tax relief to early-stage investors and founders. 

The history of QSBS has been marketed by bipartisan support in Congress and across presidential administrations starting with Bill Clinton in 1993. The provisions of Section 1202 have been expanded on multiple occasions since its introduction.

On the senate floor in 1992, Democratic Senator John Kerry said, “We want to reward the startup entrepreneur who will commercialize the next generation of technology in the United States, whether in artificial intelligence, microelectronics, biotechnology, advanced materials, or environmental engineering.”

The QSBS expansion in the One Big Beautiful Bill Act of July 2025 followed from the introduction of the Small Business Investment Act in February 2025. Regarding that Act, Republican Congressman David Kustoff said, “Small businesses play a critical role in our economy. As such, I am working to ensure they have the ability to grow and employ hardworking Americans ... [and] help give small business owners the financing and flexibility they need to expand, innovate, and create more jobs.”

In my own personal experience, QSBS has facilitated the funding and growth of a number of tech startups I founded over the past twenty-five years.