Qualified small business stock (QSBS) is stock that can qualify for a federal tax exclusion when you sell it at a gain. To qualify, the company, issuance, and holding period must meet Section 1202’s rules. Eligible shares can receive a 100% exclusion, subject to a cap; newer shares can qualify for partial exclusions sooner. Owning startup stock alone is not enough.
The tax savings potential of Section 1202
The benefit applies to the gain, not the sale proceeds. If qualifying shares cost $100,000 and sell for $1.1 million, the potential exclusion concerns the $1 million gain.
The cap generally uses the greater of an applicable dollar limit or 10 times the adjusted basis of qualifying shares sold during the year. It is calculated per taxpayer, per issuer, with adjustments for prior exclusions and special rules for married taxpayers. Selling in several installments does not reset the dollar limit each year. The current Section 1202 statute sets out those limits.
How to qualify for the QSBS exemption
Start with three tests. Each needs records; a company’s informal assurance that it is a startup is not proof.
- Company test. The issuer must be a domestic C-corporation and meet the active-business rules during substantially all of your holding period. Its aggregate gross assets must be within the applicable $50 million or $75 million limit before and immediately after issuance. At least 80% of its assets, by value, generally must support a qualifying active business. Many service businesses, including health, law, and financial services, are excluded.
- Issuance test. Original issuance for money, eligible property, or services is generally required. An ordinary secondary-market purchase does not qualify. Certain transfers, such as gifts and inheritances, have special carryover rules.
- Holding test. For shares acquired on or before July 4, 2025, the exclusion generally requires more than five years. Shares acquired after that date can receive partial exclusions at three and four years, and a full exclusion at five years.
The asset test is not the company’s headline fundraising valuation. It generally uses cash and the adjusted tax basis of other assets, with special rules for contributed property. And an option grant does not start the stock’s holding period: you must first acquire shares. Transfers, reorganizations, and redemptions can introduce additional rules.
Modern tax-law updates to QSBS
The One Big Beautiful Bill Act (OBBBA) created a more flexible framework for QSBS shares acquired after July 4, 2025:
- Tiered holding exclusions. Newer stock qualifies for a 50% exclusion after 3 years and 75% after 4 years, before reaching the full 100% at 5 years.
- Higher gains cap. For qualifying stock acquired after July 4, 2025, the dollar limit increased to $15 million, with inflation adjustments beginning after 2026. The alternative limit based on 10 times basis and prior exclusions also matter.
- Higher asset threshold. For stock issued after July 4, 2025, the gross-asset ceiling rose from $50 million to $75 million. This test follows the issuance date, while the exclusion tiers follow the applicable acquisition-date rules.
Older shares keep their applicable rules. Shares acquired after September 27, 2010 and on or before July 4, 2025 can generally receive the 100% exclusion after more than five years. Earlier acquisitions can have lower exclusion percentages. The older dollar limit generally starts at $10 million; the alternative 10-times-basis limit and prior exclusions still matter.
A 50% exclusion does not mean a 50% reduction in your total tax bill. The remaining gain has its own tax treatment, and state tax may still apply. Compare a proposed sale at three, four, or five years using the actual acquisition records and expected proceeds.
An example of the exemption in action
Consider a founder who acquired original-issuance QSBS for $100,000 in 2020 and sold more than five years later for $10.1 million, a $10 million capital gain:
- Without QSBS: assuming the entire gain otherwise faces 20% capital-gains tax plus 3.8% NIIT, the illustrative federal tax is $2,380,000.
- With QSBS: assuming all eligibility tests are met, no prior issuer exclusion reduces the available cap, and the 100% exclusion applies, the full $10 million gain is excluded from federal income tax, bringing the federal bill on the gain down to $0.
State tax laws vary. A federal exclusion does not establish a state exclusion; check the rules in each state taxing the sale before budgeting the proceeds.
Integrating QSBS with your broader equity strategy
Before an exercise or sale, collect the issuance date, purchase price, grant and exercise records, transfer history, and evidence of the issuer’s eligibility. Ask the company for support for the asset and active-business tests. Keep records for each lot separately; two grants at the same company may fall under different rules.
Acquiring shares can start a valuable holding period, but exercising early commits cash to a risky asset. Restricted shares may also require a timely 83(b) election. Weigh the tax benefit against the amount you could lose and how long your cash may be tied up.
If you need to sell before reaching the holding period, a Section 1045 rollover may defer gain on qualifying stock held for more than six months if replacement-stock and 60-day reinvestment requirements are met. See IRS Publication 550.