Qualified Small Business Stock Benefits

What Section 1202 QSBS Exclusion Provides

The Qualified Small Business Stock exclusion under IRC Section 1202 allows shareholders to exclude 100% of capital gains from federal income tax when selling stock in qualifying C corporations. The exclusion applies to the greater of $10 million or 10 times your adjusted basis in the stock.

For a founder who invested $100,000 in a startup that sells for $50 million, the QSBS exclusion eliminates federal tax on the first $10 million of gain. At the 23.8% combined federal rate (20% long-term capital gains + 3.8% net investment income tax), this represents $2,380,000 in tax savings.

The exclusion has existed since 1993, but Congress increased it to 100% for stock acquired after September 27, 2010. Stock acquired earlier receives partial exclusions (50% for pre-2009, 75% for 2009-2010).

Source: IRC Section 1202, as amended by the Creating Small Business Jobs Act of 2010.

Five Core Eligibility Requirements

Meeting all five requirements is mandatory. Missing any single requirement disqualifies the entire gain from exclusion.

Requirement 1: C Corporation Status at Issuance

The issuing company must be organized as a C corporation when it issues the stock and for substantially all of the shareholder's holding period. S corporations, LLCs, and partnerships do not qualify.

Key dates matter: A company that starts as an LLC, later converts to a C corporation, and then issues you stock qualifies for stock issued after conversion. However, any stock issued or deemed issued during the LLC phase does not qualify.

Requirement 2: Gross Assets Under $50 Million

At the time of stock issuance and immediately after your investment, the corporation's aggregate gross assets must not exceed $50 million. Gross assets means the cash plus adjusted basis of all assets (not fair market value).

The $50 million test applies at issuance: A company can grow to $500 million after you invest without disqualifying your shares, provided it was under $50 million when you acquired stock.

Example: You invest $500,000 when the company has $30 million in gross assets. The company grows to $200 million in assets over 5 years. Your stock still qualifies because it met the threshold at issuance.

Requirement 3: Original Issuance Acquisition

You must acquire the stock at original issuance directly from the corporation in exchange for:

• Cash
• Property (other than stock)
• Services rendered to the corporation

Stock purchased on secondary markets or from existing shareholders generally does not qualify. Exceptions exist for stock received through gift, inheritance, or certain tax-free exchanges.

What counts as original issuance:

• Founder stock issued at incorporation
• Stock issued upon exercise of compensatory stock options
• Stock issued in exchange for cash investment
• Stock issued for property contributed to the corporation
• Stock issued for services (consulting, employment)

What does NOT count:

• Stock purchased from another shareholder
• Stock acquired via most mergers or acquisitions

Requirement 4: Active Business Requirement

The corporation must use at least 80% of its assets in the active conduct of one or more qualified trades or businesses during substantially all of the shareholder's holding period.

Excluded industries (these do NOT qualify):

• Professional services (law, accounting, engineering, consulting, financial services, brokerage)
• Banking, insurance, leasing, investing, or similar businesses
• Farming
• Mining, oil, gas, or extractive industries
• Hotels, motels, or restaurants
• Businesses where principal asset is reputation/skill of employees

Industries that typically qualify:

• Technology and software companies
• Manufacturing
• Retail (excluding restaurants)
• Wholesale distribution
• Construction
• Transportation

Source: IRC Section 1202(e)(3) lists excluded businesses.

Requirement 5: Five-Year Holding Period

You must hold the stock for more than 5 years from the date of original issuance to qualify for the exclusion.

Partial exclusion is NOT available: If you sell at 4 years and 11 months, you receive zero QSBS exclusion. The requirement is binary.

Planning implication: Track your acquisition date precisely. Stock options count from the exercise date, not the grant date.

The Exclusion Calculation

The exclusion limit is the greater of:

1. $10 million, OR
2. 10 times your adjusted basis in the stock

Example 1: Low basis, moderate exit

• Basis: $50,000 (founder stock purchased at incorporation)
• Sale price: $8 million
• Gain: $7,950,000
• 10x basis limit: $500,000
• $10 million limit: $10,000,000
• Applicable limit: $10 million (higher)
• Excluded gain: $7,950,000 (100% of gain)
• Federal tax: $0

Example 2: Higher basis, large exit

• Basis: $2 million (early-stage investment)
• Sale price: $35 million
• Gain: $33 million
• 10x basis limit: $20 million
• $10 million limit: $10 million
• Applicable limit: $20 million (higher)
• Excluded gain: $20 million
• Taxable gain: $13 million
• Federal tax on taxable portion: $13 million x 23.8% = $3,094,000
• Tax savings from exclusion: $20 million x 23.8% = $4,760,000

Example 3: Per-issuer limitation

The $10 million or 10x basis limit applies per issuer. If you hold QSBS in multiple qualifying companies, each company provides a separate exclusion.

• Company A: $12 million gain, $500,000 basis
  • Excluded: $10 million; Taxable: $2 million
• Company B: $6 million gain, $100,000 basis
  • Excluded: $6 million (100%); Taxable: $0
• Combined exclusion: $16 million

State Tax Treatment

State tax treatment varies significantly. QSBS may provide federal exclusion while remaining fully taxable at state level.

California warning: For California residents, a $10 million QSBS gain excluded federally still generates approximately $1,330,000 in California state tax.

Common Pitfalls and Planning Errors

Pitfall 1: Assuming LLC/S-Corp qualifies

Only C corporations qualify. LLC gains, even from technology startups, receive no QSBS exclusion unless the LLC converts to C corporation before stock issuance.

Pitfall 2: Acquiring stock via secondary transaction

Buying shares from an angel investor or on secondary markets like EquityZen or Forge disqualifies the stock from QSBS treatment. Only original issuance qualifies.

Pitfall 3: Holding stock options instead of exercised shares

The 5-year holding period begins at exercise, not grant. Waiting until near an exit to exercise options may result in insufficient holding period.

Planning consideration: Early exercise of options (83(b) election) starts the QSBS clock sooner.

Pitfall 4: Redemptions and recapitalizations

Significant stock redemptions within 2 years before or after your stock issuance can disqualify QSBS treatment under anti-abuse rules.

Pitfall 5: Professional services businesses

Software companies with consulting revenue may be classified as professional services if consulting comprises too large a percentage of revenue. Maintain documentation that the primary business is product/technology, not services.

Implementation Checklist

At Investment/Stock Issuance

• Confirm issuing entity is a C corporation (not LLC or S-corp)
• Verify company gross assets are under $50 million at issuance
• Ensure you are acquiring via original issuance (not secondary purchase)
• Obtain and retain documentation of asset test compliance
• Document your cost basis precisely

During Holding Period

• Track the 5-year holding period start date (exercise date for options)
• Monitor company business activities (must be 80%+ active qualified business)
• Watch for conversions or restructurings that could affect QSBS status
• If exercising options, file 83(b) election within 30 days if applicable

Before Sale

• Confirm 5-year holding period is complete (count precisely)
• Verify company maintained QSBS eligibility throughout holding period
• Calculate exclusion limit ($10M or 10x basis, whichever is greater)
• Check state tax treatment (many states do not conform)
• Consider timing of sale relative to state residency if relocating

At Sale

• Report exclusion on Schedule D and Form 8949
• Maintain documentation supporting QSBS qualification
• Prepare for potential IRS audit (QSBS claims are scrutinized)

The QSBS exclusion represents one of the most valuable tax benefits in the Internal Revenue Code for startup investors and founders. The 100% federal exclusion on up to $10 million (or more for larger basis positions) creates substantial wealth accumulation advantages for patient investors in qualifying C corporations operating in non-excluded industries.