Qualified Small Business Stock (IRC Section 1202)
The most powerful tax exclusion in the code, if you qualify and hold long enough.
- Federal exclusion
- Up to 100% of capital gains
- Pre-July 2025 cap
- Greater of $10M or 10x basis per issuer
- Post-July 2025 cap
- Greater of $15M or 10x basis per issuer
- Holding period (legacy)
- 5-year cliff (all or nothing)
- Holding period (OBBBA)
- 50% at 3yr, 75% at 4yr, 100% at 5yr
- California
- Does not conform. Full gain taxed at state level.
What QSBS is
QSBS is a federal tax incentive under IRC Section 1202 designed to encourage long-term investment in small businesses. If your shares qualify, you can exclude a massive portion of your capital gains from federal income tax when you sell. For stock issued after July 4, 2025, the exclusion can reach $15 million per issuer. This is one of the most valuable tax benefits available to startup employees and early investors.
The eligibility checklist
Every requirement must be met. The issuing company must be a domestic C corporation at the time the stock is issued. The company's gross assets must not exceed $50 million (pre-July 2025 stock) or $75 million (post-July 2025 stock) at the time of issuance. At least 80% of the company's assets must be used in a qualified active trade or business, which explicitly excludes banking, farming, hospitality, and professional services firms. The stock must be acquired at original issuance, meaning you must receive shares directly from the company (through option exercise, for example), not by purchasing them on a secondary market. And you must hold the stock for the required period.
The OBBBA changes (July 2025)
The One Big Beautiful Bill Act significantly expanded QSBS benefits for stock issued after July 4, 2025. The gross asset threshold increased from $50M to $75M, allowing companies further along in their growth to issue qualifying stock. The per-issuer exclusion cap increased from $10M to $15M, indexed for inflation starting in 2027. Most notably, the all-or-nothing 5-year cliff was replaced with a tiered system: 50% exclusion after 3 years, 75% after 4 years, and 100% after 5 years. For the partial exclusions at 3 and 4 years, the non-excluded gain is taxed at a penal 28% federal rate, not standard long-term capital gains rates.
California does not conform
California does not recognize IRC Section 1202 or Section 1045 (QSBS rollover). The California Franchise Tax Board explicitly instructs taxpayers to include the full gain for state purposes. A California resident who sells QSBS with a $500,000 gain may owe $0 in federal tax and $66,500 in California state tax (at 13.3%). This is commonly called the 'California Dilemma.' State residency planning before a sale is a real consideration, but the FTB aggressively audits residency changes timed around liquidity events.
The AMT credit trap
If you exercise ISOs to acquire QSBS-eligible stock, you may pay AMT on the spread at exercise. If you later sell and qualify for a 100% QSBS exclusion, your federal capital gains tax drops to zero. But the AMT credit carryforward under IRC Section 53 only works when your regular tax exceeds your tentative minimum tax. With the QSBS exclusion zeroing out your regular tax, you can never generate the surplus needed to recover the credit. The AMT you paid at exercise becomes a permanent sunk cost. This dynamic is why many advisors recommend early exercise with an 83(b) election to lock in a near-zero spread, starting the QSBS clock while minimizing the AMT exposure.
Common mistakes
Assuming the holding period starts at grant rather than at exercise. The IRS measures from the date the stock is issued, which is when you exercise your options and purchase shares. Waiting too long to exercise, causing the company's gross assets to exceed the $50M or $75M threshold by the time you buy shares. Failing to document QSBS eligibility throughout the holding period (board consents, cap table evidence, gross asset certifications). Planning around QSBS without accounting for California's non-conformity. Treating 'startup stock' as automatically qualifying when the company may fail the active business test or the C-corp requirement.
Common questions
Do stock options automatically qualify as QSBS?
No. The option itself is not QSBS. The shares you receive when you exercise the option can be QSBS if all eligibility requirements are met at the time of exercise (original issuance, gross assets test, C-corp status, active business test). The QSBS holding period starts at exercise, not at grant.
Can I stack QSBS exclusions?
The per-issuer cap applies per taxpayer per issuer. If you hold QSBS in multiple qualifying companies, each issuer gets its own separate exclusion cap. Advanced practitioners also use gifting to non-grantor trusts before a liquidity event, because each trust is a distinct taxpayer with its own exclusion cap. This 'stacking' strategy can multiply the total tax-free amount significantly.
What if my company converts from LLC to C-corp?
Stock issued after the conversion to a C-corp can qualify, but stock or membership interests held before the conversion do not. The gross assets test is measured at the time of issuance in the C-corp form. Timing the conversion relative to fundraising and employee exercises is a key planning consideration.
Does QSBS apply to RSUs?
It can, if the RSUs settle in actual shares of a qualifying C-corp and all other QSBS requirements are met at the time of settlement. However, because RSU settlement is taxed as ordinary income and the QSBS holding period starts at settlement, the 5-year clock starts later than it would for an early option exercise.
Sources
Use the scenario modeler to see how Qualified Small Business Stock (IRC Section 1202) mechanics play out with your specific grant. The full app goes deeper: per-grant modeling, fund signals, and competing lender terms matched to your situation.