Investing in startups and other small businesses can be highly rewarding, but it also can carry significant risk. Historically, gains from these investments weren’t always tax-efficient, so to incentivize investment in emerging companies, the U.S. tax code offers a special provision: Qualified small business stock (QSBS), governed by Section 1202 of the Internal Revenue Code (IRC).

Introduced in 1993, and recently updated to enhance its benefits, QSBS allows non-corporate investors who hold the stock long enough to potentially exclude up to 100% of capital gains from federal taxes when the stock is sold. This exclusion can create a significant tax advantage, sometimes reducing a multi-million dollar gain to a $0 tax liability. 

Discover the key QSBS rules, eligibility requirements, and benefits for a clear overview of this tax-friendly opportunity to build wealth. 

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What is QSBS?

QSBS refers to shares issued by a domestic C corporation that meet the requirements of Section 1202 of the IRC. Congress created QSBS to incentivize investments in startups and small businesses, offering tax incentives to offset the high risk of early-stage investing. 

QSBS status only applies to original issuances after August 10, 1993. The issuing company’s gross assets cannot exceed $50 million for stock acquired prior to July 2025 or $75 million for stock acquired after that date. 

The primary benefit of QSBS is the federal capital gains tax exclusion, known as the QSBS exemption. Here’s an overview:

• 100% exclusion for most stock acquired after September 27, 2010, if held for at least five years.
• 75% exclusion for stock acquired between February 18, 2009, and September 27, 2010. 
• 50% exclusion for stock acquired between August 10, 1993, and February 17, 2009. 

The exclusion limit is generally the greater of $10 million or 10 times the taxpayer’s basis in the stock, with recent legislation increasing this cap to $15 million for QSBS acquired after July 4, 2025.

Types of QSBS

To qualify as QSBS, shares must be acquired directly from a domestic C corporation at original issuance. How you acquire QSBS can affect your five-year holding period and eligibility. Common scenarios include the following.

Founder and original-issue common stock

This is the most straightforward form of QSBS. Founders or early-stage investors acquire shares directly from the company in exchange for cash or property. The holding period starts on the date of acquisition. 

Preferred stock and other classes of stock

QSBS is not limited to common stock. Preferred shares, voting or non-voting stock, can also qualify. If you convert preferred stock to common stock, the IRS generally still considers the shares QSBS and the original holding period carries over. 

Convertible debt, warrants, and stock issued upon conversion

If your ownership arises from the conversion of another asset, the five-year holding period starts only upon conversion to common stock. For example, stock options typically convert into common stock, but if the company exceeds the $50 million or $75 million gross asset threshold at conversion, those shares won’t qualify as QSBS. 

Stock received in reorganizations, mergers, or tax-free exchanges

Typically, you can’t buy QSBS from another shareholder. However, if you receive QSBS as a gift inheritance, or in a tax-free corporate merger or reorganization, it generally maintains QSBS status and the original owner’s holding period carries over.

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QSBS pros and cons

Whether planning for retirement or simply aiming to build wealth, tax efficiency may be a priority. QSBS offers unique tax advantages, but it also comes with limitations. Understanding QSBS benefits and drawbacks can help investors make an informed decision. Here’s a breakdown.

QSBS pros

QSBS provides some of the most favorable tax treatments available to individual investors. Key benefits include:

• Potentially exclude up to 100% of federal capital gains: For stock held at least five years, federal capital gains on qualifying QSBS can be fully excluded – up to a cap. For example, a $10 million QSBS sale could result in $10 million tax-free, compared with roughly $2.38 million in federal taxes on non-QSBS stock (depending on your situation).
• Exemption from certain taxes on qualified gains: QSBS gains are generally also excluded from alternative minimum tax (AMT) and net investment income tax (NIIT), providing additional savings potential. 
• Ability to defer gains via 1045 rollover: If you sell QSBS after six months but before five years, you can roll gains into the new QSBS within 60 days. This defers taxes, restarts the holding period, and maintains the tax benefits when done correctly. 
• High gain cap per issuer ($10 million–$15 million): The QSBS capital gains exclusion applies to each qualifying C corporation investment, so multiple investments can maximize tax-free gains.

QSBS cons

QSBS comes with risks and restrictions investors should consider. These include:

• Strict corporate and shareholder requirements at issuance: QSBS eligibility is determined at issuance. If the issuing company exceeds $50 million or $75 million in gross assets (depending on acquisition date), even temporarily, the stock may lose QSBS status. 
• Holding period ties up capital: To claim the capital gains exclusion, you must hold shares for at least five years. Selling early means paying regular capital gains taxes. 
• Ineligible business types and disqualification triggers: Certain industries are excluded, including financial services, real estate, and hospitality, where the firm’s main asset is employee skill or reputation. QSBS status can also be lost if the company holds 20% or more of its assets in unrelated passive investments. 
• High risk investments: Although a lot of tax benefits may be offered, there is no guarantee that the company shares will grow in price. Coupled with strict & complex IRS rules, small businesses are inherently riskier and more prone to business failure. In addition, QSBS status can be lost due to a number of reasons such as failure to meet specific IRS requirements and tax laws can change.

QSBS requirements

While the tax benefits are significant, the IRS enforces strict requirements for QSBS status that must be met from issuance and throughout the five-year holding period. Both the issuing corporation and the shareholder must satisfy the following criteria. 

Issuer

The issuer must be a domestic C corporation. Foreign corporations, S corporations, and LLCs (unless electing to be taxed like a corporation) cannot issue QSBS. The company must maintain C corporation status throughout the holding period. 

Asset cap

The gross assets of the issuing corporation cannot exceed $50 million for stock acquired before July 2025 and $75 million for stock acquired after July 2025, both before and immediately after issuance. Gross assets include cash and the adjusted tax basis of other assets. 

Active business test

For most of the shareholder’s holding period, the corporation must use at least 80% of its assets in its primary business operations. Companies issuing QSBS cannot operate in excluded industries, including financial services, real estate, and hospitality. 

Original issue

The investor must acquire the QSBS directly from the qualified C corporation, not via a secondary market, in exchange for cash, property or as compensation for services provided to the corporation. 

Holding period

To qualify for the full 100% capital gains tax exclusion, you must hold your QSBS investment for a minimum of five years. For stock acquired prior to July 2025, the full five-year period is required. For stock acquired after July 2025, the IRS will allow:

• 50% exclusion after three years
• 75% exclusion after four years
• 100% exclusion after five years

QSBS tax treatment

Section 1202 of the IRC provides tiered capital gains exclusions depending on when the QSBS was acquired: 

• 50% exclusion for QSBS acquired between August 11, 1993, and February 17, 2009. The IRS will generally tax the remaining 50% of capital gains at the maximum 28% rate and the AMT may apply. 
• 75% exclusion for QSBS acquired between February 18, 2009, and September 27, 2010. The remaining 25% will be subject to the 28% capital gains tax rate and the AMT. 
• 100% exclusion for QSBS acquired on or after September 28, 2010. Gains are fully excluded from the federal capital gains tax and are generally exempt from the AMT and NIIT.

The IRS limits the total gain eligible for QSBS exclusion from a single C corporation to the greater of:

• $10 million (per issuer), which increases to $15 million for QSBS acquired after July 4, 2025. This amount is reduced by prior excluded gains from the sale of QSBS from the same issuer.
• 10 times the tax-adjusted cost basis of the QSBS sold during the tax year. 

Tax-efficient retirement planning with Gainbridge 

While QSBS provides significant tax advantages for early-stage investors, it represents just one component of a broader financial strategy. To learn about other options for your retirement planning, explore Gainbridge. We offer valuable tools and comprehensive educational resources designed to help you plan for sustainable growth and long-term financial security. 

With an innovative platform and no hidden fees or commissions, Gainbridge can guide you through the annuity process and help grow your savings. 

Explore Gainbridge today and lay the foundations for a strong financial future. 

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This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The GainbridgeⓇ digital platform provides informational and educational resources intended only for self-directed purposes. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results.