Who wouldn’t love to sell their business, or a successful angel investment or portfolio company, partially or totally income tax-free? If selling tax-free sounds good, it is time to learn about qualified small business stock (QSBS), especially since recent legislation makes the benefits of QSBS better than ever.
What is qualified small business stock (QSBS)?
Congress enacted the qualified small business stock (QSBS) exemption in 1993 to encourage investment in certain small businesses, and in 2025, Congress greatly expanded the QSBS benefits with the One Big Beautiful Bill Act (OBBBA). Since 1993, QSBS has saved founders and investors billions of tax dollars. With advance planning, plenty of successful founders and investors have had large exits totally income tax-free.
The QSBS provisions in the tax code create essentially five requirements for powerful tax savings. In short, QSBS applies to shares originally issued from a U.S. C corporation that has less than $50 million ($75 million if the shares were acquired after July 4, 2025) of assets at the time of the investment. Shares from limited liability companies (LLCs), S corporations, and partnerships do not qualify – although read on, as some of these entities can be converted to qualify. QSBS-eligible companies include firms in sectors like technology and manufacturing, but not those in sectors like hospitality, professional services, finance, and agriculture. Capital gains from the sale of QSBS are partly or wholly exempt from federal taxes and from most state income taxes as well. This capital gains exclusion does have some limits, but before we share these limits, let’s flesh out the five requirements for eligibility for the QSBS exemption.
The 2025 OBBBA legislation creates some new rules that make qualifying for QSBS easier and better, but these new rules only apply to shares that were acquired after July 4, 2025. We’ll refer to the new rules by specifying what applies to “new shares” but also detail what rules apply to shares acquired on or before July 4, 2025, by referring to the rules for “older shares.” The five requirements include:
Shares must be held for at least five years for older shares or three years for newer shares
For older shares, the owner must hold the shares for at least five years from the date they are acquired to the date they are sold to receive QSBS treatment. For newer shares, QSBS tax savings phase in at 50% after holding three years, 75% at four years, and fully at five years.
In some common situations, the holding period of stock from two companies or two owners could be combined. Specifically, if shares are converted or exchanged into other stock in a tax-free transaction, the owner’s holding period of stock received includes the holding period during which the owner held the converted or exchanged stock. For shares received by gift or inheritance, the holding period of the recipient includes the holding period of the donor or decedent.
Shares must be acquired directly from the company, not on the secondary market
To get qualified small business stock benefits, the shares must have been acquired after 1993 directly from a domestic C corporation or its underwriter in exchange for money, property, or services. In other words, shares purchased on the secondary market are not QSBS.
There are rules in place to prevent corporations from simply redeeming shares and reissuing stock at original issuance to qualify it as QSBS. As such, if certain redemptions occur within a specific time period before the selling shareholder received their shares, QSBS treatment may be unavailable.
Suppose the selling shareholder acquired the stock by gift or inheritance from someone who purchased their shares directly from the company. As long as the original shareholder who made the gift or left the inheritance received the QSBS directly from the company, the shares are deemed to have been acquired at original issuance.
The business’s gross assets cannot exceed $50 million for older shares or $75 million for newer shares
Herein lies the first “S” in QSBS – small. As stated, Congress’ goal in enacting the QSBS exclusion was to encourage investment in small businesses, and applicable tax rules essentially define small for older shares as having no more than $50 million of assets on the balance sheet from the company’s inception until immediately after the shareholder receives the QSBS.1 For newer shares, the company may have up to $75 million2 of assets on the balance sheet at the time the shares were issued and still qualify. The amount of assets the business has after the shareholder invests is irrelevant. The valuation of the company (inclusive of certain important intangibles like its special brand, etc.) is also irrelevant. Limiting the definition of “small” to just a view of the company’s assets on the balance sheet means that many asset-light businesses like technology companies can qualify for QSBS even if they are highly valued.
The company must be involved in a qualified active trade or business
QSBS treatment is only available if the business uses a majority of its assets in connection with an active trade or business. Specifically, at least 80% of business assets must be used in the active conduct of business in any field, except for the following:
- The performance of services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, or financial/brokerage services
- Banking, insurance, financing, leasing, investing, or similar businesses
- Farming
- Production or extraction of oil, gas, or other natural deposits
- Hotels, motels, restaurants, or similar businesses
- Any business where the principal asset is the reputation or skill of one or more employees
Stock within these excluded industries cannot qualify as QSBS. Research, experimental, and startup activities related to a future qualified trade or business generally qualify.3
It can be tricky if a business straddles a qualifying activity and a nonqualifying activity, such as technology and financial services (fintech) or manufacturing and healthcare. In these situations, to determine whether the business qualifies as QSBS or not, Internal Revenue Service (IRS) guidance indicates that the following factors should be considered:
- Where does the company derive most of its revenues – from the qualifying or nonqualifying activity? For example, are customers paying for a personal service (like healthcare, which would not qualify) or a manufactured product (like a medical device or tangible product, which would)?
- Are most of the company’s employees involved in the qualifying activity or the nonqualifying activity?
- Is the company’s uniqueness or success dependent on a qualifying or nonqualifying activity? For example, if the company’s unique differentiating factor is its amazing technology platform, that would help lead to the conclusion that the company is predominantly a technology company that could qualify for QSBS.
Other factors to consider include:
- Are the qualifying and nonqualifying activities conducted in separate legal entities? If yes, do the entities file a single consolidated tax return?
- Are 80% or more of the company’s assets used for the qualifying or nonqualifying activity?
Shareholders and founders of businesses in sectors like fintech or healthcare manufacturing that straddle a qualifying activity and a nonqualifying activity might consider seeking a tax or legal opinion that their shares qualify for QSBS from an expert such as an attorney or other tax advisor. Professional guidance may protect from penalties on any tax liability in the event the IRS disagrees with the position that the business’s activity qualifies for QSBS treatment. There have been several IRS rulings recently whereby the IRS indicates that a fintech or insurtech company does indeed qualify for QSBS.
The shareholder must elect QSBS treatment on tax return
Although some QSBS qualifications are a bit more complex, the mechanics of making the QSBS election are relatively simple. A shareholder can make a QSBS election on Schedule D of their tax return in the year they report the sale of the shares. No election needs to be made or filed when the shares are acquired or at any time other than when reporting the ultimate sale of the QSBS.
Sufficient proof that the shares qualify as QSBS should be obtained from the business and retained for a minimum of three years following the filing of the relevant tax return in case the IRS audits or questions whether the stock qualified as QSBS. It is much harder to create a paper trail when/if the IRS questions the return – which would likely occur years after the company has been sold – than to be proactive and document QSBS qualification when the shares are acquired and during the entire holding period.
Limits and restrictions on QSBS
While QSBS is truly one of the greatest provisions of the tax code, it does have its limits. Under current law, the maximum amount a shareholder can exclude from taxable gain on the sale of QSBS is the greater of 10 times their basis in the shares or $10 million for older shares or $15 million for newer shares.
Many startup entrepreneurs, especially those in the tech sector, have invested a tremendous amount of time and talent into their businesses but have only invested limited financial or capital assets and have very little basis in their shares. In these common situations, the founder or shareholder could sell up to $10 million or $15 million of QSBS completely income tax-free.
Note that these rules and limits apply on a per-issuer (corporation) basis. In essence, the shareholder gets the greater of 10 times basis or $10 million or $15 million (subject to any additional caps such as those explained earlier for three or four years for newer shares or shares acquired before September 2010, explained below) for each company that meets the definition of a qualified small business.
For example, if the shareholder owns QSBS in three different companies, she can reap the tax benefits of the QSBS exclusion three separate times – excluding $30 million to $45 million or more of gain from her taxes.
Under current law, the $10 million (or 10 times basis) exclusion is cut if the shareholder acquired the shares before September 28, 2010. For shares acquired before February 18, 2009, up to 50% of the shareholder’s total gain may be excluded from tax. Finally, if the shareholder acquired the shares between February 18, 2009, and September 27, 2010, up to 75% of their total gain may be excluded from tax.
Note that these caps work similar to the 50% exclusion for newer shares held for three years and the 75% exclusion for newer shares held for four years with a notable exception described below.
QSBS exclusion percentage for shares held five years, by acquisition date |
|
Date acquired |
Exclusion |
On or after July 5, 2025 |
$15 million (or 10 times basis) |
September 28, 2010 – July 4, 2025 |
$10 million (or 10 times basis) |
February 18, 2009 – September 27, 2010 |
75% of the $10 million (or 10 times basis) exclusion |
On or before February 17, 2009 |
50% of the $10 million (or 10 times basis) exclusion |
How do these caps really work? The 50% and 75% cap on QSBS is worse than it would seem at first blush. Take the 50% cap, for example – it is not as simple as applying the 20% long-term capital gains tax rate to 50% of the gain and a 0% rate to the other 50% of the gain, giving you a total blended rate of a modest 10%. Instead, the QSBS laws require that 50% of the gain is taxed at a higher 28% capital gains rate and also subject to the 3.8% net investment income tax (assuming the income threshold is reached), meaning that the tax rate for the 50% excluded from QSBS is 31.8%.
In addition, for older shares only, the 50% of the gain that gets QSBS treatment is a preference item for purposes of the alternative minimum tax, so 7% of the QSBS excluded gain is still subject to a 28% tax.
These rules are extremely dense, so some examples are necessary:
