Individuals who hold qualified small business stock (QSBS) may be eligible for significant savings on their capital gains tax liability. This is because they can receive up to a 100% exemption on federal gains taxes up to ten times their initial investment or up to a value of $10 million—whichever is greater.

Knowing how to use this tax advantage can have a substantial impact on your finances. Savvy investors should inform themselves about the potential benefits of holding QSBS and how to maximize the benefits of the QSBS tax exemption.

What Is Qualified Small Business Stock (QSBS)?

Qualified small business stock (QSBS), or Section 1202 stock, allows shareholders in qualifying small businesses to exclude a significant part of associated capital gains when selling or exchanging their stock if shares have been held for over five years. Depending on when you purchased stock, you could exclude between 50% and 100% of the sale of the stock from your gross income on your federal income tax return.

QSBS is typically owned by investors and employees of small businesses. Section 1202 of the Internal Revenue Code (the Tax Code) defines what a qualified small business is and the regulations surrounding QSBS.

Both Issuing and Purchasing QSBS Can Be Advantageous

According to the U.S. Chamber of Commerce, nearly half of the American workforce is employed by small businesses, which make up 43.5% of the country’s GDP.

Although many small businesses don’t succeed, investors who invest in a small business that thrives—especially one that qualifies for small-business tax exemption—could benefit from potential returns and tax savings that make the risk of investment well worth taking.

For small business owners, issuing QSBS can encourage investment in their business to raise capital and help the business grow.


Take an investor who discovered a startup with a dynamic founder and a concept likely to revolutionize the industry. This individual invested $3 million into the business in 2011 and received the corresponding shares the same year. The business took off and the investor liquidated his share for $15 million in 2022. Because the shares in the company qualify under the QSBS exemption, the investor can pocket the $12 million capital gain without being subject to any federal income taxes on this amount.

QSBS Eligibility for Companies

To benefit from the QSBS tax exemption, you must invest in a qualifying company. This means:

  • The company is an active, domestic C corporation: The business must be incorporated in the U.S. as a C Corp. S corporations aren’t permitted. The corporation must be active in its business operations rather than a holding company.
  • The stock was issued after August 10, 1993.
  • Stock must be acquired directly from the company in exchange for money, property, or compensation.
  • Assets owned by the issuer must not be greater than $50 million. This applies before and after the issuance of stock.

Prohibited Industries

There are several prohibited industries that cannot issue QSBS. These include:

  • Personal services
  • Banking, finance, insurance, investing, or leasing
  • Farming or mining
  • Running a hotel, motel, or restaurant

It’s essential to get the right advice on the Section 1202 exclusion—whether you’re starting a new venture, planning your future exit strategy, or if you’ve already sold your stock. You may also need help if the IRS challenges your position. Experts in tax planning services can help you understand if an idea for a future business might qualify and what documentation you would need to gather to support your fiscal position.

QSBS Tax Benefit Eligibility for Stockholders

You may be eligible for QSBS tax benefits if you meet the following criteria:

  • You can’t be a corporation: Only individuals, pass-through entities, or trusts can qualify for the QSBS tax exclusion.
  • You must fulfill the stipulated holding period: Gains on stocks acquired after September 27, 2010, are tax-free if they’ve been held for over five years. Stocks held for between one and five years and less than one year are subject to long and short-term capital gains tax, respectively.
  • There is a maximum gain cap: Gains up to 10 times the adjusted basis or up to $10 million can be excluded.
  • You could defer your gain: Shareholders who reinvest proceeds from selling QSBS stock can still receive tax benefits if they’ve held the original stock for longer than six months and the proceeds are reinvested in another QSBS within a 60-day period.

Stock Acquired Before September 10, 2010

QSBS acquired before September 10, 2010, is subject to different regulations. Keep these regulations in mind if your stock was purchased before this date:

  • Stock purchased before February 18, 2009, and held for longer than five years: The maximum capital gains exclusion is 50%. 7% of the gain is also subject to the alternative minimum tax.
  • Stock acquired from February 18, 2009, to September 27, 2010, and held for over five years: The maximum capital gains exclusion is 75%. 7% is also subject to the same alternative minimum tax as stock acquired before this date.

How to Offer QSBS as a Small Business

Your business must follow several steps to offer QSBS:

  1. Form a C Corp: You must define your business purpose, the number of authorized shares, and the par value of each share. You must also create bylaws to govern internal procedures within the C corp.
  2. Financial Review: Work with financial advisors or auditors to assess your assets and confirm that your assets don’t exceed the $50 million limit.
  3. Legal Counsel: A legal team will perform a compliance review to ensure stock issuance adheres to state and federal tax law.
  4. Stock Documentation: Create contracts such as stock purchase agreements and shareholders’ agreements. These outline the terms of stock sale and ownership.
  5. Board Approval: Stock issuance must be approved by the board of directors.
  6. Stock Issuance: Carefully document each share issued. Stock certificates must disclose the issuance date, par value, and any restrictions.
  7. Ongoing Compliance: Monitor for compliance regularly. Conduct periodical financial assessments to make sure the company’s asset value remains within the limits. Also, consult legal advisors to confirm that business activities meet QSBS regulations.

How to Buy QSBS as an Investor

Supporting an entrepreneur with a great project and vision who you know personally is perhaps the most tried and tested way to invest in QSBS. However, not everyone has an inspiring entrepreneur in their lives.

Venture capital funds offer an alternative. This is because venture capitalists can qualify for a 100% QSBS tax exclusion. Venture capital funds therefore offer a viable option for individuals who wish to invest in up-and-coming small businesses.

How to Sell QSBS

When it’s time to sell your QSBS after holding it for five or more years, take the following steps:

  1. Tax analysis: Work with a tax professional to understand whether you will be eligible for a partial or full tax exemption on the sale of your stock. This tax professional can also review the documentation related to your stock ownership.
  2. Legal consultation: A legal team will prepare and review the necessary paperwork to get you ready for the sale. Be prepared to provide documentation for a buyer performing due diligence.
  3. Final approvals: The board of directors will likely need to approve the sale.
  4. Closing transaction: Finalize the sale and retain all documents, including the stock purchase agreement, corporate resolutions, and payment transfer.
  5. Post-sale filings and notifications: Update the stock ledger to reflect the change in stock ownership. You may also need to make regulatory filings to document the sale.
  6. Tax filings: Report the sale of QSBS on your tax return. Work with expert tax professionals to make sure you report the sale accurately, maximize your tax exemption, and avoid any problems with the Internal Revenue Service.

How Businesses Use QSBS

Small businesses can use their stock strategically to maximize their profits. Businesses can use QSBS to:

Attract Investors

Startups or small businesses looking to expand can use QSBS as a way to raise capital. Individuals or partners in partnerships can benefit from the tax break because the tax exclusion only applies to individuals (not corporations). This exclusion is limited to the partner’s percentage interest in the partnership when they acquired the stock.

Reward Employees

The IRS allows companies to issue QSBS in exchange for services. This can work out well for startups that may have limited cash flow to compensate employees. Stock issuance can also work as an incentive for employees both to stay at the company and to work to help it succeed.

Please note that QSBS issued as compensation to employees is subject to payroll taxes, including income tax withholding, FICA taxes (Social Security and Medicare), and FUTA (federal unemployment) taxes.

Potential Causes of QSBS Disqualification for Companies and Stockholders

The following actions by a company could disqualify its QBS status and subsequently its shareholders’ access to the QSBS tax exclusion. These include:

Share Repurchases

If a company’s buyback of its shares goes over the threshold, all shares issued a year before the buyback may be disqualified. There can also be a one-year period in which all shares after the repurchase aren’t QSBS-eligible.

Changes to the Business Model

Changing business models may disqualify companies if they begin to perform non-qualifying activities. In this case, your QSBS may be affected.

Exceeding the Asset Threshold

If your company exceeds the $50 million limit in gross assets, it can lose its QSBS status. This can happen as a result of acquisitions, fundraising, inventory, or licensing agreements.

Stay Informed About QSBS Tax Benefits

Savvy investors who are willing to invest in new ventures have a lot to gain from QSBS tax benefits. However, they should also stay informed of any potential changes to this tax exemption before investing.

To this end, working closely with tax professionals is essential at every stage of the process. Whether you’re considering investing, wish to sell, or have any other doubts about QSBS, an expert CPA can help.

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