QSBS Stock: The Complete Guide to Qualified Small Business Stock (Section 1202)

QSBS stock (Qualified Small Business Stock) is one of the most powerful tax benefits available to startup founders and early investors. Under Section 1202 of the Internal Revenue Code, eligible taxpayers may exclude up to 100% of capital gains on the sale of certain small business stock, potentially eliminating millions in federal tax.

If you're a founder, early employee, or angel investor, understanding QSBS can materially change your long-term tax outcome.

This guide explains:

• What QSBS stock is
• How the 100% exclusion works
• Eligibility requirements
• Common pitfalls
• Planning strategies founders should consider

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What Is QSBS Stock?

QSBS stock refers to shares in a qualified small business that meet the requirements of Section 1202 of the Internal Revenue Code.

If all conditions are met, eligible shareholders may exclude the greater of (1) up to $10 million, or (2) 10× their adjusted basis in the stock, from federal capital gains tax.

That exclusion applies when the stock is sold after a required holding period.

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How the QSBS Tax Exclusion Works

The percentage of gain you can exclude depends on when the stock was acquired:

Acquisition Date	Exclusion Percentage
Before Feb 18, 2009	50%
Feb 18, 2009 – Sept 27, 2010	75%
After Sept 27, 2010	100%

For most modern startup founders and investors, the relevant rule is the 100% exclusion.

Example

You acquire startup stock for $100,000.

Five years later, you sell for $8 million.

If the stock qualifies as QSBS:

• Federal capital gains tax on the gain may be fully excluded
• Potential federal tax savings: ~$1.5M+ (depending on rate assumptions)

State tax treatment varies.

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QSBS Eligibility Requirements

To qualify as QSBS stock, several requirements must be met.

1. The Company Must Be a C Corporation

Only stock issued by a domestic C corporation qualifies.

• S corporations do not qualify
• LLCs taxed as partnerships do not qualify
• Converting to a C corporation can start eligibility going forward

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2. The Company Must Be a "Qualified Small Business"

At the time of stock issuance:

• Gross assets must not exceed $50 million
• At least 80% of corporate assets must be used in an active trade or business

Certain industries are excluded, including:

• Professional services (law, accounting, consulting)
• Financial services
• Banking
• Insurance
• Hospitality
• Farming
• Mining

Technology, manufacturing, and product-based startups commonly qualify.

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3. The Stock Must Be Acquired at Original Issuance

You must acquire the stock:

• Directly from the company
• In exchange for money, property, or services

Buying shares from another shareholder generally does not qualify.

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4. Five-Year Holding Period

You must hold the QSBS stock for more than five years before selling.

If sold earlier, other rollover provisions (like Section 1045) may apply.

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QSBS Stock for Founders

For founders, QSBS planning should begin at incorporation.

Key considerations:

• Confirm C corporation status from the start
• Monitor gross assets before and after funding rounds
• Track issuance dates carefully
• Preserve documentation of eligibility

If the company exceeds $50 million in assets later, previously issued shares may still qualify. Eligibility is tested at issuance.

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QSBS and Secondary Sales

Selling shares in a secondary transaction does not automatically disqualify QSBS status.

However:

• The buyer does not receive QSBS treatment
• The original holder may qualify if all conditions are met
• Proper documentation and holding period tracking are critical

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State Tax Treatment of QSBS

Federal exclusion does not guarantee state-level exclusion.

Some states conform to federal QSBS rules. Others:

• Partially conform
• Do not conform at all

High-tax states may materially reduce the benefit.

Planning ahead is essential.

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Common QSBS Pitfalls

1. Incorporating as an LLC and converting later without analyzing timing
2. Asset transfers that disrupt eligibility
3. Failing to document original issuance
4. Assuming service businesses qualify
5. Selling before five years without evaluating rollover options

QSBS errors are often discovered too late, at exit.

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Advanced QSBS Planning Strategies

1. Stacking the Exclusion

Through gifting or trust planning, some founders attempt to "stack" multiple $10M exclusions.

This requires careful structuring and compliance analysis.

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2. QSBS + 1045 Rollover

If you sell before five years:

• Section 1045 may allow rollover into new QSBS
• The holding period may tack under certain conditions

Timing rules are strict.

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3. Holding Company Structures

Using holding companies can complicate QSBS eligibility.

Eligibility generally depends on:

• Asset use tests
• Active business requirements
• Proper structuring at issuance

Improper structuring can disqualify the exclusion.

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Is QSBS Stock Worth It?

For qualifying startups, QSBS can be one of the most powerful tax incentives in the Internal Revenue Code.

For founders expecting:

• Significant appreciation
• Acquisition
• IPO

The potential federal tax savings can be transformative.

But eligibility is technical and fact-specific.

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Final Thoughts on QSBS Stock

QSBS stock offers a potential 100% federal capital gains exclusion under Section 1202, but only if strict requirements are met.

If you are:

• Forming a startup
• Issuing founder shares
• Evaluating a C-corp conversion
• Planning for exit

You should analyze QSBS eligibility early, not at liquidity.

The difference between qualifying and not qualifying can be millions.