QSBS Tax Exemption Explained (Section 1202 Guide for Founders & Investors)

If you own stock in a startup or small C corporation, the QSBS tax exemption could allow you to exclude up to 100% of your capital gains from federal income tax when you sell.

Under Internal Revenue Code § 1202, Qualified Small Business Stock (QSBS) offers one of the most powerful tax benefits available to founders, early employees, and investors — but the rules are strict.

This guide explains:

• What the QSBS tax exemption is
• How the 5-year holding rule works
• The $50 million gross asset test
• Who qualifies (and who doesn't)
• How QSBS affects long-term capital gains tax
• Common mistakes that disqualify stock

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What Is the QSBS Tax Exemption?

The QSBS tax exemption allows eligible taxpayers to exclude 50%, 75%, or 100% of gain from the sale of qualified small business stock held for more than 5 years.

For most stock issued after September 27, 2010, the exclusion is 100% of eligible gain — meaning zero federal capital gains tax on that portion.

The exclusion is subject to a per-issuer limit:

The greater of:

• $10 million, or
• 10× your basis in the stock

This can translate into millions in federal tax savings.

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How the QSBS Exemption Affects Capital Gains Tax

Normally, long-term capital gains are taxed at:

• 0%
• 15%
• 20% (plus Net Investment Income Tax in some cases)

If stock qualifies as QSBS and is held for more than 5 years, eligible gain can be excluded entirely at the federal level.

Important: Many states do not conform to federal QSBS rules. You may still owe state capital gains tax.

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QSBS Requirements: Who Qualifies?

To qualify for the QSBS tax exemption, several requirements must be met.

1. The Company Must Be a Domestic C Corporation

QSBS only applies to stock issued by a U.S. C corporation.

It does not apply to:

• LLCs taxed as partnerships
• S corporations
• Foreign corporations

If your company is not a C Corp at the time of issuance, it cannot generate QSBS.

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2. The $50 Million Gross Asset Test

At the time the stock is issued — and immediately after issuance — the company's aggregate gross assets must not exceed $50 million.

This is one of the most common disqualifiers.

If the company exceeds $50 million in gross assets before or immediately after issuing your shares, the stock generally does not qualify.

Private equity rollups often fail here.

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3. 80% Active Business Requirement

At least 80% of the corporation's assets (by value) must be used in the active conduct of a qualified trade or business.

Qualified businesses generally include:

• Technology companies
• Manufacturing
• E-commerce
• Retail
• Construction
• Plumbing and contracting

Excluded businesses include:

• Health services
• Law
• Accounting
• Consulting
• Financial services
• Brokerage
• Hospitality
• Farming
• Mining

The exclusion often depends on how the business is structured and operated.

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4. Original Issuance Requirement

You must acquire the stock:

• At original issuance, directly from the corporation
• In exchange for money, property, or services

Buying stock from another shareholder does not qualify.

In certain tax-free reorganizations or rollovers, QSBS treatment can sometimes carry over — but this depends heavily on deal structure.

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5. 5-Year Holding Period

You must hold the stock for more than five years.

The holding period begins on the date you acquire the stock.

In some qualifying exchanges, holding periods may "tack" — but this is fact-specific.

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Who Typically Benefits from QSBS?

QSBS is most common among:

• Startup founders
• Early-stage employees with stock
• Angel investors
• Venture capital investors
• Early shareholders in C corporations

It is particularly valuable for:

• Pre-IPO tech companies
• Acquisitions of high-growth startups
• Founder exits

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Common QSBS Mistakes

Many taxpayers assume they qualify — but fail on technical details.

Mistake #1: The Company Is Too Large

If the company's gross assets exceeded $50 million at issuance, the stock generally does not qualify.

This frequently disqualifies:

• Private equity holding companies
• Rollup acquisitions
• Late-stage growth rounds

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Mistake #2: Incorrect Entity Type

Stock issued before converting from an LLC to a C Corp does not qualify.

QSBS applies only to C corporation stock issued while the company is a C Corp.

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Mistake #3: Buying Shares from Another Shareholder

Secondary purchases do not meet the original issuance requirement.

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Mistake #4: Assuming State Conformity

Many states — including California — do not follow the federal QSBS exclusion.

You may still owe state tax on the full gain.

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Can Rollover Stock Qualify for QSBS?

In M&A transactions, founders often roll equity into a holding company.

Whether that rollover stock qualifies depends on:

• Whether it was issued at original issuance
• Whether the transaction was a qualifying tax-free reorganization
• Whether the new company meets the $50 million asset test
• Whether the active business test is satisfied

Private equity holding companies frequently exceed the gross asset limit, which disqualifies new stock.

This analysis requires deal-specific review.

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QSBS vs. Long-Term Capital Gains

Here's the key distinction:

Scenario	Federal Capital Gains
Regular long-term capital gain	0–20%
QSBS qualifying (100% exclusion)	0% on eligible gain

The difference can mean millions in savings.

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Planning Around QSBS

If you believe your stock may qualify:

• Confirm the company's gross assets at issuance
• Confirm it was issued at original issuance
• Track acquisition date carefully
• Preserve documentation
• Model federal vs. state outcomes
• Plan liquidity events around the 5-year mark

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Bottom Line: Is the QSBS Tax Exemption Worth It?

Yes — when you qualify, the QSBS exemption is one of the most powerful federal tax benefits available.

But qualification is not automatic.

It depends on:

• Entity type
• Gross asset levels
• Active business tests
• Issuance structure
• Holding period

Before assuming eligibility, consult a tax advisor experienced in M&A and § 1202.

And if you want to understand how your potential exit would look with and without the QSBS exemption, Margen can help you model the gain and federal tax impact so you can plan accordingly.