Understanding Qualified Small Business Stock (QSBS): Rules, Benefits, and How to Qualify

Updated on May 29, 2025

Equity ownership in startups and SMBs can yield massive returns, but when it comes time to sell, those gains can be consumed by an equally massive tax bill. After accounting for long-term capital gains and other applicable taxes, you could lose up to 23.8% in federal taxes alone. Fortunately, Qualified Small Business Stock (QSBS) offers a viable way to hold on to your gains. When used correctly, QSBS can allow owners, employees and investors to not only reduce their federal capital gains taxes, but eliminate them entirely.

What is QSBS?

Qualified Small Business Stock (QSBS) is a special type of stock defined under Section 1202 of the Internal Revenue Code (IRC) that offers significant tax advantages for founders and early investors. If certain conditions are met, those who purchase QSBS can exclude up to 100% of federal tax on as much as $10 million in capital gains (or 10x their original investment, whichever amount is greater).

Not all companies are eligible to issue QSBS, and not every investment qualifies for the exclusion. To take advantage of these benefits, both the company and the stock must meet specific criteria set by the IRC.

How Do You Qualify for QSBS?

According to Section 1202 of the IRC, four primary criteria must be met for stock to qualify as QSBS:

1. The Issuing Company Must Qualify for Small Business Status: Companies that are registered as LLCs or S-Corps cannot issue QSBS. Your business must be a domestic C-Corporation with no more than $50 million in aggregate gross assets immediately before and after issuance. This means issuing shares during a temporary dip below $50 million in assets won’t work.
2. The Business Must Be Active: At least 80% of the company’s assets must be actively used in its core business operations. If a company is sitting on large amounts of cash or its capital is primarily tied up in passive investments, it may not qualify.
3. The Stock Must Be Acquired at Original Issuance: Shares must be obtained in exchange for cash, property, or services, either directly from the company or through the lead underwriter in an IPO. You can’t buy this stock on a secondary market and still have it qualify for exclusions, nor can it be purchased through another C-Corp.
4. The Stock Must Be Held for More Than Five Years: To qualify for the exclusion, QSBS must be held for a minimum of five years. If you sell before then, it will not qualify for QSBS tax exclusions unless the proceeds are reinvested in a replacement QSBS within 60 days, as outlined by IRC Section 1045.

Do All Industries Qualify for QSBS?

While many industries and businesses qualify for QSBS, some are excluded. These exclusions are typically based on how the business is classified using NAICS industry codes. Industries that may not qualify include:

Businesses in certain areas of the hospitality sector, such as those that operate restaurants, hotels, or motels, may also not be eligible to issue QSBS. Businesses with hybrid models may still be able to structure separate subsidiaries to pursue QSBS eligibility. This requires careful planning and should be done with the assistance of a qualified financial advisor.

While the exclusion list seems restrictive, a qualified financial advisor can explain the nuances of industry exclusions and identify ways your business may still qualify. Take the “Consulting” category as an example: while Section 1202 may seem to bar all consultants, it actually only excludes firms whose principal asset is the “reputation or skill of one or more of its employees.” A technology consultancy with proprietary software or a research team, for instance, could still qualify. The IRS has reinforced this interpretation through Private Letter Rulings, confirming that eligibility depends on a company’s asset mix and revenue sources rather than a broad NAICS label. Before ruling your company out, meet with a tax advisor experienced in QSBS to see whether these exemptions apply to you.

Do Founders Qualify for QSBS?

Founders can benefit from QSBS, provided their shares meet the criteria outlined by Section 1202. In fact, these IRC rules were designed in part to incentivize founders and small business owners.

Originally created as a part of the 1993 Omnibus Budget Reconciliation Act, the rules governing QSBS were amended in 2010 by the Small Business Jobs Act. While the legislation in 1993 only allowed for a 50% tax exclusion, subsequent acts increased that to 75% for stock acquired between February 18th, 2009, and September 27th, 2010. Any QSBS acquired on or after September 28th, 2010 is eligible for the 100% exclusion rate, as per the Protecting Americans from Tax Hikes (PATH) Act of 2015 (which made the 100% rate permanent).

What are the Benefits of QSBS?

The primary benefit of QSBS is the capital gains tax exclusion, which can equal 100%. That means that the entire gain from qualified stock will be taxed at a rate of 0% up to $10 million or 10 times the investor’s cost basis, whichever is greater. This means that a QSBS investment of $5 million could lead to a $50 million tax-free gain. Other benefits include:

• AMT and NIIT Tax Exclusion: Because gains associated with QSBS are excluded from federal taxable income, investors can be exempt from both the Alternative Minimum Tax (AMT) and the Net Investment Income Tax (NIIT). While taxes may still apply at a state level, nearly ⅔ adhere to the federal inclusion or impose no capital gains tax at all.
• Increased Investor Interest: Issuing QSBS is an effective strategy to attract early investors and maximize seed funds. By offering a better after-tax internal rate of return (IRR), QSBS can make investments far more attractive than those subject to standard capital gains taxes.
• Advanced Tax Planning Strategies: QSBS expands the number of tax planning strategies one can use. For example, the $10 million cap applies per taxpayer, so shares can be spread out amongst family members and trusts to multiply the available exclusion. Section 1045 also offers a rollover option: if you need liquidity before the five-year holding period is up, you have an option to sell the shares after six months and reinvest in new QSBS within 60 days. This defers the gain and restarts the clock, but allows you to still benefit from the exclusion once five years have passed.

These benefits are available in a majority of the United States, either through IRC Section 1202 adherence or a lack of capital gains tax. However, it’s important to know how QSBS is handled in each state to accurately determine eligibility and use.

Do All States Recognize QSBS?

While a majority of U.S. states either adhere to federal QSBS exclusion rules or impose no state capital gains tax at all, some areas may not conform to IRC Section 1202. Below is a breakdown of how each U.S. state, territory, and district handles QSBS.

• States and districts that fully adhere to IRC Section 1202 include: Arkansas, Arizona, Colorado, Connecticut, Delaware, District of Columbia, Georgia, Idaho, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maine, Maryland, Michigan, Minnesota, Montana, Missouri, Nebraska, New Mexico, New York, North Carolina, North Dakota, Massachusetts, Ohio, Oklahoma, Oregon, Rhode Island, South Carolina, Utah, Vermont, Virginia, West Virginia, and Wisconsin
• States that partially adhere to IRC Section 1202: Hawaii (Allows for 50% of capital gains to be excluded from state income taxes)
• States and territories that do not adhere to IRC Section 1202: Alabama, California, Mississippi, New Jersey, Pennsylvania, and Puerto Rico
• States that adhere to IRC Section 1202 by not having state income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington*, and Wyoming
• States that adhere to IRC Section 1202 by not taxing capital gains: New Hampshire and Tennessee

*Washington State has particularly complicated rules when it comes to QSBS. While the state does not have a state-level income tax, it did implement a 7% capital gains tax in 2022 on annual gains exceeding $250,000. Those that qualify for federal QSBS exclusions can also be exempt from Washington’s capital gains tax, provided specific requirements are met.

Can You Still Qualify for QSBS In a Non-Conforming State?

Yes, it is possible to qualify for QSBS exclusions if you reside in a non-conforming state, but it requires careful planning. There are several strategies that can help you qualify for the tax exclusion before you sell, including establishing residency or setting up an irrevocable non-grantor trust in a QSBS-friendly state. These strategies involve complex rules and regulations that necessitate the assistance of trained financial advisors, tax professionals, and legal counsel.

Because QSBS eligibility, structuring, and tax planning are highly specialized areas, they require input from experienced professionals. In most cases, financial advisory firms are best equipped to handle this type of work due to their familiarity with QSBS regulations and transactions.

Can You Still Qualify for QSBS if you are an LLC or S-Corp?

Yes, you can still claim the QSBS exclusion if you are an LLC or S-Corp. First, you need to convert to a C-Corp. This is relatively simple for an LLC. For S-Corps, the owners usually need to carry out an F-Reorganization to satisfy the “original issuance” rule before converting. Because the rules are highly technical and mistakes can be costly, it’s important to work with an experienced tax advisor who understands both Section 1202 and F-Reorgs. Although the process adds some complexity, the financial upside at exit can be substantial.

Owners who convert can exclude the greater of $10 million or ten times the company’s value on the conversion date. For example, if the business is worth $3 million when it becomes a C-Corp, the owners of the shares can exclude up to $30 million in capital gains on top of the initial $3 million conversion value. Despite this potential benefit, many founders who start their business as an LLC or S-Corp aren’t even aware conversion is possible, thereby missing out on a significant tax advantage.