QSBS (Section 1202)
A federal tax provision that may exclude part or all of the gain on eligible qualified small business stock, subject to acquisition-date, holding-period, issuer, shareholder, and limitation rules.
What Is QSBS?
Qualified Small Business Stock (QSBS), governed by Section 1202 of the Internal Revenue Code, may allow a noncorporate taxpayer to exclude part or all of eligible gain. The exclusion percentage, gross-asset threshold, and dollar component of the per-issuer limitation depend in part on when the stock was acquired.
Requirements for QSBS Eligibility
Company Requirements
Not all company stock qualifies. The company must meet several criteria:
- C-corporation status — The company must be a domestic C-corporation at the time the stock is issued. S-corps, LLCs, and partnerships do not qualify.
- Applicable gross-asset test — For stock issued after July 4, 2025, the threshold is generally $75 million before and immediately after issuance. The earlier $50 million threshold generally applies to stock issued on or before that date.
- Active business requirement — At least 80% of the company's assets must be used in the active conduct of a qualified trade or business. Certain industries are excluded, including financial services, hospitality, farming, mining, and professional services (law, accounting, consulting, etc.).
Shareholder Requirements
- Original issuance — The stock must be acquired directly from the company in exchange for money, property, or services. Stock purchased on the secondary market generally does not qualify.
- Five-year holding period — The stock must be held for at least five years from the date of acquisition to qualify for the full exclusion.
The Exclusion Amount
Eligible stock acquired after September 27, 2010 and on or before July 4, 2025 generally can qualify for a 100% exclusion after more than five years, subject to the greater of a $10 million dollar limitation or 10 times adjusted basis. For eligible stock acquired after July 4, 2025, the dollar amount is generally $15 million and the new graduated holding-period schedule can apply. Prior dispositions and special spouse and transfer rules affect the available limitation.
2025 OBBBA Changes
Public Law 119-21, enacted July 4, 2025, made changes that generally apply to stock acquired after that date:
- Increased exclusion cap: From $10 million to $15 million per issuer
- Increased gross asset limit: From $50 million to $75 million
- Graduated exclusion schedule: The exclusion percentage now depends on holding period:
- 3 years but less than 4 years: 50% exclusion
- 4 years but less than 5 years: 75% exclusion
- 5 years or more: 100% exclusion (full exclusion, unchanged)
Practical Implications for Startup Employees
Exercising Options and QSBS
An option holder generally acquires stock on exercise, but restricted-stock, 83(b), basis, and transfer facts can affect the analysis. Obtain the grant, exercise, issuer, and tax records needed to support the acquisition date and basis.
The 83(b) Election Advantage
An 83(b) election for substantially nonvested shares can affect when tax and holding periods begin. Its 30-day deadline and the Section 1202 interaction should be reviewed against the actual documents.
Planning Around the Five-Year Hold
The five-year holding requirement means timing matters significantly. If a company is likely to be acquired or go public within five years of your exercise, you may not meet the holding requirement. However, there is a provision allowing you to roll gains into new QSBS within 60 days of sale if you have not yet met the five-year threshold. This is known as a Section 1045 rollover.
State Tax Considerations
While the federal QSBS exclusion is generous, state tax treatment varies. Some states like California do not conform to Section 1202 and will tax the gain at the state level regardless. Others fully or partially adopt the federal exclusion. Check your state's rules before assuming a completely tax-free outcome.
How It Relates to Exercising Stock Options
QSBS can be one factor in an exercise decision, but it does not make an illiquid investment suitable or establish that the company qualifies. Confirm the applicable acquisition-date rules, issuer records, holding period, and shareholder limitations before relying on the exclusion.