Qualified Small Business Stock

What Is Qualified Small Business Stock?

QSBS is stock issued by a qualifying domestic C corporation under Internal Revenue Code Section 1202. When the company, shareholder, shares, and sale meet the rules, section 1202 stock can provide a substantial federal capital gains exclusion for founders, employees, and early investors. Qualification depends on facts established from issuance through sale.

What a Company Has to Be to Issue QSBS

The issuer must be a domestic C corporation when the shares are issued and during substantially all of the shareholder’s holding period.

Gross assets generally cannot exceed $75 million before and immediately after stock issued after July 4, 2025; the limit is $50 million for earlier issuances.

At least 80% of corporate assets must support one or more qualified active businesses.

Excluded businesses generally include health, law, accounting, consulting, financial services, banking, insurance, farming, mining, hotels, and restaurants.

The company must monitor redemptions, passive investments, and real estate holdings that can threaten QSBS eligibility.

An F Reorganization may support a restructuring, but it does not automatically cure shares that failed the original requirements. The tax treatment and continuity of the existing shares should be reviewed before the restructuring is completed.

What an Investor Has to Do to Qualify for the Exclusion

• Be an eligible taxpayer. The exclusion generally applies to noncorporate taxpayers, not corporate shareholders.
• Acquire the stock properly. The stock generally must be acquired at original issuance for cash, qualifying property, or services. Certain conversions, gifts, inheritances, and partnership distributions may preserve QSBS treatment and allow holding-period tacking.
• Meet the QSBS holding period. For stock acquired after July 4, 2025, the exclusion is tiered: 50% after 3 years, 75% after 4 years, and 100% after 5 years. Earlier stock generally requires more than 5 years.
• Maintain corporate eligibility. The corporation must satisfy C corporation and active-business requirements during substantially all of the holding period.
• Avoid disqualifying short positions. Under Section 1202(j), an offsetting short position may prevent the QSBS exclusion.

How Much of the Gain Is Excluded and What the Limits Are

Shares acquired after September 27, 2010, and on or before July 4, 2025, can generally receive a 100% federal exclusion after the required holding period. Later shares use the 50%–75%–100% schedule.

The per-issuer limit is generally the greater of $10 million or 10 times basis for earlier shares, and $15 million or 10 times basis for shares acquired after July 4, 2025. The $15 million amount is indexed for inflation after 2026.

Planning Strategies That Maximize the QSBS Benefit

Founders should evaluate QSBS before formation, financing, option exercises, conversions, and acquisitions. Useful steps include issuing qualifying stock early, preserving capitalization records, documenting asset use, tracking gross assets at issuance, and reviewing eligibility annually.

Section 1045 may defer gain when QSBS held more than six months is sold and replacement QSBS is purchased within 60 days. Gifts to properly structured trusts may spread the per-taxpayer limit, although trust stacking requires careful tax and legal analysis.

A valuation may include a Discount for Lack of Control (DLOC) when a minority interest is transferred. That discount may affect gift or estate tax value, but it does not create QSBS status or increase carryover basis.

FAQ

Can an LLC or S corporation issue QSBS?

No. QSBS must be stock issued by a domestic C corporation. An LLC taxed as a partnership and an S corporation cannot issue qualifying shares. A later conversion may allow newly issued C corporation stock to qualify, but it generally does not retroactively turn the earlier ownership interest into QSBS.

What happens to the QSBS exclusion if the company is acquired before the five-year holding period is met?

The result depends on the transaction and acquisition date. Shares acquired after July 4, 2025, may receive a partial exclusion after three or four years. A qualifying tax-free stock exchange may preserve holding-period credit. Otherwise, Section 1045 may defer gain if replacement QSBS is purchased within 60 days.

Does the QSBS exclusion apply to state income taxes as well as federal?

Not automatically. Section 1202 is federal, and state conformity varies. Some states follow the exclusion, while others modify or reject it. California, for example, does not conform. Shareholders should analyze their resident state and any other state that may tax the gain before closing.

Can the QSBS exclusion be combined with a 1045 rollover to defer tax?

Potentially, but not on the same gain at the same time. Section 1045 can defer gain on QSBS held more than six months when replacement QSBS is purchased within 60 days. Deferred gain reduces the replacement stock’s basis, which may later qualify for Section 1202 treatment if all requirements are met.

How BT Can Help

For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Richard Bartolanzo, partner in charge of Bennett Thrasher’s Business Tax Practice, or call us at 770.396.2200.