Your Guide to Qualified Small Business Stock (Section 1202)

Your Guide to Qualified Small Business Stock (Section 1202)

If you’re an entrepreneur or investor, here’s some exciting news that could save you thousands—maybe even millions—in taxes: Qualified Small Business Stock (QSBS), outlined under Section 1202 of the Internal Revenue Code, offers exceptional tax benefits for those who invest in small businesses. It’s a win-win scenario—fueling innovation and entrepreneurship while rewarding you with significant tax savings.

This unique tax benefit was introduced in 1993 to encourage investment in small businesses by offering substantial tax exclusions on capital gains when selling QSBS. Over the years, it has become a game-changer for early-stage companies and their investors, providing a critical incentive to support small businesses and fuel economic growth.

What Exactly Is Qualified Small Business Stock?

QSBS is stock in a small business that meets specific criteria laid out by Section 1202 of the IRS Code. It’s not just any stock—it must follow a set of rules to qualify for the associated tax benefits. Let’s dive into the details to understand what makes stock “qualified.”

What Makes Stock “Qualified”?

Not all stock is QSBS. To unlock its tax-saving potential, a few key requirements must be met:

• Issuer Type: The issuing company must be a domestic C corporation. This excludes S corporations, LLCs, and partnerships. The business also must actively conduct operations—not just hold onto investments or passive assets.

• Asset Limitation: The corporation’s gross assets cannot exceed $50 million at the time the stock is issued. This includes assets immediately before and after funding, ensuring the company remains within the “small business” threshold.

• How Stock Is Acquired: The stock must be acquired directly from the company in exchange for cash, property, or services. It cannot be purchased from another investor or acquired on a secondary market.

• Holding Period: To fully benefit from QSBS tax exclusions, you must hold the stock for at least five years. Selling earlier may forfeit your eligibility for the tax break.

Additionally, companies involved in certain restricted industries—like financial institutions, farming, and hospitality—might not qualify. This rule ensures QSBS is targeted toward businesses driving innovation, technology, and long-term growth.

Why Is QSBS Such a Big Deal?

The tax benefits of QSBS are enormous, especially for early-stage investors and entrepreneurs. If you meet all the requirements, you may be able to exclude up to 100% of your capital gains from federal taxes when selling QSBS. Here’s how the exclusion works:

• You can exclude the greater of $10 million or 10 times the stock’s adjusted basis from capital gains taxes.

• The exclusion applies to gains from selling qualified stock that you’ve held for at least five years.

• This exclusion significantly reduces the amount you owe in taxes, leaving more money in your pocket to reinvest or use as you see fit.

For example, if you invest $1 million in QSBS and your stock grows tenfold to $10 million over five years, your capital gains could be entirely tax-free under Section 1202.

Even if you exceed the federal exclusion limit, many states offer additional benefits, as some have aligned with federal QSBS rules.

RECENT EXPANSION OF QSBS VIA “ONE BIG BEAUTIFUL BILL ACT”

The “One Big Beautiful Bill Act,” signed into law on July 4, 2025, significantly expands the tax benefits of QSBS.

Here’s a breakdown of the changes:

1. Tiered-Gain Exclusion:

• Instead of the previous “five-year cliff” for 100% exclusion, the new law introduces a tiered system for QSBS acquired after July 4, 2025.
  • 50% exclusion: Applies to stock held for at least 3 years but less than 4 years.
  • 75% exclusion: Applies to stock held for at least 4 years but less than 5 years.
  • 100% exclusion: Applies to stock held for at least 5 years

2. Increased Gain Exclusion Amount:

• The maximum amount of gain eligible for exclusion is increased from $10 million to $15 million per issuer.
• The exclusion also applies to the greater of $15 million or 10 times the taxpayer’s basis in the stock. 

3. Higher Gross Assets Limit:

• The maximum gross assets a corporation can have for its stock to qualify as QSBS is increased from $50 million to $75 million for stock issued after the enactment date.
• This limit is also subject to inflation adjustments beginning in 2027. 

4. Effective Date:

• These changes only apply to QSBS acquired after July 4, 2025.
• Stock acquired on or before that date is still subject to the previous QSBS rules. 

Why QSBS Matters

QSBS is more than just a tax benefit—it’s a tool for supporting innovation and small business growth. For investors, it creates a powerful incentive to back early-stage companies. For entrepreneurs, it provides access to capital that might otherwise be difficult to secure.

By investing in small businesses, you’re not only boosting your financial returns—you’re also helping to build the next wave of innovation, create jobs, and foster economic development. Whether you’re funding the next breakthrough tech company, supporting a healthcare startup, or helping a local business thrive, QSBS rewards your commitment to making a real impact.

Who Should Care About QSBS?

If you’re an entrepreneur seeking investment or an investor looking for strategic opportunities, QSBS should be on your radar. Startups structured as C corporations may find it easier to attract investors when they qualify for QSBS benefits. On the flip side, investors looking for high-growth opportunities can leverage QSBS to maximize returns while minimizing tax obligations.

Getting Started with QSBS

Understanding QSBS and its requirements is crucial for maximizing its potential. If you’re a business owner, consulting with a tax advisor can help ensure your company qualifies under Section 1202. If you’re an investor, working with a financial planner can help you identify and evaluate QSBS opportunities.

Section 1202 of the IRS Code isn’t just another tax rule—it’s a powerful incentive to support small businesses, drive innovation, and reap significant financial rewards along the way. Whether you’re an entrepreneur or investor, QSBS is a tool worth understanding and leveraging for long-term success.

Writer: Martha Hadaway, EA – Tax Director

Return to News