What is Qualified Small Business Stock and Why Does It Matter for You and Your Startup?

Many thanks to Alexander Lee and Mark Windfeld-Hansen for their assistance with this post.

Over the past three decades, the US tax code has given founders and investors a significant tax break. Taxpayers holding qualified small business stock (QSBS) may be able to avoid tax on all or part of their gain from the sale of QSBS if certain requirements are met. Because of this, founders should carefully consider qualification for QSBS benefits when forming, operating and selling their companies.      

What is QSBS?

QSBS is stock in a United States C corporation that had gross assets of $50 million or less at all times before and immediately after the issuance of the QSBS and has been actively engaged in a “qualified trade or business” (for QSBS acquired after July 4, 2025, this amount is increased to $75 million and adjusted for inflation beginning in 2027). What constitutes a qualified trade or business is pretty broad, though it excludes certain service businesses (law, healthcare, financial services and architecture), financial businesses (banking and insurance), and other specified industries (farming, mining, hospitality and restaurants). While this list is not exhaustive, in our experience, many early-stage investments in technology companies meet these requirements, and thus stock in many startups can qualify as QSBS.

What are the benefits of QSBS?

If the requirements described below are met, a person holding QSBS may be able to exclude between 50% – 100% of the gain on the sale of their QSBS from US federal, and some states’, income tax. The amount of the exclusion depends on when the holder acquired the QSBS:

• QSBS acquired after September 27, 2010, may qualify for a 100% exclusion.
• QSBS acquired after February 17, 2009, and before September 28, 2010, may qualify for a 75% exclusion.
• QSBS acquired before February 18, 2009, may qualify for a 50% exclusion.

For QSBS acquired on or before July 4, 2025, the amount of the exclusion is limited to the greater of $10 million or 10 times the holder’s adjusted tax basis in the QSBS that is sold. So, if a person who acquired QSBS after September 27, 2010, and before July 5, 2025, has an adjusted tax basis of near $0 in that QSBS (as would be the case if you acquired your QSBS at formation for a nominal amount ) and sells that QSBS for $25 million, the person would only pay capital gains tax on $15 million of gain, rather than the full $25 million.

For QSBS acquired after July 4, 2025, the exclusion amount depends on the time the holder has held the QSBS. If the holder has held the QSBS for three years at the time of sale, the holder is entitled to a 50% gain exclusion. If the holding period is four years, the exclusion increases to 75%. And for five years, the exclusion is 100%.

In addition, for QSBS acquired after July 4, 2025, the limitation on the total amount of excludable gain is increased to the greater of $15 million or 10 times the holder’s adjusted tax basis in the QSBS that is sold.

Note that favorable QSBS treatment does not apply to C corporations that own QSBS.

What are the major requirements to qualify for QSBS benefits?

There are two main requirements that a holder must meet to take advantage of these benefits.

Original issue

• With a few exceptions, the holder must have acquired the QSBS directly from the company in exchange for money, property (not including stock) or as compensation for services.

Holding period

• For QSBS acquired on or before July 4, 2025, the holder must have held the QSBS for more than five years at the time of sale.
• For QSBS acquired after July 4, 2025, QSBS exclusions begin to apply as soon as the holding period is three years, as described above.

The company itself must also comply with various rules in order to allow its shareholders to qualify for favorable QSBS treatment. For instance, certain redemptions by the company can cause certain of its stock acquired within specified periods before or after the redemptions to fail to qualify as QSBS. In addition, the company must remain a US C corporation and actively engaged in a qualified trade or business throughout substantially all of the five-year holding period. Accordingly, decisions on how to organize and operate a company are important for QSBS purposes.

What if a person hasn’t held QSBS for the required holding period?

If a holder sells QSBS before five years (or three years, in the case of QSBS acquired after July 4, 2025), such holder may be able to avoid tax by investing the proceeds from the sale into other QSBS. To take advantage of these “rollover” rules, the holder must have held the QSBS that was sold for more than six months. The holder has 60 days to compete the rollover, and the company into which the holder rolls its gain must be a US C corporation with gross assets of $75 million or less (adjusted for inflation beginning in 2027) that is actively engaged in a qualified trade or business for substantially all of the first six months following the rollover.

Provided these requirements are met, the holder should qualify for the QSBS benefits described above once its combined holding period in the “old” and “new” QSBS exceeds three years. In addition, if a holder exchanges QSBS for stock that isn’t QSBS in certain tax-free transactions, that other stock will be treated as QSBS to the extent of the gain that would have been recognized at the time of the exchange if the transaction had not qualified as tax-free. As with the rollover provisions described above, a holder may combine its holding period in the “old” and “new” QSBS for purposes of qualifying for the five-year holding period. Note, however, that the holding period in QSBS will be suspended if, prior to completing that holding period, the holder has an “offsetting short position” with respect to its QSBS, including if the holder makes a short sale of its QSBS or acquires an option to sell its QSBS. 

A video on this topic is available on Cooley’s Taxplaining page.