Qualified small business stock (QSBS)

Authors:

Michael Sechuga, JD, CPA, Holli Heiles Pandol

Read time:

12 minutes

Published date:

February 18, 2026

Understand the qualified small business requirements and how to take advantage of QSBS tax treatment for eligible stock options.

What is qualified small business stock (QSBS)?

The qualified small business stock (QSBS) exclusion is a U.S. tax benefit that applies to eligible shareholders of a qualified small business (QSB). The QSBS tax exclusion is set forth in Section 1202 of the U.S. Internal Revenue Code (IRC), and allows founders and investors to potentially exclude up to 100% of federal capital gains tax on the sale of qualified stock held for over five years, if all the required conditions are met.

In 2025, new legislation expanded QSBS eligibility by raising the asset cap from $50 million to $75 million, increasing the individual benefit cap from $10 million to $15 million, and phasing in the benefit (50% capital gains tax exclusion for a three-year holding period, 75% exclusion for four years, 100% after five years). These changes only apply to shares issued after July 4, 2025.

Originally enacted as part of the Omnibus Budget Reconciliation Act of 1993, QSBS was designed to encourage investment in small businesses by rewarding entrepreneurs, early employees, and investors for taking the financial risk to build and fund new companies. Because founding, investing in, and working for a startup can be riskier by nature, the QSBS exclusion helps encourage people to take that risk. For anyone involved in a startup, understanding QSBS is an essential part of the journey, as Carta and industry groups like the NVCA actively work to protect QSBS at the federal level.

What are the requirements for QSBS?

To secure this significant tax break, both the company issuing the stock and the shareholder receiving it must meet a specific set of rules. The rules can be broken down into two main categories. The first set of rules applies to the issuing company itself, defining what makes it a qualified small business. The second set applies to the individual shareholder, outlining how and when they must acquire and hold the stock to be eligible for the tax benefit.

While the QSBS requirements are detailed, they are manageable, especially when you plan for them from the very beginning of your company's life. Getting these details right from day one can prevent major headaches and lost opportunities years down the road.

Qualified small business (QSB) rules for eligibility

For a company's shares to be considered qualified small business stock, the issuing corporation itself must meet several criteria at the time the stock is issued. These rules are designed to ensure the tax benefit goes to the types of small, growing businesses it was intended to support.

A company is known as a qualified small business when it meets the below qualification requirements:

• C corporation structure: The company must be incorporated as a domestic C corporation in the U.S. This means stock from an S corporation or an LLC does not qualify unless the company converts its legal structure to a C corp before issuing the shares.

• Gross assets test: The company's aggregate gross assets are $75 million or less at all times before and immediately after the equity was issued. For shares issued before July 4, 2025, the gross assets threshold is $50 million. This rule is why the benefit is targeted at early-stage, growing businesses rather than large, established corporations.

• Active business requirement: At least 80% of a company's assets must be used in the active conduct of a qualified trade or business. Excluded business types are determined by the IRS and include companies that:

• Perform services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, finance, banking, insurance, leasing, investing, or brokerage

• Rely on an employee or owner's reputation (i.e. if it endorses products or services, uses an individual's image, or has an employee make appearances at events or on media outlets.)

• Produce products, such as fossil fuels, for which percentage depletion (a type of tax deduction) can be claimed

• Operate a hotel, motel, restaurant, or similar business

• Are a farming business

Stock issued by a company that no longer meets the QSB requirements may not qualify as QSBS. For a full list of requirements, see IRS's Pub. 550 or Section 1202.

2025 QSBS expansion: Main differences in eligibility requirements

QSBS holding period requirements

For shares issued on or after July 4, 2025, you must hold eligible stock for at least three years in order to qualify for QSBS tax benefits. Benefits are phased in, with a 50% capital gains tax exclusion for a three-year holding period, a 75% exclusion for a four-year holding period, and full exclusion up to 100% when eligible stock is held for five years, if you've met all required conditions resulting in significant tax savings.

If you hold eligible shares, you may be subject to tax liabilities on the sale of those shares if you decide to sell before the holding period has been completed. Tender offers (buyback events), bilateral secondary transactions, and IPO events are some of the ways you can sell private company stock.

QSBS tax treatment and benefits

Normally when you sell shares, they could be subject to either short or long term capital gains rates. Short term capital gains rates may be as high as 37% whereas long term capital gains rates may be as high as 20%. QSBS status offers the ability to lock in a 0% capital gains tax rate for federal purposes. However, the tax benefits differ depending on when the QSBS shares were acquired.

Generally speaking, if you acquired QSBS-eligible stock after September 27, 2010, you can exclude up to 100% of the qualified gain. If you acquired the eligible stock before September 26, 2010, you can exclude a smaller percentage of the qualified gain—either 50% or 75%, depending on the acquisition date, and a portion of the gains may be subject to the alternative minimum tax (AMT).

QSBS location eligibility

Since QSBS is an amendment to the U.S. tax code, only employees who are U.S. taxpayers can take advantage of this federal income tax benefit. And while many state jurisdictions conform to the federal tax code for state taxes, some states do not.

As of today, if you (the shareholder of company stock) are a resident in one of the following states or territories, you are not eligible for the QSBS tax exclusion at the state level:

• Alabama
• California
• Mississippi
• Pennsylvania
• Puerto Rico

Hawaii and Massachusetts partially conform with the QSBS tax exclusion. The requirements vary based on the state of incorporation (for the company) and the state of residency (for the shareholder).

How to maintain QSBS eligibility and avoid common pitfalls

Qualifying for QSBS is not a one-time event. It is possible to lose QSBS eligibility even after stock is originally issued as qualified small business stock. The benefit can be lost if statutory requirements are not continuously met for “substantially all” of the shareholder's holding period, as required by Section 1202. As a company grows, raises capital, and evolves its business, certain actions can unintentionally disqualify its stock, putting the future tax benefits for all shareholders at risk. Founders and operators need to be aware of these common pitfalls to protect the value they are creating for their team and investors.

Here are some of the most common disqualifying events to watch for:

• If the company no longer meets QSBS requirements (such as changing business models) during a substantial portion of your holding period, future QSBS claims could be at risk.

• In mergers or acquisitions, eligibility may be preserved in some cases (for example, through tax-free share exchanges), but outcomes can vary, and you may need to track "tacked" holding periods or face limitations on the exclusion.

• QSBS can generally only be transferred without losing its status through gift, inheritance, divorce, or from a partnership to its partners. Any other type of transfer will typically result in the loss of QSBS eligibility.

How to prove your QSBS eligibility

The responsibility for proving that your shares qualify for the QSBS tax exclusion falls on you, the taxpayer. Years after you receive your stock, it can be incredibly difficult to track down the historical financial records, board consents, and data needed to prove every requirement was met. This administrative burden can be a significant barrier to claiming the benefit you've earned, leading to a situation where workers are leaving money on the table.

Because eligibility must be maintained over time, a single letter at the time of issuance isn't enough. As a best practice, companies should perform a QSBS eligibility review and refresh their attestation letter at least once per year, as well as after major events like large financings, stock repurchases, or business model changes.

Frequently asked questions about QSBS

Does the QSBS exclusion apply to state taxes?

The QSBS exclusion is a federal tax benefit, and its treatment at the state level varies. Some states conform to the federal rule, while others, like California, do not offer a similar exclusion, so you should consult a tax professional.

Can an LLC or S-corp issue QSBS?

No, only a C corporation can issue QSBS. If your company is currently an LLC or an S corporation, it must convert to a C corp before issuing the stock for it to be eligible.

What is a Section 1045 rollover?

A Section 1045 rollover is a related tax provision that allows a shareholder to sell their QSBS and defer paying capital gains tax. This is possible if they reinvest the proceeds into another QSBS opportunity within a specific timeframe.