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Originally enacted as part of the Omnibus Budget Reconciliation Act of 1993, QSBS was designed to encourage investment in small businesses by rewarding entrepreneurs, early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.

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.

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.