Qualified Small Business Stock (QSBS): The Hidden Tax Break for Founders, Employees, and Early Investors
If you’re a founder, early employee, or investor in startups, there’s a powerful but often overlooked tax benefit that could save you millions: Qualified Small Business Stock (QSBS)
Originally created to stimulate startup activity following the 2008 financial crisis, QSBS allows eligible taxpayers to exclude up to 100% of capital gains on the sale of qualified stock. Yes, you read that right—potentially zero federal tax on up to $10 million in gains
Let’s break it down
What Is QSBS?
Qualified Small Business Stock (QSBS) refers to shares in certain early-stage U.S. companies that meet a specific set of criteria outlined in Section 1202 of the Internal Revenue Code
To encourage innovation and job creation, the U.S. government created QSBS rules to reward those who invest in and support small businesses. For qualifying individuals, this can result in up to 100% exclusion of capital gains from federal taxes
Who Is Eligible?
To benefit from QSBS, you must be a non-corporate U.S. taxpayer. This includes individuals, trusts, and pass-through entities like LLCs and partnerships
Most importantly, you must receive newly issued stock—either by:
Investing directly in a qualifying company
Exercising stock options or receiving equity as compensation (for example, as an early employee or advisor)
The 5 Key QSBS Requirements
To qualify for the tax exclusion under QSBS, all five of the following must be true
You must hold the stock for at least five years before selling it. (Note: pending legislation could reduce this to three years)
The stock must have been issued after August 10, 1993
The stock must be issued by a U.S. C corporation with less than $50 million in gross assets at the time of issuance
At least 80% of the company’s assets must be used in an active trade or business, excluding certain industries such as finance, law, or hospitality
The company must not have engaged in disqualifying stock redemptions around the time your shares were issued
How Does It Work in Practice?
Imagine you joined a startup as one of the first ten employees. You exercised your options early, and seven years later, the company gets acquired
Your shares are now worth $1 million. Because they meet QSBS criteria
You could pay $0 in federal capital gains tax
And in many states, $0 in state tax as well
Compare that to the typical 20% federal long-term capital gains tax, plus state taxes, and you’ve saved hundreds of thousands of dollars
Limitations to Keep in Mind
While QSBS is incredibly powerful, it doesn’t apply in every situation. It generally does not apply to
Late-stage investments where the company exceeds the $50 million asset threshold
International companies
Public companies
Stock not held for the full five-year term
There is also a cap on the tax benefit: the greater of $10 million or 10 times your basis in the stock
Why Founders, Employees, and Angels Should Care
QSBS can be a life-changing benefit for people who
Take risks joining startups early
Invest at the seed or pre-seed stage
Choose to hold their equity long term
Are founders who structure their startups properly from the beginning
In a world where liquidity events are rare and hard-fought, every dollar counts. Knowing how QSBS works and planning around it can mean the difference between a decent return and a life-altering one
Final Thoughts
QSBS is one of the most entrepreneur and investor-friendly sections of the tax code. Yet, surprisingly few people take advantage of it or even know it exists
If you’re building, joining, or investing in a startup, make sure your legal and tax advisors understand QSBS and help you set up the right structures early
Startups are risky. This tax break rewards the risk-takers