Qualified Small Business Stock, commonly known as QSBS, is one of the most valuable tax incentives available to founders, early employees, and investors in high-growth companies. Under Section 1202 of the Internal Revenue Code, eligible shareholders may exclude a significant portion, and in many cases up to 100 percent, of the gain from a qualifying stock sale from federal income tax, provided specific requirements are satisfied.
In practical terms, QSBS can transform a successful exit into a far more tax-efficient outcome, sometimes saving millions of dollars. The key is recognizing and preserving the opportunity early, often at formation or during initial funding rounds.
What Is QSBS?
QSBS rewards early investment in U.S. growth companies. When qualifying shareholders sell eligible stock after meeting the holding-period requirement, some or all of the gain may be excluded from federal tax. Because the benefit applies on a per-taxpayer, per-company basis, the potential savings can be substantial for founders, early investors, and key employees.
Unlike strategies that rely on last-minute structuring, QSBS eligibility is shaped by decisions made years before an exit, including entity selection, capitalization, and business activities.
Why QSBS Matters
Taxes often represent one of the largest costs of a liquidity event. Federal capital gains tax can approach 20 percent or more, with state taxes adding further impact. QSBS can dramatically reduce that burden by excluding qualifying gains, increasing after-tax proceeds without altering deal economics.
Who May Benefit?
QSBS generally applies to non-corporate shareholders, including: Founders; Early-stage investors; Key employees who receive equity compensation; Certain trusts and estates.
Corporations typically do not qualify for the exclusion, making ownership structure an important planning consideration.
High-Level Requirements to Qualify
The Company Must Be a U.S. C Corporation. QSBS applies to stock issued by domestic C corporations. S corporations and partnerships generally do not qualify, making entity choice a critical early decision.
The Stock Must Be Acquired at Original Issuance. Shareholders usually must receive stock directly from the company, rather than from another investor, whether in exchange for cash, property, or services.
The Company Must Meet Size Limits at Issuance. The business must fall below certain asset thresholds when the stock is issued. Many early-stage companies meet these requirements even if they later grow significantly.
Active Business Requirement. For most of the holding period, the company must deploy the majority of its assets in an active trade or business. Certain service-based industries, including law, accounting, consulting, and healthcare, are generally excluded.
Minimum Holding Period. To capture the full benefit, shareholders typically must hold qualifying shares for at least five years.
Common Pitfalls
QSBS is powerful, but not automatic. Common missteps include selecting an entity structure without considering exit goals, issuing equity without tracking QSBS status, business changes that disqualify the company, and identifying QSBS opportunities only after a sale process begins. Once a letter of intent is signed, it is often too late to correct these issues.
The Importance of Early Planning
QSBS strategies work best when tax advisors are involved early, at formation, during funding rounds, and at major ownership changes. Maintaining documentation and periodically reassessing eligibility can help preserve this benefit and prevent costly surprises.
Final Thoughts
QSBS remains one of the most favorable incentives available to entrepreneurs and early investors, but it rewards foresight, not hindsight. With proper planning, it can meaningfully increase after-tax exit proceeds and improve transaction outcomes.
At SingerLewak, we work with founders, investors, and growing businesses to evaluate QSBS eligibility, uncover planning opportunities, and position companies for tax-efficient exits. If you are building or investing for long-term growth, now is the time to ensure QSBS is part of the conversation.
