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The Tax Break Most Founders Don't Know About
There is a provision in the US tax code that can exclude up to $10 million in capital gains from federal income tax. For stock acquired after July 4, 2025, the cap increases to $15 million. It applies per-issuer, meaning a founder with stock in multiple qualifying companies could exclude $15 million from each.
It's called QSBS: Qualified Small Business Stock, under IRC Section 1202.
It is a US tax benefit, so founders should not assume it applies unless they are a US person.
Despite the size of the benefit, most founders have never heard of it. And many who have heard of it don't realize that qualifying requires planning from the moment of incorporation, not at exit.
What QSBS Is and How It Works
QSBS is stock in a domestic C-corporation that meets specific requirements under Section 1202. Shareholders who meet the holding period and acquire stock at original issuance can exclude some or all of their capital gains from federal income tax when they sell.
Unlike many tax benefits, there is no special election required. If the stock qualifies and the holding period is met, the exclusion applies automatically.
The Key Requirements
Shareholder requirements:
- Must be a noncorporate taxpayer (individuals, trusts, estates, and partnerships qualify; C-corporations do not)
- Must acquire the stock directly from the corporation at original issuance (not on the secondary market)
- Must hold the stock for the required period
Corporation requirements:
- Must be a US C-Corporation at issuance, at sale, and for substantially all of the holding period
- Gross assets must not exceed $75 million at the time of issuance (for stock issued after July 4, 2025)
- At least 80% of assets must be used in a qualified active business
- Cannot be in a disqualified industry (health, law, financial services, banking, insurance, farming, hospitality)
The Holding Period
For stock acquired before July 5, 2025, the holding period is more than 5 years for the full 100% exclusion.
For stock acquired after July 4, 2025, a tiered system applies:
- 3 years: 50% exclusion
- 4 years: 75% exclusion
- 5+ years: 100% exclusion
The Dollar Cap
The exclusion is limited to the greater of:
- $15 million per issuer (for post-July 2025 stock), reduced by prior exclusions from the same issuer
- 10 times the aggregate adjusted basis of the stock sold in the taxable year
The 10x basis rule is powerful. If you contributed property worth $2 million to the corporation in exchange for stock, your 10x cap is $20 million, even if your tax basis is zero.
What Starts the Clock
The holding period begins at different points depending on how the stock was acquired:
- Stock purchases: The day after acquisition
- Stock options: The exercise date, not the grant date
- Restricted stock with 83(b) election: The date of the 83(b) election
- Gifts and inheritance: The recipient tacks on the transferor's holding period
This is why the 83(b) election matters so much for QSBS purposes. Filing the 83(b) within 30 days of receiving restricted stock starts the QSBS clock immediately. Without it, the clock doesn't start until each tranche vests, which can push the 5-year requirement years further out.
The Biggest Mistakes We See
Incorporating as an LLC first. Only C-corporation stock qualifies. If you incorporate as an LLC and later convert, the QSBS holding period begins at conversion. All the time the company existed as an LLC is lost.
Missing the 83(b) deadline. The 30-day window is absolute. No extensions, no exceptions. Missing it delays your QSBS clock by years.
Exceeding the gross asset cap before issuance. Once the corporation's gross assets exceed $75 million, any stock issued after that point does not qualify. This matters for later-stage companies planning additional equity issuances.
Secondary transfers between founders. If one founder transfers stock to another, the receiving founder does not get QSBS treatment on those shares. QSBS requires original issuance. A founder-to-founder transfer is a secondary sale, even at a nominal price.
Redemptions that trigger anti-churning rules. If the corporation redeems stock during the period around a QSBS issuance, the anti-churning rules under Section 1202(c)(3) can disqualify the stock. Exceptions exist for termination, death, disability, and divorce, but the rules are strict.
Strategies for Maximizing the Exclusion
Sell low-basis and high-basis stock together. The 10x basis cap is calculated annually. Selling both in the same year can dramatically increase the total exclusion.
Contribute appreciated property. For QSBS purposes, stock basis equals the fair market value of contributed property, not the tax basis. This inflates the 10x cap.
Gift QSBS to family members. Each recipient gets their own Section 1202 limitation. A shareholder with $40 million in potential gains could distribute stock across family members to shelter the full amount.
Incorporate before exceeding the asset cap. If a partnership is approaching the $75 million threshold, incorporating before crossing it preserves QSBS eligibility.
Corporate Transactions and QSBS
QSBS status can survive mergers and reorganizations under Section 368. In a qualifying reorganization, stock received in exchange for QSBS maintains its status even if the new corporation doesn't independently qualify.
The Section 1045 rollover allows taxpayers to defer gain on QSBS held for more than 6 months by reinvesting in new QSBS within 60 days. Unlike the Section 1202 exclusion, this requires an affirmative election on the tax return.
State Tax Considerations
Section 1202 is a federal provision. State tax treatment varies significantly. Some states conform to the federal exclusion. Others do not. California, for example, does not recognize the QSBS exclusion for state income tax purposes. A founder in California could still owe state capital gains tax even with a full federal exclusion.
The Bottom Line
QSBS is not an obscure loophole. It is one of the most powerful tax planning tools available to startup founders, and the 2025 OBBBA updates made it even more valuable.
But it requires planning from day one. The entity choice, the 83(b) election, the holding period, the asset cap, the anti-churning rules: all of these decisions compound over the life of the company.
We help founders structure their companies to qualify for QSBS from incorporation. If you're building a startup and haven't thought about Section 1202 yet, reach out.
