Nerdy takeaways
- QSBS lets shareholders of qualified small businesses realize capital gains without paying taxes.
- There are strict definitions of a qualifying small business.
- As the investor, you must meet specific shareholder criteria.
- Benefits include attracting long-term investors with tax incentives.
Small businesses are the heart of the American economy, employing nearly half of the country's workforce, according to the U.S. Chamber of Commerce. The organization says that over five million new small business applications are filed annually.
Although many don’t succeed, if you’re able to invest in a small business that does — especially a company that falls under the qualified small-business tax exemption — the potential returns and tax benefits could make the risk worth taking.
What is qualified small-business stock (QSBS)?
Qualified small business stock (QSBS) is specially designated stock (also known as Section 1202 stock) that permits shareholders to exclude a significant portion of capital gains tax on the profit from selling or exchanging that stock if they hold the shares for a long time.
For example, say you discover a startup with a business concept likely to disrupt and revolutionize its industry. You invest $100,000 in the business and receive QSBS in return. The business takes off and you’re able to liquidate your shares for $1 million six years later. Because the shares are QSBS shares, you may be able to pocket the $900,000 profit without paying any capital gains taxes.
The idea behind the QSBS tax benefit is to promote investment in small businesses and startup ventures in order to grow the economy. Investors and employees or founders of small businesses typically own QSBS.
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ADAdvertisementHow much is the QSBS exemption?
How much QSBS profit you can exclude from capital gains tax depends on when you bought the shares, how long you held them and how much QSBS profit you made.
For QSBS shares acquired | Portion of profits you can exclude from capital gains tax | Maximum you can exclude |
|---|---|---|
On or before July 4, 2025 | 50% if you hold for at least 5 years | $10,000,000 ($5,000,000 if married filing separately) |
After July 4, 2025 |
| $15,000,000 ($7,500,000 if married filing separately); adjusts annually for inflation |
Which small businesses qualify for the QSBS exemption?
In order to issue QSBS, the company must meet the following requirements:
- The business must be an active domestic C-corp. The company must be incorporated in the U.S. as a C corporation; S corporations are not permitted. The corporation also must be actively engaged in business operations (as opposed to being a holding company).
- The company’s assets must be under the limit before and immediately after the issuance. The limit in 2026 is $75,000,000.
- The business must not involve prohibited industries. Prohibited industries are personal services; banking, financing, insurance, investing or leasing; farming; mining; and running a hotel, motel or restaurant. Examples of industries that generally qualify include technology, wholesale or retail and manufacturing.
- The business must issue the stock directly. Known as the original issuance rule, the stock must be acquired directly from the issuer either in exchange for cash or property or as compensation. Employee benefits such as restricted stock units (RSUs), options and convertible securities are allowed, but acquiring stock from another person or through the secondary markets is not.
🤓Nerdy Tip
As part of wealth transfer and charitable giving, the IRS provides an exception that enables QSBS to be gifted, subject to certain rules.What is the 80% rule for QSBS?
Small-business founders and employees will want to pay careful attention to an additional rule — the active business test. This requires that at least 80% of the assets of the corporation (by value) are used in the conduct of one or more qualified trades or businesses.
"The 80% can include working capital, investments expected to finance research and experimentation or increased working capital within two years," says Mark Luscombe, principal federal tax analyst at Wolters Kluwer, a global information and software services company. "After the corporation exists for two years, no more than half of its assets can be working capital or investments held for future research or working capital."
Businesses that want to take advantage of the exemption also need to be cautious about where they invest or save that capital and the other 20% of their assets.
"Portfolio securities, which are stocks in a non-subsidiary corporation that are not investments held for future research or working capital, cause the corporation to fail the active business test for any period during which they constitute more than 10% of its net worth," explains Luscombe. "It might be best, therefore, to avoid volatile securities that might increase quickly in value."
Instead, small businesses with cash to save or invest often take advantage of short-term, high-yield government debt options like Treasury bills and Treasury accounts.
- You cannot be a corporation. Only individuals, trusts or pass-through entities can benefit from the qualified small-business stock exemption.
- You must satisfy a holding period. In order to get the favorable tax treatment, you have to hold the shares for at least three years (and possibly longer, depending on when you bought the shares). See the table above.
- There is a maximum gain cap. A shareholder can exclude any gain up to the greater of 10 times the adjusted cost basis — which is the original asset value of the investment — or $10 million.
- You may be able to defer your gain. Shareholders wanting to sell stock prior to holding it for five years can still receive tax benefits as long as the original qualified small-business stock was held for longer than six months and all proceeds are reinvested into another QSBS within 60 days.
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Qualified small business stock pros and cons
Pros
Valuable tax advantages
Helps attract talent
Helps raise capital
Preserves cash
Cons
Complex compliance requirements
Considerable due diligence required
Advantages of QSBS
- Potentially tax-free gains. Avoiding capital gains tax can save thousands or even millions of dollars.
- May help with hiring. Being able to offer such large tax incentives means that qualifying corporations can attract investors and leverage stock as employee benefits to recruit and retain talent.
- May help raise capital for growth. For small businesses hoping to drum up additional funding, issuing QSBS can appeal to individual investors and encourage investors to become longer-term shareholders.
- Preserves cash. For small businesses in a growth phase, often cash can be scarce. Using stock options and RSUs as part of employee compensation packages can lure key talent and act as motivation for employees to take ownership.
Disadvantages of QSBS
Beyond dotting your i's and crossing your t’s with the requirements outlined above, there can be situations that muddy the waters with QSBS.
- Compliance can be difficult. Qualifying small businesses should be vigilant when it comes to redeeming shares (when the company forces shareholders to sell stock back to the company). Too many redemptions could invalidate the remaining stock from QSBS eligibility. "There is always the risk to investors that the corporation will cease to qualify as a QSBS due to a violation of one of the rules," says Luscombe. "It is also somewhat burdensome to constantly monitor to make sure the QSBS rules are not violated."
- Requires more due diligence for investors. As a shareholder, consulting with tax, investment and legal advisors with expertise in qualified small-business stock can help ensure you’re aware of all the rules and investing in corporations that qualify for this exemption. There are other factors to keep in mind, such as alternative minimum tax and obtaining the appropriate documentation. Working with a knowledgeable team of advisors can help provide peace of mind that you’ve thoroughly and thoughtfully considered all of the details when formulating your investment plan.
Article sources
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- 1.U.S. Chamber of Commerce. Small Business Data Center. Accessed Oct 31, 2025.
- 2.U.S. Small Business Administration. Qualified Small Business Stock: What Is It and How to Use It. Accessed Oct 31, 2025.
- 3.Congress.gov. H.R.1 - One Big Beautiful Bill Act 119th Congress (2025-2026). Accessed Oct 31, 2025.
- 4.Congressional Research Service. Small Business Tax Benefits: Current Law. Accessed Oct 31, 2025.
- 5.Cornell Law School Legal Information Institute. 26 CFR § 1.1202-2 - Qualified small business stock; effect of redemptions. Accessed Oct 31, 2025.
