Qualified small business stock: What founders need to know

For startup founders, investors and early employees, timing and corporate structure can make a multimillion-dollar difference when it comes to taxes. One of the most powerful tools is qualified small business stock (QSBS) — shares issued by eligible C corporations that offer significant federal tax exclusions on capital gains. Recent updates under the One Big Beautiful Bill Act (OBBBA) have expanded the potential benefits, making QSBS even more attractive to those who invest early in qualified U.S. businesses. The incentive is designed to promote entrepreneurship and long-term investment, but taking full advantage of it requires advance planning, accurate tracking and strict compliance with IRS rules.

What is qualified small business stock?

Qualified small business stock refers to shares in a U.S.-based C corporation that meet specific conditions under Section 1202 of the Internal Revenue Code. Only companies in some industries qualify, including those in technology, manufacturing or retail. Financial services, hospitality and professional services are typically excluded.

This provision primarily benefits those who take on early-stage risk, such as founders, early employees granted equity and angel investors. When structured properly, QSBS can offer substantial federal tax exclusions on capital gains, potentially shielding millions in proceeds from taxation. Because eligibility depends on both the company’s characteristics and how the stock is issued and held, early planning is critical when structuring equity grants or financing rounds.

How to qualify for QSBS

To take advantage of the potential tax benefits of QSBS, both the company and the stock itself must meet specific IRS requirements. These criteria, including how long the stock must be held and how much gain can be excluded, were significantly updated under the One Big Beautiful Bill Act (OBBBA), which introduced new rules for stock acquired on or after July 4, 2025. The IRS requirements can significantly impact a founder’s or investor’s ability to claim the exclusion, so understanding them upfront is key.

Core Requirements (Apply to All QSBS):

Regardless of when the stock is acquired, the following conditions must be met:

• The company must be a U.S.-based C corporation
• The stock must be originally issued (not purchased on secondary markets).
• At least 80% of the company's assets must be used in the active conduct of a qualified trade or business
• Certain industries are excluded, including finance, law, consulting, hospitality and others that rely heavily on personal skill or reputation

If Stock Was Acquired Before July 4, 2025:

• Holding period: Must be held for at least 5 years to qualify.
• Exclusion amount: Up to 100% of capital gains may be excluded.
• Gain cap: The greater of $10 million or 10× the original investment.
• Gross asset test: The company must have had no more than $50 million in gross assets at the time of issuance.

If Stock Is Acquired On or After July 4, 2025

• Holding period: Tiered exclusions apply

• 3 years → 50% exclusion
• 4 years → 75% exclusion
• 5 years → 100% exclusion (as under prior law)

• Exclusion amount: Up to 100% of capital gains may be excluded (unchanged under both pre- and post-July 4 rules).
• Gain cap: Increased to $15 million (indexed for inflation starting in 2027) or 10× the original investment, whichever is greater.
• Gross asset test: The company must have no more than $75 million in gross assets at the time of issuance.

Under the expanded rules, founders should seek to structure their company and early fundraising rounds with an eye toward QSBS eligibility. However, the old rules still apply for stock acquired before July 4, 2025. Founders, employees, and investors who hold pre-July 4 QSBS must still meet the legacy requirements to claim the federal capital gains exclusion. Additionally, simple agreements for future equity (SAFEs) and convertible notes may not qualify depending on how and when they convert into QSBS. It's critical to confirm QSBS eligibility, ensure that the company qualified at the time of issuance, and that your holding period is tracked accurately.

Benefits of QSBS

The standout benefit of QSBS is the potential to exclude up to 100% of federal capital gains tax on eligible stock sales. For stock acquired on or after July 4, 2025, this applies to the greater of:

• Up to $15 million in gains (for stock acquired on or after July 4, 2025)
• 10 times what you originally paid for the stock

For example, if a founder pays $1 million for QSBS shares, holds them for five years and then sells for $12 million, up to $11 million in gains (the higher of $15 million cap or 10× basis) could potentially be excluded from federal taxes, resulting in a tax savings of $2 million or more, depending on the applicable capital gains rate.

That kind of tax shield can be transformative for founders, enabling them to reinvest in new ventures or allocate proceeds to philanthropic or family wealth planning.

How to acquire QSBS

Founders and early stage employees typically receive or acquire QSBS when the startup is incorporating. Equity grants or purchases have to be structured and exercised properly to qualify for the tax benefit. Founders are required to:

• Incorporate as a C corporation: QSBS only applies to C corps. Many startups default to Delaware C corps for this reason, because of their favorable legal framework.
• Issue stock early: Founders should issue stock as early as possible, ideally at a low valuation, to maximize potential gains.
• Use proper documentation: This includes board resolutions authorizing the stock issuance, signed stock purchase agreements, stock certificates, cap tables and proof of payment.
• Track holding periods: Diligently ensure the minimum five-year holding requirement by maintaining records and any relevant vesting or transfer events.
• Maintain corporate and financial records: Demonstrate the company's asset levels and business activities were below the $75 million threshold at the time of issuance (for stock acquired on or after July 4, 2025).

Angel investors and venture capitalists can also acquire QSBS when investing in priced equity rounds, assuming the issuing company qualifies.

How to sell and use the QSBS exemption

When it comes time to sell, proper documentation is again key. The IRS doesn't require special filings when acquiring QSBS, but you must report any gains from the sale using Form 8949 and Schedule D of your federal tax return.

To protect the exemption:

• Confirm the company remained a qualified small business throughout your holding period, including meeting updated asset thresholds.
• Keep detailed records documenting when and how you acquired the stock. The stock must meet QSBS requirements both at issuance and at the time of sale.
• If you plan to defer gains, consider using the Section 1045 rollover, which allows you to reinvest proceeds into another QSBS-qualified company within 60 days.
• Work closely with your private banker and tax professionals on documentation, elections and strategic planning — especially if you're rolling over proceeds or managing trust and estate matters.

What else to know about QSBS

Additional rules and strategies can significantly impact your potential tax savings. From how state laws treat QSBS to advanced planning techniques, it's worth understanding these factors early on:

• There are limits. The federal QSBS exemption applies per issuer, per taxpayer. This means married couples who acquire stock separately may each claim their own exclusion, potentially doubling the benefit. Under recent law changes, the exclusion cap increased to up to $15 million (indexed for inflation).
• It's a federal benefit. Many states, including New York and California, do not conform to federal QSBS rules. State tax treatment varies and should be reviewed separately with local tax advisers to understand any additional filing requirements or limitations.
• Advanced strategies exist. "Trust stacking" enables QSBS owners to gift shares into one or multiple trusts for different beneficiaries, potentially multiplying the federal tax benefits. These strategies are complex and should be developed in partnership with experienced advisors.

Make QSBS work for you

QSBS can be a game-changer, but only if you set the groundwork early. It's not just about saving on taxes. It's about setting up your business with a clear eye on the future.

Citizens Private Bank helps founders navigate complex financial and tax landscapes, including QSBS qualification and planning. Whether you’re raising your first round or eyeing an exit, we’re here to support you every step of the way.