Qualified Small Business Stock (QSBS)
Qualified small business stock
Megan Slatter
March 20, 2023

An Overview and Company Qualifications

Internal Revenue Code Section 1202 provides a potentially powerful tax benefit to business owners and investors looking to exit a business,  commonly referred to as the qualified small business stock (QSBS) exemption. Under certain circumstances, a taxpayer may be eligible to eliminate  tax on all or part of their gain from the sale of QSBS. Entrepreneurs often have a great idea but may not have the start-up capital or experience running and growing a business. While early-stage investing offers a lot of potential, it also comes with significant risk. QSBS was created to incentivize investment and attract talent in the early stages of a company. The potential benefits of QSBS treatment are considerable:

  • Up to 100% exclusion of federal capital gains. Not all states conform to Federal QSBS treatment, and investors should confirm tax treatment eligibility at a state level.
  • The option to roll and defer taxable gains through reinvesting in other QSBS companies.
  • Capturing multiple exclusions through careful planning and the use of gifts and transfers.
  • QSBS isn’t just for founders! Any taxpayer can take advantage of the benefit – including private equity investors or employees holding an interest in a qualified company as individuals, partnerships, S-corps, estates & trusts.

The maximum amount a shareholder may exclude from the taxable gain on a sale of QSBS is $10 million or ten times the shareholder’s adjusted tax basis, whichever is greater The tax benefits vary based on when you acquired your stock:

  • 8/10/93 – 2/17/09: 50% of gain can be excluded.
    • 2/18/09 – 9/27/10: 75% of gain can be excluded.
    • After 9/27/10: 100% of gain can be excluded.
    • Exclusions available for venture capital fund investors, known as a Limited Partner, or LP, operate on a per-LP and per-company profit distribution basis.

Sec 1202 Gain Exclusion Requirements

An investor must confirm their stock is obtained from a Domestic C-Corporation and is considered original issue shares, meaning you purchased or received them directly from the company (or through an underwriter). Section 1202(h)(2) lists exceptions to the original issuance requirement. Before selling their stock, an investor must hold it for at least five years to qualify for QSBS treatment. There are many considerations for when that five-year window starts, especially if the asset is something other than stock, like RSUs or Grants.

Company Requirements

In addition to being a domestic C-Corporation, a company must also meet the following requirements to be eligible to issue QSBS stock:

  • The corporation must be engaged in a qualified trade or business (holding companies do not qualify)
  • Its aggregate gross assets must be less than $50MM at all times before and immediately after issuance of the stock
  • At least 80% of the corporation’s assets must be used in its qualified business activities

Qualified Business

The company must be engaged in a qualified trade or business activity. The qualified eligibility requirements are broad; most businesses will be considered eligible if not on the IRS’s list of excluded business types. Some of these exclusions include businesses that rely on an individual or team of professionals, for example, CPA firms or medical practices (see IRC Section 1202 for the complete list of exclusion criteria). Additionally, specific industries, such as brokerage, hospitality, restaurants, and mining, do not qualify. If a company manufactures or develops a product, it will likely meet the qualified business requirement. Confirming compliance with this requirement can be difficult depending on the business’s product and often requires additional exploration.

Small Business – Gross Assets cannot exceed $50 million

The small business requirement is satisfied when the company’s aggregate gross assets (not to be confused with the company’s fair market value) do not exceed $50 million; this includes the time immediately before and after issuing QSBS. If the company’s assets exceed the $50 million threshold, the business will not qualify for QSBS in the future. However, any QSBS issued before crossing that threshold will still be eligible. This becomes particularly important when navigating RSUs or stock grants (the exclusion may be lost if the units are converted to stock after exceeding the $50 million threshold). A company’s aggregate gross asset amount must include cash, contributed property, and assets on an aggregate adjusted basis. Contributed property is segregated from other assets because it is valued at its fair market value on the contribution date. This is so shareholders can’t contribute highly valued property with a low-cost basis to circumvent the $50 million threshold. Using the aggregate adjusted basis for the company’s remaining assets is helpful because this amount will typically be lower than the asset’s current value. Intangibles and goodwill are also included as assets on the company’s balance sheet. Once the business has exceeded the $50 million limit, they no longer qualify for future QSBS issuance, even if the assets dip below $50 million. However, any QSBS previously issued does not lose its status.. Therefore, a company should be mindful when raising capital that any capital payments received with the issuance of QSBS do not push the aggregate gross assets over the limit. For example, suppose the company currently has $45 million in gross assets and raises an additional $7 million. In that case, this series of funding no longer qualifies for QSBS status since the assets exceed $50 million.

Active Business – At least 80% of its assets must be used in that qualified trade or business activity

Achieving the active business requirement is typically met when at least 80% of the assets are used in the business’s “active conduct of one or more qualified trades or businesses.” The rule requires that the active requirement is met during “substantially all“of the investor’s holding period. So, while the 80% test is measured at the company level, how long is determined at the shareholder level. Because there is no clear guidance on what qualifies as “substantially all,” it is advised that as long as a company has shareholders actively trying to qualify for the QSBS benefits, it should continuously meet the active business requirement. If the company no longer reaches the active business requirement, it risks disqualifying the exemption for any QSBS stock still held by a shareholder. Since maintaining the active business requirement is critical, it’s essential to be aware of the pitfalls that could eliminate this qualification, typically through ownership in subsidiaries or holding too much stock, cash, or real estate.

Working Capital Needs & Subsidiaries

Since most of the assets in the business must be used by the corporation in its activities, maintaining too much working capital risks disqualification. Part of the active business requirement includes a “working capital needs” test to discourage a company from holding too many investment assets. Cash and investment assets can be included in the 80% rule when they will be used towards the working capital needs over the business’s next operating cycle or used within two years to finance research and experimentation. However, once a company is over two years old, it cannot have more than 50% of its assets applied toward the working capital exception. This can be tricky to manage when a company raises too much capital after its second anniversary- it may find itself with too much cash on hand. Additionally, the company will fail the active business requirement when more than 10% of its assets are real property not used in the business’s qualified activities. Owning, dealing in, or renting real property cannot be counted towards the 80% requirement. If a company owns at least 50% of a subsidiary, then the subsidiary’s assets and business will be factored into the active business qualification. Finally, when more than 10% of a company’s net assets include stock or securities in non-subsidiaries and do not qualify under the working capital exception, they will fail the active business requirement. The bottom line is that holding too much cash, investments and real estate, or ownership in subsidiaries can disqualify the exemption. Therefore, a corporation needs to monitor the 80% asset test on an ongoing basis.

Stock Redemptions

Often, a company will satisfy all the QSBS requirements and inadvertently disqualify the exemption due to a “significant” redemption of shares. The impact of an exemption disqualification can range from a single shareholder to all of the stock issued during a two-year window. Companies are subject to material thresholds surrounding the timeline, quantity, and individuals from which they can repurchase shares. Typical examples that could jeopardize the exemption are when a founder or prominent investor redeems stock, or a company is trying to clean up its cap table. The spirit of the QSBS rule is to help small companies get access to cash to help them grow, and this part of the rule intends to prevent a company from redeeming and reissuing QSBS stock or using its assets toward stock buybacks. There are a few exceptions when a company can repurchase shares without impacting its QSBS exemption. They are linked to the termination of an employee or director, death, disability or mental incompetency, or divorce. Since there are several nuances around redemption criteria, a company should evaluate each and work with their tax or legal professional before entering into a repurchase transaction.


Good documentation is essential after determining your company will issue QSBS-eligible stock. The IRS doesn’t require documentation when making the Section 1202 election on an investor’s tax return; however, you will be expected to provide supporting documentation if audited. As QSBS’s popularity increases, IRS scrutiny is expected to increase. Maintaining a documented paper trail along your company’s life cycle confirming the QSBS criteria were met throughout the process supports shareholders electing the tax exemption at the exit.


Rigorous eligibility requirements must be met to qualify for QSBS treatment. Companies must become familiar with these requirements; otherwise, they risk jeopardizing their team and investors’ QSBS exemption. Section 1202 has several inconsistencies, and little case law or IRS guidance has been issued. This makes planning critical otherwise, qualifying for QSBS treatment may be challenging or unavailable. However, with proper planning, using QSBS could save someone millions of dollars in taxes. This article highlights some common pitfalls a company should be aware of, but it is not an exhaustive list and should not be relied on for legal or tax advice. Consulting with a professional is vital to get the best guidance on this valuable but complex tax benefit.

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