Key Takeaways

  • QSBS can allow founders, early employees, and investors to exclude up to $10M or 10× basis in federal capital gains—whichever is greater—if key requirements are met (C-corp, original issuance, ≤$50M gross assets at issuance, 5-year hold, active business).  
  • “qsbs founder stock” eligibility hinges on original issuance (stock received directly from the company) and the five-year holding period; secondary purchases typically don’t qualify.  
  • If you exit before 5 years, a §1045 rollover can keep the QSBS clock running by reinvesting proceeds into new QSBS within allowed timelines.  
  • In stock-for-stock acquisitions, previously “earned” QSBS gain can remain eligible even if the buyer isn’t a qualifying small business.
  • Excluded industries and passive-asset accumulation can jeopardize status; confirm the active business test and industry exclusions early.  
  • Conversions from LLC to C-corp: only the post-conversion gain can qualify going forward if all other rules are met.
  • Keep meticulous paperwork and investor reps around QSBS eligibility; many investors expect them in financing documents. 

What is Qualified Small Business Stock (QSBS)?

If you are a founder, angel investor, or an employee of a successful early-stage company, you need to be aware of certain qualifications that could help your investors protect up to $10 million from federal taxes. How so? The tax benefit is called the “Qualified Small Business Stock (QSBS) exclusion,” which is shorthand for a provision in Section 1202 of the Internal Revenue Code (IRC). This Section 1202 of the IRC outlines rules that potentially investors exclude from federal taxation the entire gain on the sale of Qualified Small Business Stock (QSBS). The gain exclusion is 50% for QSBS issued before February 18, 2009, and 75% for QSBS issued between February 18, 2009, and September 27, 2010.  The Creating Small Business Jobs Act of 2010 increased the exclusion to 100% of the total gain for all QSBS issued after September 27, 2010.  

Why QSBS matters for founders and early employees

For founders and early hires, qsbs founder stock can dramatically improve after-tax outcomes on a successful exit. If the company and the holder both meet Section 1202’s requirements, up to 100% of the gain may be excluded, capped at $10 million or 10× the original investment—whichever is higher. Besides benefiting you personally, clearly signaling QSBS eligibility can make your rounds more attractive to investors and potential hires.

General Overview

Section 1202 allows a taxpayer to exclude up to 100% of the eligible gain realized from the sale or exchange of QSBS issued after September 27, 2010. The QSBS must be held for more than five years to qualify for the exclusion. QSBS must be issued by a “qualified small business” and generally be acquired by the taxpayer at original issuance, either in exchange for cash or other property (not including stock) or as compensation for services rendered to the corporation (other than services an underwriter of the stock).  

Who is eligible for the QSBS exclusion? 

Generally, you can use the exclusion if:

  1. you have held the stock for at least five years;
  2. the stock was issued after August 10, 1993;
  3. the stock was issued by a domestic C corporation, with a max of $50 million of gross assets when the stock was issued;
  4. the company uses at least 80% of its assets in an active trade or business (“Active Business Test”), and
  5. you are a non-corporate taxpayer.

We often advise startup clients to think about qualifying for the QSBS exclusion by either incorporating as a qualifying C-Corp. or converting their limited liability company (LLC) to make investment from VCs more appealing. To qualify for the QSBS exclusion, investors will need a business that is properly structured, and they will need to plan for a multiyear investment 

Two related and important Section 1202 requirements consist of the following:

  • “Activity Business Test” - Whether the test has been satisfied; and
  • “80% Test” - Whether at least 80% of the corporation’s assets are used in the active conduct of one or more “qualified trades or businesses”.

Active Business Test

QSBS is only available if the corporation satisfies the “active business requirement” during substantially all of the stockholder’s holding period. The test will be satisfied if:

  • The issuer was a C corporation both when the QSBS was issued and when the QSBS was sold
  • During substantially all of the taxpayer’s QSBS holding period:
    • The corporation was a C corporation
    • At least 80% (by value) of the corporation’s assets were used in the active conduct of a trade or business
    • No more than 10% by value (in excess of liabilities) of the corporation’s assets consisted of stock or securities in corporations which are not subsidiaries

For purposes of this rule, assets actually should be used in start-up activities or research and development. No more than 10% (by value) of the corporation’s assets should consist of real estate or investments not used in the active conduct of a trade or business.

The “80% Test”

At least 80% (by value) of a corporation’s assets must be used in the active conduct of one or more qualified business activities (the “80% Test”).

This requirement is satisfied unless more than 20% of the corporation’s assets (by value) consists of the sum of

  • assets used in business activities that are not qualified trade or business activities, and
  • other assets held or used by the corporation for any purpose other than in the active conduct of a qualified trade or business. Included in this excluded category are investment securities, non-active business-related real estate and excess cash (subject to the exceptions described below for certain start-up activities).

Holding period & financing instruments (notes, SAFEs, options)

The 5-year holding period generally begins when you receive stock. Instruments such as convertible notes, SAFEs, or options typically start the QSBS clock when they convert or are exercised into stock, not when the instrument was first purchased or granted. Plan equity timing deliberately so employees and investors can reach the 5-year mark. 

Original issuance only—common traps to avoid

To qualify, shares must be acquired directly from the company (original issuance). Purchases from prior holders generally don’t qualify. Both common and preferred stock may qualify; however, S-corps and LLCs cannot issue QSBS—you need a domestic C-corporation at issuance. 

Benefit limits—$10M or 10× basis (and why basis matters to founders)

QSBS excludes gain up to the greater of $10,000,000 or 10× the stock’s adjusted basis. Founders often have a low basis on founder shares, which means the $10M cap is typically the more valuable limit in practice. Make sure you (and your tax preparer) can substantiate basis and track per-certificate eligibility over time.

What are the potential pitfalls?

First, the five-year requirement is critical. Second, Satisfying the 80% Test on a continuing basis during a taxpayer’s QSBS holding period is one of the most difficult Section 1202 requirements. The determination of whether a corporation has met the 80% Test during a stockholder’s entire QSBS holding period requires both a constant look at the current nature of the corporation’s business activities and a determination of whether the corporation ever experienced a disqualifying accumulation of non-active business-related assets. Third, there are legal and financial caveats to consider when electing to become a C-Corporation. To take advantage of the benefit the investor will have to sell the stock. Buyers generally want to buy assets because with stock, they inherit any liabilities and prior issues.  Finally, if you don’t meet the 5-year requirement, you may still be able to save the benefit. 

Missed the 5-year mark? Use a §1045 rollover

Exiting early doesn’t always kill the benefit. Section 1045 lets you roll proceeds from QSBS held >6 months into replacement QSBS within allowed timelines so the 5-year clock keeps ticking. This can preserve eventual 1202 exclusion on a later sale of the replacement stock. 

M&A tip—stock-for-stock deals can preserve your “earned” exclusion

In a stock-for-stock acquisition where your QSBS is exchanged for non-qualifying buyer stock, your already-earned QSBS gain can remain excludable on a later sale of the buyer stock (subject to caps). This preserves hard-won tax benefits through the deal.

Who benefits from Section 1202?

If you’re already a C-Corporation, you should take advantage of this provision in relation to conveying to investors that you have met the requirements from the company’s end. Investors will need to make sure that the appropriate steps have been followed when it’s time to sell the stock. 

If you are a startup founder looking to set up a new company today that will have outside investors, Section 1202 should be one of the important parts in dealing with and deciding how to best structure of your entity. Founders and legal advisors should review the business model, the investors, goals, exit strategy, timeline, etc. to make a choice on the best entity structure.

Founder & investor checklist (what to document now)

  • Gross-assets at issuance (≤$50M, including cash and assets at original cost).
  • Active-business substantiation and industry qualification.
  • Original-issuance evidence per holder; avoid secondary transfers.
  • Cap table flags noting which certificates are QSBS-eligible and the basis used for cap calculations.
  • Investor representations & warranties about QSBS in financing documents, plus internal recordkeeping (stock certificates, board approvals, financials) to support eligibility.  

If you want help evaluating eligibility or drafting QSBS representations for your next round, you can find an experienced startup attorney on UpCounsel.

Frequently Asked Questions

  1. Does qsbs founder stock apply to both common and preferred shares?
    Yes—if all other requirements are met and the shares were originally issued by a qualifying domestic C-corp.
  2. My company started as an LLC—can we still benefit?
    Possibly. After converting to a C-corp, only post-conversion gain can qualify (assuming other rules are met).
  3. What if I sell before five years?
    Consider a §1045 rollover to replacement QSBS; it can preserve your timeline toward the 5-year requirement.
  4. Which industries are typically excluded?
    Services like healthcare, law, finance, and certain hospitality and passive-income businesses are commonly excluded under §1202.
  5. What documents should I keep to support QSBS?
    Maintain stock certificates, board approvals, financials, cap-table annotations, and transaction records to prove original issuance, gross-asset levels, and active-business status.

If you need help with understanding qsbs founder stock, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.