QSBS Basics & Overview: Understanding Qualified Small Business Stock

Qualified Small Business Stock (QSBS) is a powerful tax benefit available to investors in eligible small businesses. Under Internal Revenue Code Section 1202, taxpayers may exclude from federal income tax a significant portion—and in some cases, all—of the capital gains realized from the sale of QSBS, provided certain requirements are met.

This page provides a comprehensive overview of QSBS, including what it is, how it works, key eligibility requirements, and the tax benefits available to qualifying investors.

What is Qualified Small Business Stock (QSBS)?

Qualified Small Business Stock (QSBS) refers to stock issued by a qualified small business that meets specific statutory requirements set forth in IRC Section 1202. The QSBS provisions were originally enacted in 1993 as part of the Revenue Reconciliation Act of 1993 to encourage investment in small businesses.

Statutory Definition

Section 1202(c) defines "qualified small business stock" as stock in a C corporation that:

1. Is originally issued after August 10, 1993 (the date of enactment of the Revenue Reconciliation Act of 1993) [IRC §1202(c)(1)]
2. Is issued by a corporation that qualifies as a "qualified small business" as of the date of issuance [IRC §1202(c)(1)(A)]
3. Is acquired by the taxpayer at its original issue (directly or through an underwriter) in exchange for money or other property (not including stock), or as compensation for services provided to the corporation (other than services performed as an underwriter) [IRC §1202(c)(1)(B)]

Important Note: The stock must be acquired at original issue. Stock purchased on the secondary market does not qualify as QSBS, even if the issuing corporation otherwise meets the qualified small business requirements.

The Tax Benefit: Capital Gains Exclusion

The primary benefit of QSBS is the ability to exclude capital gains from federal income tax. The exclusion percentage depends on when the stock was acquired and how long it has been held.

Exclusion Percentages

For Stock Acquired on or Before the "Applicable Date" (Currently July 4, 2025):

• 50% exclusion if held for more than 5 years [IRC §1202(a)(1)(A)]

For Stock Acquired After the "Applicable Date":

The exclusion percentage is based on holding period (the "applicable percentage"):

• 50% exclusion if held for at least 3 years but less than 4 years
• 75% exclusion if held for at least 4 years but less than 5 years
• 100% exclusion if held for 5 years or more [IRC §1202(a)(1)(B), (a)(5)]

Historical Exclusion Percentages:

• Stock acquired between February 18, 2009, and September 27, 2010: 75% exclusion if held for more than 5 years [IRC §1202(a)(3)]
• Stock acquired after September 27, 2010, and on or before the applicable date: 100% exclusion if held for more than 5 years [IRC §1202(a)(4)]

Per-Issuer Limitations

The exclusion is subject to significant dollar limitations:

For Stock Acquired on or Before the Applicable Date:

• Limited to $10 million (or 10 times the taxpayer's adjusted basis in the QSBS, if greater) per issuer [IRC §1202(b)(1), (b)(4)(A)]

For Stock Acquired After the Applicable Date:

• Limited to $15 million (or 10 times the taxpayer's adjusted basis in the QSBS, if greater) per issuer [IRC §1202(b)(1), (b)(4)(B)]
• This amount is adjusted for inflation beginning in 2027 [IRC §1202(b)(5)]

Note: These limits apply on a per-issuer basis, meaning a taxpayer can potentially exclude gains from multiple different QSBS issuers, subject to each issuer's separate limit.

Key Eligibility Requirements

1. Qualified Small Business Requirements

The issuing corporation must meet several requirements to qualify as a "qualified small business":

Corporate Status:

• Must be a domestic C corporation (S corporations, partnerships, LLCs, and other entities do not qualify) [IRC §1202(e)(4)]

Asset Test:

• The corporation's aggregate gross assets must not exceed $75 million (as of the applicable date; previously $50 million) at all times from August 10, 1993, through the date of stock issuance [IRC §1202(d)(1)(A), (d)(1)(B)]
• Aggregate gross assets immediately after the issuance (including amounts received in the issuance) must not exceed $75 million [IRC §1202(d)(1)(B)]

Active Business Requirement:

• At least 80% (by value) of the corporation's assets must be used in the active conduct of one or more qualified trades or businesses [IRC §1202(e)(1)(A)]
• The corporation must be an "eligible corporation" (which excludes certain types such as DISCs, RICs, REITs, REMICs, and cooperatives) [IRC §1202(e)(1)(B), (e)(4)]

Qualified Trade or Business:

• The business must not be in certain excluded industries, including:
  • Professional services (health, law, engineering, architecture, accounting, consulting, etc.)
  • Financial services (banking, insurance, financing, leasing, investing)
  • Farming
  • Natural resource extraction
  • Hospitality (hotels, motels, restaurants) [IRC §1202(e)(3)]

2. Stock Acquisition Requirements

• Must be acquired at original issue (directly from the corporation or through an underwriter) [IRC §1202(c)(1)(B)]
• Must be acquired in exchange for money or other property (not stock), or as compensation for services [IRC §1202(c)(1)(B)]

3. Holding Period Requirements

• For stock acquired on or before the applicable date: Must be held for more than 5 years to qualify for exclusion [IRC §1202(a)(1)(A)]
• For stock acquired after the applicable date: Must be held for at least 3 years (with exclusion percentage increasing based on holding period up to 5 years) [IRC §1202(a)(1)(B), (a)(5)]

4. Taxpayer Eligibility

• Only available to taxpayers other than corporations (individuals, trusts, estates, and certain pass-through entities) [IRC §1202(a)(1)]
• C corporations cannot claim the Section 1202 exclusion

Special Rules and Exceptions

Redemption Restrictions

Stock will not qualify as QSBS if the issuing corporation makes certain redemptions:

• Redemptions from the taxpayer or related persons during a 4-year period beginning 2 years before issuance [IRC §1202(c)(3)(A)]
• Significant redemptions (more than 5% of aggregate stock value) during a 2-year period beginning 1 year before issuance [IRC §1202(c)(3)(B)]

See [Reg. 1.1202-2] for detailed rules on redemptions and de minimis exceptions.

Pass-Through Entity Treatment

Section 1202(g) provides special rules for QSBS held through partnerships, S corporations, regulated investment companies, and common trust funds. Gains from the sale of QSBS by these entities may flow through to their owners and qualify for the exclusion if the owner held an interest in the entity when the QSBS was acquired and continuously until disposition. [IRC §1202(g)]

Important: Partners holding QSBS through partnerships should be aware of the capital interest limitations in Section 1045 regulations, which may affect rollover benefits (see discussion in related pages).

Transfers and Conversions

Section 1202(h) provides rules for transfers by gift, transfers at death, and certain corporate reorganizations that allow QSBS status to be preserved in many cases.

Relationship to Section 1045 Rollovers

Section 1045 provides a related benefit allowing taxpayers to defer gain from the sale of QSBS by rolling the proceeds into replacement QSBS within 60 days. Section 1045 uses the same definition of "qualified small business stock" as Section 1202 [IRC §1045(b)(1)].

Recent Legislative Changes

The "applicable date" referenced throughout Section 1202 refers to July 4, 2025, the date of enactment of recent legislation (Pub. L. 119-21) that made significant changes to QSBS provisions, including:

• Increased the gross asset threshold from $50 million to $75 million
• Increased the per-issuer exclusion limit from $10 million to $15 million (for post-applicable date stock)
• Introduced tiered exclusion percentages based on holding period (for post-applicable date stock)

Key Takeaways

1. QSBS provides significant tax benefits: Up to 100% exclusion of capital gains, subject to per-issuer dollar limits

2. Strict eligibility requirements: Must meet corporate, asset, business, and acquisition requirements

3. Original issue requirement: Stock must be acquired at original issuance, not on the secondary market

4. Holding period matters: Generally requires at least 3-5 years of holding, depending on acquisition date

5. Per-issuer limits apply: $10 million or $15 million limit per issuer (depending on acquisition date)

6. Planning is critical: Investors should verify QSBS eligibility at the time of investment and maintain proper documentation

Sources and Citations

All factual statements in this page are verified against the following primary sources:

• IRC Section 1202: Internal Revenue Code Section 1202, as amended through 2025
• IRC Section 1045: Internal Revenue Code Section 1045 (rollover provisions)
• Reg. 1.1202-2: Treasury Regulation 1.1202-2 (redemption rules)
• Pub. L. 119-21: Public Law 119-21 (2025 legislation establishing "applicable date" and related changes)

Verification Date: January 2025

Note: This page reflects the law as of January 2025. Tax law changes frequently, and this information should not be construed as legal or tax advice. Consult with a qualified tax professional regarding your specific situation.