This guide covers everything startup founders and early-stage investors need to know about Qualified Small Business Stock (QSBS) and the enhanced tax benefits now available under Section 1202:
- What QSBS is and how it can save you millions in federal taxes
- The new rules under the One Big Beautiful Bill Act (OBBBA) signed July 4, 2025
- Key requirements your company must meet to qualify
- Which states recognize (and don't recognize) the QSBS exclusion
- Common mistakes that disqualify stock from QSBS treatment
- How to plan ahead for a tax-efficient exit
The Simplest Explanation of QSBS
Here's the deal: when you sell stock in a startup, you normally pay federal capital gains tax on your profit. That tax can eat up roughly 23.8% of your gains (20% capital gains rate plus 3.8% Net Investment Income Tax).
QSBS changes that. If your stock qualifies, you can exclude up to 100% of those gains from federal income tax and potentially save millions of dollars.
Think of it this way: sell $10 million worth of qualifying stock, and instead of writing a check to the IRS for $2.38 million, you keep the entire amount. That's the power of Section 1202.
The tax code created this benefit to encourage people to invest in small businesses. Congress figured if founders and investors could keep more of their gains when a startup succeeds, they'd be more willing to take the risk in the first place.
The catch? Your stock has to meet specific requirements, and you need to plan ahead. Miss one detail, and the entire benefit disappears.
What Changed for QSBS in 2026: The One Big Beautiful Bill Act
The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, made the most significant changes to QSBS since 2010. If you're issuing or acquiring stock after that date, here's what's different:
Higher Exclusion Cap
The maximum gain you can exclude jumped from $10 million to $15 million per company. Starting in 2027, this amount will be indexed for inflation.
Larger Companies Now Qualify
The gross asset threshold increased from $50 million to $75 million. This means more companies can continue issuing QSBS through later funding rounds. Previously, many startups exceeded the $50 million cap after their Series A or B, making subsequent stock grants ineligible.
New Tiered Holding Periods
Under the old rules, you had to hold stock for more than five years to get any exclusion at all. Now, for stock issued after July 4, 2025:
- Hold for 3+ years: 50% exclusion
- Hold for 4+ years: 75% exclusion
- Hold for 5+ years: 100% exclusion
This tiered structure gives founders and investors more flexibility. If you need to exit early, you can still capture some tax benefit rather than losing everything.
Important: Stock issued before July 4, 2025 still follows the old rules. You’ll need the full five-year hold for any exclusion, and the cap remains at $10 million.
Requirements Your Company Must Meet
QSBS eligibility isn't automatic. Your company and your stock must satisfy several requirements outlined in Section 1202 of the Internal Revenue Code:
C Corporation Status
Only domestic C corporations qualify. S corporations, LLCs taxed as partnerships, and other entity types don't work. However, an LLC can elect to be taxed as a C corporation or convert to one, and stock issued after the conversion may qualify.
Gross Asset Limit
At the time your stock is issued (and immediately after), the company's aggregate gross assets cannot exceed $75 million for post-OBBBA stock or $50 million for older stock. "Gross assets" means cash plus the adjusted basis of other property, with contributed property valued at fair market value.
Active Business Requirement
During substantially all of your holding period, at least 80% of the company's assets must be used in an active qualified trade or business. This prevents companies from parking gains in passive investments.
Original Issuance
You must acquire the stock directly from the company in exchange for money, property (other than stock), or services. Buying shares on the secondary market doesn't qualify.
Qualified Trade or Business
This is where many companies trip up. Section 1202 specifically excludes certain industries:
- Professional services (health, law, engineering, architecture, accounting, consulting)
- Financial services (banking, insurance, investing, brokerage)
- Hospitality (hotels, motels, restaurants)
- Farming and natural resource extraction
- Any business where the principal asset is the reputation or skill of employees
Most technology and software companies qualify, as do manufacturing, retail, and wholesale businesses. But the line between "technology company" and "consulting firm" can get blurry. A SaaS platform typically qualifies; a custom software development shop might not.
State Taxes: The Hidden Variable
Here's something many founders overlook: QSBS is a federal benefit. States can choose whether to follow the federal rules, and several don't.
States That Don't Conform (Full State Tax on QSBS Gains)
According to Frost Brown Todd, these states currently don't recognize the QSBS exclusion:
- California (13.3% top rate on the full gain)
- Alabama
- Mississippi
- Pennsylvania
Good News for New Jersey Residents
New Jersey enacted legislation in 2025 to conform to federal QSBS rules starting January 1, 2026. If you're planning an exit in 2026 or later, this could save significant state taxes.
Partial Conformity States
Hawaii allows only a 50% exclusion. Massachusetts has limitations that reduce the effective benefit.
The Practical Impact
A California founder selling $15 million of QSBS might pay zero federal tax but still owe roughly $2 million to the state. That's why residency planning matters. Your state of residence at the time of sale determines your state tax treatment, not where the company is incorporated.
Common Mistakes That Kill QSBS Eligibility
The QSBS exclusion is powerful but fragile. Here are the most common ways founders and investors accidentally disqualify their stock:
Starting as the Wrong Entity Type
If you formed an S corp or LLC and operated for years before converting to a C corp, your QSBS clock starts at conversion. Time spent in the prior structure doesn't count toward your holding period.
Exceeding the Asset Threshold
A large funding round can push your gross assets over the limit. Once that happens, stock issued after that point doesn't qualify. Track your asset levels carefully, especially around fundraising.
Shifting Into an Excluded Business
Companies pivot. But if your SaaS company pivots into consulting, or your hardware startup moves into financial services, you may lose QSBS eligibility for gains accrued during that period.
Stock Redemptions
Significant stock buybacks within certain windows around issuance can disqualify QSBS. The rules here are complex and require careful navigation.
Poor Documentation
If the IRS questions your QSBS claim, you need records proving the company met all requirements throughout your holding period. Companies should maintain QSBS attestation documentation from day one.
How Warp Helps Startups Stay Compliant
Warp is the only AI-native HR & Payroll platform built for ambitious companies. Instead of clicking through clunky dashboards or .gov websites for taxes, Warp's AI agents open every state tax account, file every payroll form, and resolve every tax notice automatically.
When you're focused on building a company that qualifies for QSBS, the last thing you need is compliance headaches derailing your exit. Multi-state payroll complexity, missed tax filings, and unresolved notices can all create problems during due diligence.
Every Warp company gets a dedicated Account Manager and Benefits Advisor included to guide them through payroll setup, multi-state expansion, and benefits selection. You don't have to spend hours on hold with tax agencies or worry about compliance mistakes.
With Warp, you'll never visit a government website, negotiate with tax agencies, or pay accountants $150 per filing. Just focus on building your business while Warp handles payroll, compliance, and benefits for your team across any state or country.
Thousands of fast-growing startups trust Warp to stay compliant while they scale. See how Warp works.
Plan Early, Save Millions
QSBS can be one of the most valuable tax benefits available to startup founders and investors. But it only works if you plan ahead and get the details right.
If you're starting a company, incorporating as a C corporation from day one preserves optionality. If you're already operating as an LLC or S corp, talk to a tax advisor about whether conversion makes sense.
Document everything. Track your gross assets. Make sure your business activities stay within qualified trade or business boundaries. And pay attention to your state of residence before any liquidity event.
The difference between planning properly and ignoring these rules can be measured in millions of dollars saved or lost. Start the conversation with your tax advisor now, not when you're already negotiating term sheets.
Frequently Asked Questions
Can I exclude gains from multiple companies?
Yes. The exclusion cap applies per company. If you hold QSBS in three different startups, you can potentially exclude $15 million from each one. There's no aggregate lifetime limit across companies.
What if I need to sell before five years?
For stock issued after July 4, 2025, you can still get partial benefits (50% at three years, 75% at four years). Alternatively, Section 1045 allows you to roll gains into new QSBS within 60 days if you've held for at least six months, deferring the tax while your holding period "tacks" onto the replacement stock.
Do stock options qualify?
Options themselves don't qualify. But when you exercise options and receive actual shares, those shares can qualify as QSBS if all requirements are met at the time of exercise.
What about acquisitions?
It depends on the deal structure. In a stock-for-stock exchange, you may be able to preserve QSBS treatment. Cash deals are trickier. Get tax advice before signing anything.
Can I gift QSBS to family members?
Yes, and this is a common planning strategy. Each recipient gets their own exclusion cap, potentially multiplying the tax benefit. Gifts to trusts in no-income-tax states can also help with state-level planning.
