For many startup founders, the largest tax bill arrives when the company succeeds.
A funding round, acquisition, or IPO can create substantial capital gains. The Qualified Small Business Stock (QSBS) tax exclusion under Section 1202 may allow eligible founders and early investors to exclude a significant portion of those gains from federal tax.
The One Big Beautiful Bill Act expanded the opportunity for stock issued after July 4, 2025 by introducing shorter holding periods for partial exclusions, increasing the maximum exclusion, and allowing more startups to qualify.
The rules remain technical. Both the company and shareholder must qualify, and the way the stock is issued matters. This guide explains how the QSBS exclusion works in 2026 and what founders should consider before a financing round or exit.
The Qualified Small Business Stock tax exclusion, commonly referred to as Section 1202 QSBS, allows eligible shareholders to exclude a significant portion, and in many cases all, of their federal capital gain when they sell qualifying startup stock.
Congress introduced Section 1202 to encourage investment in innovative American businesses by rewarding long-term ownership. Rather than reducing taxes during a company’s early operating years, the benefit is realized when the stock is sold.
For founders, early employees, angel investors, and certain trusts, this can translate into millions of dollars of federal tax savings if every requirement is satisfied.
The benefit applies only to federal capital gains tax. State treatment varies. California, for example, does not currently conform to the federal QSBS exclusion, so qualifying gains may still be fully taxable for California income tax purposes.
The biggest developments come from the OBBBA, which expanded the QSBS rules for stock issued after July 4, 2025. Three changes stand out.
A shorter holding period now provides partial tax benefits
Previously, founders generally needed to hold qualifying stock for more than five years before receiving any Section 1202 benefit. The OBBBA introduced a graduated system for newly issued QSBS.
Holding Period | Federal Gain Exclusion |
3 years | 50% |
4 years | 75% |
5 years or more | 100% |
This gives founders and investors more flexibility when an acquisition opportunity arises before the traditional five-year holding period.
The maximum gain exclusion increased
For qualifying stock issued after July 4, 2025, the exclusion limit increased from $10 million to $15 million per taxpayer, per issuing corporation. Taxpayers may instead exclude up to 10 times their adjusted basis in the stock if that amount is greater. Beginning after 2026, the $15 million limit is indexed for inflation.
More startups now qualify
Historically, a corporation generally could not exceed $50 million in aggregate gross assets immediately before or after issuing QSBS. The OBBBA increased that threshold to $75 million, allowing more venture-backed companies to remain eligible through later funding stages.
Not every startup can issue Qualified Small Business Stock. Eligibility depends on both the corporation and the shareholder, and every requirement must be considered together.
Requirement | What It Means |
Domestic C Corporation | The company must be a U.S. C corporation when the stock is issued. LLC interests, S corporation stock, and partnership interests do not qualify. |
Gross Assets Test | Aggregate gross assets generally cannot exceed $75 million immediately before and after the stock issuance for post-OBBBA shares. |
Original Issuance | The shareholder must generally receive stock directly from the corporation in exchange for cash, property, or services. A secondary purchase usually does not qualify. |
Qualified Trade or Business | The corporation must conduct an eligible active trade or business under Section 1202. |
Active Business Requirement | At least 80% of corporate assets must generally be used in the active conduct of the qualified business during substantially all of the holding period. |
Holding Period | The shareholder must satisfy the applicable holding period before claiming the exclusion. |
Product-focused technology companies are often well positioned for QSBS. Businesses that commonly qualify include software, SaaS, artificial intelligence, cybersecurity, biotechnology, medical devices, semiconductors, and advanced manufacturing.
Section 1202 excludes several businesses whose primary value comes from professional services or specialized expertise. These generally include accounting, law, consulting, financial services, banking, insurance, brokerage, farming, mining, and certain hospitality businesses.
This distinction is especially important for software companies. A scalable product business may qualify, while a technology consulting firm that primarily sells professional expertise may not. The company’s actual activities matter more than its branding.
QSBS is available only for stock issued by a qualifying C corporation. LLC interests and S corporation shares do not qualify.
If a startup converts from an LLC later, the QSBS holding period generally begins when qualifying C corporation stock is issued, not when the original business was formed. A late conversion can therefore reduce the benefit available at exit.
Startups expecting venture funding or a future acquisition should evaluate entity structure before a financing round rather than after it. The decision also affects equity compensation, R&D credits, international expansion, and future exit planning.
The value of QSBS becomes easier to understand when you compare the numbers. Consider a founder who receives qualifying stock when a software company is incorporated.
If the stock qualifies for the 100% exclusion, the founder may exclude the entire $12 million gain from federal capital gains tax, assuming it falls within the applicable Section 1202 limit.
Scenario | Federal Tax Treatment |
Without QSBS | The entire gain is generally subject to federal capital gains tax. |
With QSBS | Up to the applicable Section 1202 amount may be excluded, potentially eliminating federal tax on the entire gain. |
The savings can reach several million dollars for a successful startup. The actual result depends on the issuance date, holding period, ownership structure, stock basis, and whether the company satisfies the ongoing eligibility requirements.
QSBS eligibility is not determined only when a company is incorporated. It can be lost later if the rules are not monitored carefully.
Buying shares from another shareholder
Section 1202 generally applies only to stock acquired directly from the issuing corporation. Purchasing shares from an existing founder or investor usually does not qualify.
Exceeding the gross asset threshold
The corporation must satisfy the gross asset test when stock is issued. Financing rounds and acquisitions should be monitored carefully to preserve eligibility for future issuances.
Operating in a nonqualified business
A company’s activities matter as much as its legal structure. If the business falls within an excluded industry, shareholders generally cannot claim the exclusion.
Assuming every shareholder qualifies
A corporation may qualify while a particular shareholder does not. Gifted shares, inherited stock, trusts, partnerships, and reorganizations can involve additional rules.
The answer depends on more than the potential exclusion. A C corporation may make sense when a company expects to:
An LLC may remain preferable when the company:
Founders should also consider California’s tax rules. Although federal law provides the QSBS exclusion, California currently does not conform to Section 1202. Gains excluded federally may still be subject to California income tax.
The entity decision should therefore be evaluated alongside fundraising plans, ownership structure, current profitability, and long-term exit objectives rather than solely as a way to qualify for QSBS.
For venture-backed software companies, QSBS is worth evaluating early because eligibility often depends on decisions made years before an acquisition or IPO. The exclusion can significantly reduce the federal tax cost of a successful exit, but only when the company and its shareholders satisfy the Section 1202 requirements from the beginning.
Through our services for software developers and consultants, ASAM LLP helps startups evaluate entity structure, assess QSBS eligibility, and align tax planning with fundraising and future exit goals. If you are planning your next funding round or preparing for long-term growth, contact Vivian Ni, CPA at vivian.ni@asamllp.cpa or call +1 (415) 788-2371 to discuss your startup tax strategy.
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