What is the QSBS tax exemption? Under Section 1202, the Qualified Small Business Stock (QSBS) exemption allows founders and early employees to exclude up to 100% of federal capital gains tax upon selling their shares. The tax-free limit is capped at the greater of $10 million ($15 million for stock issued after July 4, 2025) or 10 times your adjusted cost basis.
The tax savings potential of Section 1202
Section 1202 was created to encourage long-term investment in early-stage domestic startups. If you receive early equity that qualifies as QSBS and hold your shares for the required time, you can exclude the gain from federal taxes when you sell.
For most startup founders and early employees, the flat exclusion limit is the number that matters. Because it is calculated per issuer, you can claim the full exclusion on equity across multiple qualifying startups.
How to qualify for the QSBS exemption
To claim a Section 1202 exclusion, your equity must clear three tests:
- Company test. The business must be a domestic C-corporation, both when your stock is issued and while you hold it. S-corps, LLCs, and partnerships do not qualify. Its aggregate gross assets must be under the limit ($50 million, or $75 million under newer rules), and at least 80% of its assets must be actively used in a qualifying business. Excluded fields include healthcare, financial services, law, farming, and hospitality.
- Issuance test. You must acquire the shares directly from the company, in exchange for cash, property, or services. Buying shares from another shareholder on a secondary platform disqualifies them.
- Holding test. Hold for 5 years for the full exclusion (or 3 to 4 years for partial exclusions under the newer rules below).
Modern tax-law updates to QSBS
The One Big Beautiful Bill Act (OBBBA) created a more flexible framework for QSBS shares acquired after July 4, 2025:
- Tiered holding exclusions. Newer stock qualifies for a 50% exclusion after 3 years and 75% after 4 years, before reaching the full 100% at 5 years.
- Higher gains cap. The maximum federal exclusion rose from $10 million to $15 million, now indexed annually for inflation.
- Higher asset threshold. The maximum qualifying startup size rose from $50 million to $75 million in gross assets.
Shares issued on or before July 4, 2025 remain subject to the legacy rules: a strict 5-year hold for a 100% exclusion, a $10 million gains cap, and a $50 million gross-asset limit.
An example of the exemption in action
Consider a founder who acquired original-issuance QSBS for $100,000 and sold those shares five years later for $10.1 million, a $10 million capital gain:
- Without QSBS: at the top federal capital gains rate of 20% plus the 3.8% net investment income tax (NIIT), this sale would trigger a federal tax bill of roughly $2,380,000.
- With QSBS: the full $10 million gain is excluded from federal income tax, bringing the federal bill on the gain down to $0.
State tax laws vary. Many states mirror the federal QSBS exclusion, but some (such as California) do not recognize Section 1202 and will tax the gain at standard state rates.
Integrating QSBS with your broader equity strategy
Because QSBS rules are highly technical, early planning is essential. Exercising your options early starts your holding-period clock sooner, which is why this is often paired with an 83(b) election to lock in a low cost basis, and coordinated with your ISO vs NSO timing.
If you need to sell before reaching the holding period, a Section 1045 rollover lets you defer the gain by reinvesting the proceeds into a new qualifying small business within 60 days.
