Qualified small business stock (QSBS)

What is qualified small business stock (QSBS)?

The qualified small business stock (QSBS) exclusion is a U.S. tax benefit that applies to eligible shareholders of a qualified small business (QSB). The QSBS tax exclusion is set forth in Section 1202 of the U.S. Internal Revenue Code (IRC), and allows founders and investors to potentially exclude up to 100% of federal capital gains tax on the sale of qualified stock held for over five years, if all the required conditions are met.

In 2025, new legislation expanded QSBS eligibility by raising the asset cap from $50 million to $75 million, increasing the individual benefit cap from $10 million to $15 million, and phasing in the benefit (50% capital gains tax exclusion for a three-year holding period, 75% exclusion for four years, 100% after five years). These changes only apply to shares issued after July 4, 2025.

Originally enacted as part of the Omnibus Budget Reconciliation Act of 1993, QSBS was designed to encourage investment in small businesses by rewarding entrepreneurs, early employees, and investors for taking the financial risk to build and fund new companies. Because founding, investing in, and working for a startup can be riskier by nature, the QSBS exclusion helps encourage people to take that risk. For anyone involved in a startup, understanding QSBS is an essential part of the journey, as Carta and industry groups like the NVCA actively work to protect QSBS at the federal level.

Note: The following article is intended to be a general summary of QSBS. We strongly recommend talking to a tax advisor before making any decisions about exercising or selling any equity.

What are the requirements for QSBS?

To secure this significant tax break, both the company issuing the stock and the shareholder receiving it must meet a specific set of rules. The rules can be broken down into two main categories. The first set of rules applies to the issuing company itself, defining what makes it a qualified small business. The second set applies to the individual shareholder, outlining how and when they must acquire and hold the stock to be eligible for the tax benefit.

While the QSBS requirements are detailed, they are manageable, especially when you plan for them from the very beginning of your company's life. Getting these details right from day one can prevent major headaches and lost opportunities years down the road.

A founder’s guide to QSBS

Our free guide to help startup founders navigate the nuances of QSBS and maintain their company’s status.

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Qualified small business (QSB) rules for eligibility

For a company's shares to be considered qualified small business stock, the issuing corporation itself must meet several criteria at the time the stock is issued. These rules are designed to ensure the tax benefit goes to the types of small, growing businesses it was intended to support.

A company is known as a qualified small business when it meets the below qualification requirements:

• C corporation structure: The company must be incorporated as a domestic C corporation in the U.S. This means stock from an S corporation or an LLC does not qualify unless the company converts its legal structure to a C corp before issuing the shares.

• Gross assets test: The company's aggregate gross assets are $75 million or less at all times before and immediately after the equity was issued. For shares issued before July 4, 2025, the gross assets threshold is $50 million. This rule is why the benefit is targeted at early-stage, growing businesses rather than large, established corporations.

• Active business requirement: At least 80% of a company's assets must be used in the active conduct of a qualified trade or business. Excluded business types are determined by the IRS and include companies that:

  • Perform services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, finance, banking, insurance, leasing, investing, or brokerage

  • Rely on an employee or owner's reputation (i.e. if it endorses products or services, uses an individual's image, or has an employee make appearances at events or on media outlets.)

  • Produce products, such as fossil fuels, for which percentage depletion (a type of tax deduction) can be claimed

  • Operate a hotel, motel, restaurant, or similar business

  • Are a farming business

Stock issued by a company that no longer meets the QSB requirements may not qualify as QSBS. For a full list of requirements, see IRS's Pub. 550 or Section 1202.

If your company uses Carta for QSBS attestation, you can see which shares are eligible for the QSBS exclusion today—as well as which shares will be eligible for tax benefits after the required holding period—within your Carta account.

2025 QSBS expansion: Main differences in eligibility requirements

→ Learn more about Carta's role in the QSBS expansion.

Free QSBS eligibility guide

Knowing how to maintain QSBS eligibility is crucial to protecting your potential tax savings.

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QSBS attestation letter

A QSBS attestation letter offers in-depth review of your company's QSB status under IRS guidelines and helps to support the eligibility of your shares. Carta is the only provider that delivers both:

• A company-level summary for due diligence and internal compliance purposes

• Individualized shareholder letters that can be used to support personal tax filings

Annual QSBS attestation helps to ensure founders, employees, and investors have reliable documentation if their QSBS benefit is ever reviewed or questioned.

What can cause QSB disqualification for companies

Certain actions by a company can disqualify its QSB status, and therefore impact shareholders' ability to gain the QSBS tax exclusion. Here are some of the ways companies can be disqualified:

• Share repurchases: If a company buyback of its own shares exceeds a certain threshold, shares issued one year prior to and one year after the buyback may be disqualified.

• Cash management of investments: Investing company assets into non-cash deposit instruments, like corporate bonds or money market funds, with liquidity terms more than 24 months could impact QSBS eligibility depending on the amount and company age.

• Business model changes: If your company changed its business model and began to perform non-qualifying activities, your QSBS status may be affected.

• Exceeding asset threshold: Under QSBS rules, your company must have less than $75 million* in gross assets at the time of share issuance and immediately thereafter. Acquisitions, fundraising rounds, licensing agreements, and inventory can cause a company to exceed this threshold and lead to QSBS disqualification. Due to this $75 million* threshold rule, companies tend to lose their QSB status after raising multiple funding rounds. (* For shares issued prior to July 4, 2025, the asset limit is $50 million.)

• The “substantially all” trap: It is a common misconception that QSBS is a “set it and forget it” benefit. Under Section 1202, a company must satisfy the active business requirements for “substantially all” of a shareholder's holding period. If a company fails these tests—perhaps by holding too much cash or pivoting to an excluded service industry—for a significant window of time, the stock may permanently lose its QSBS status. This is why annual attestation is critical. Waiting until an exit to review eligibility is often too late to correct issues that occurred years prior.

Qualified small business stock (QSBS) rules for eligibility for shareholders

In addition to the company-level rules, there are requirements that apply to the person or entity holding the stock. These rules focus on who can receive the benefit and how they must acquire their shares.

• Eligible shareholder: The stock must be held by a non-corporate taxpayer. This includes individuals, trusts, and pass-through entities.

• Original issuance: You must have acquired the stock directly from the company at its original issuance. This means you cannot buy shares from another shareholder on a secondary market and have them qualify. Stock received from exercising stock options (including ISOs and NSOs), warrants, or convertible debt like a SAFE is considered acquired at original issuance.

Once you hold the stock, confirm whether your company is a QSB, as defined by the IRS and outlined above.

How to pay less taxes on your startup shares

In this episode of Startup Essentials, learn the basics of QSBS.

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QSBS holding period requirements

For shares issued on or after July 4, 2025, you must hold eligible stock for at least three years in order to qualify for QSBS tax benefits. Benefits are phased in, with a 50% capital gains tax exclusion for a three-year holding period, a 75% exclusion for a four-year holding period, and full exclusion up to 100% when eligible stock is held for five years, if you've met all required conditions resulting in significant tax savings.

If you hold eligible shares, you may be subject to tax liabilities on the sale of those shares if you decide to sell before the holding period has been completed. Tender offers (buyback events), bilateral secondary transactions, and IPO events are some of the ways you can sell private company stock.

Carta Equity Advisory offers 1:1 sessions with an equity tax advisor and QSBS tax filing guidance for startup employees. Find out how Carta can help your team make informed decisions on their equity.

QSBS tax treatment and benefits

Normally when you sell shares, they could be subject to either short or long term capital gains rates. Short term capital gains rates may be as high as 37% whereas long term capital gains rates may be as high as 20%. QSBS status offers the ability to lock in a 0% capital gains tax rate for federal purposes. However, the tax benefits differ depending on when the QSBS shares were acquired.

Generally speaking, if you acquired QSBS-eligible stock after September 27, 2010, you can exclude up to 100% of the qualified gain. If you acquired the eligible stock before September 26, 2010, you can exclude a smaller percentage of the qualified gain—either 50% or 75%, depending on the acquisition date, and a portion of the gains may be subject to the alternative minimum tax (AMT).

The thresholds, dates, and rules around QSBS might be subject to change due to legislative action. Despite these limitations and thresholds, shareholders can claim the entire amount of eligible gains in one year, or spread it out over multiple years. If a shareholder works for or invests in multiple companies that qualify, they may independently claim the tax benefit for shares in each company.

See how much you could save with the QSBS exclusion

Estimate your potential tax savings based on your specific shares and holding period with this simple tool.

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QSBS location eligibility

Since QSBS is an amendment to the U.S. tax code, only employees who are U.S. taxpayers can take advantage of this federal income tax benefit. And while many state jurisdictions conform to the federal tax code for state taxes, some states do not.

As of today, if you (the shareholder of company stock) are a resident in one of the following states or territories, you are not eligible for the QSBS tax exclusion at the state level:

• Alabama

• California

• Mississippi

• Pennsylvania

• Puerto Rico

Hawaii and Massachusetts partially conform with the QSBS tax exclusion. The requirements vary based on the state of incorporation (for the company) and the state of residency (for the shareholder).

→ Learn more about QSBS stacking and packing

How QSBS is handled in investor rights agreements

While QSBS allows employees to exclude up to $15 million in federal capital gains, it can help investors save even more. QSBS protects up to 10x their investment from long-term capital gains taxes, or $15 million, whichever is greater. For example, an investor who put in $15 million could avoid paying federal capital gains tax on up to $150 million.

For this reason, venture capital and angel investors have a vested interest in making sure the companies they fund take advantage of QSBS rules. Investor rights agreements (IRAs) play a pivotal role in this context. The National Venture Capital Association provides an IRA template, used as the industry standard by many law firms, that states a company will take reasonable actions to maintain QSBS eligibility and, if requested, send the required information to claim QSBS to investors.

With Carta QSBS attestation, you'll get the annual QSBS eligibility review, attestation letter, and ongoing guidance you need to meet investor rights agreement requirements.

How to maintain QSBS eligibility and avoid common pitfalls

Qualifying for QSBS is not a one-time event. It is possible to lose QSBS eligibility even after stock is originally issued as qualified small business stock. The benefit can be lost if statutory requirements are not continuously met for “substantially all” of the shareholder's holding period, as required by Section 1202. As a company grows, raises capital, and evolves its business, certain actions can unintentionally disqualify its stock, putting the future tax benefits for all shareholders at risk. Founders and operators need to be aware of these common pitfalls to protect the value they are creating for their team and investors.

As Anthony Cimino, former Head of Policy at Carta, explained during Carta's Equity Compensation: Three Essentials You're Not Thinking About webinar, timing is critical for employees. "Where you see this get tripped up a lot is when the company might issue a grant when it's below the asset threshold. But as that company grows, if an employee hasn't exercised that grant, it loses its eligibility."

Here are some of the most common disqualifying events to watch for:

• If the company no longer meets QSBS requirements (such as changing business models) during a substantial portion of your holding period, future QSBS claims could be at risk.

• In mergers or acquisitions, eligibility may be preserved in some cases (for example, through tax-free share exchanges), but outcomes can vary, and you may need to track "tacked" holding periods or face limitations on the exclusion.

• QSBS can generally only be transferred without losing its status through gift, inheritance, divorce, or from a partnership to its partners. Any other type of transfer will typically result in the loss of QSBS eligibility.

→ Learn how to preserve QSBS eligibility through a Section 1045 rollover

How to prove your QSBS eligibility

The responsibility for proving that your shares qualify for the QSBS tax exclusion falls on you, the taxpayer. Years after you receive your stock, it can be incredibly difficult to track down the historical financial records, board consents, and data needed to prove every requirement was met. This administrative burden can be a significant barrier to claiming the benefit you've earned, leading to a situation where workers are leaving money on the table.

Because eligibility must be maintained over time, a single letter at the time of issuance isn't enough. As a best practice, companies should perform a QSBS eligibility review and refresh their attestation letter at least once per year, as well as after major events like large financings, stock repurchases, or business model changes.

These annual letters create a year-over-year paper trail of the company's status. This helps shareholders and tax advisors substantiate claims and, crucially, allows the company to address potential eligibility issues early before they violate the “substantially all” requirement.

For companies like Luminary Cloud, providing this documentation was key to helping employees see the real value of their equity. The attestation letter gave them the confidence that their shares had a potential upside that larger companies couldn't match.

Having this letter from a trusted third party like Carta provides the peace of mind and proof needed to confidently claim the tax benefit.

How to use QSBS to build your company

For a savvy founder, QSBS is not simply a tax break, but a strategic tool for building and growing the business. When you understand and plan for it from the beginning, it can give your startup a competitive edge in both fundraising and hiring. It transforms a tax compliance task into a strategic asset.

• Attracting investors: Sophisticated angel investors and venture capitalists actively seek out QSBS-eligible companies because it significantly enhances their potential returns. Presenting a company that is QSBS-ready with clean documentation signals that you are a professional and organized founder, making your startup a more attractive investment.

• Hiring and retaining talent: QSBS can be a significant differentiator when determining how much equity to give early employees in your compensation package. For early employees, the potential for tax-free gains on their equity can be a more compelling incentive than a higher salary at a large, established company. While a large salary offers security, startup equity offers a once-in-a-lifetime economic opportunity—the allure of a 10x or even 1,000x return that could provide a lifetime of financial security, helping you compete for top talent.

Startup Mezcalum is a perfect example of this strategy in action. By working with Carta to structure the company correctly from the start, they were able to tap into this tax strategy to directly benefit their investors, founders, and employees, making their equity compensation more valuable for everyone involved.

To learn how Carta can help you track eligibility and maximize your tax benefits, request a demo of our QSBS solution today.

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Frequently asked questions about QSBS

Does the QSBS exclusion apply to state taxes?

The QSBS exclusion is a federal tax benefit, and its treatment at the state level varies. Some states conform to the federal rule, while others, like California, do not offer a similar exclusion, so you should consult a tax professional.

Can an LLC or S-corp issue QSBS?

No, only a C corporation can issue QSBS. If your company is currently an LLC or an S corporation, it must convert to a C corp before issuing the stock for it to be eligible.

What is a Section 1045 rollover?

A Section 1045 rollover is a related tax provision that allows a shareholder to sell their QSBS and defer paying capital gains tax. This is possible if they reinvest the proceeds into another QSBS opportunity within a specific timeframe.

The founder's guide to QSBS

Download our free guide to learn more about QSBS benefits, rules, and best practices—including how to take advantage of the QSBS tax exclusion and business actions that impact QSBS eligibility.