QSBS: The $10 Million Tax-Free Exit

QSBS: The $10 Million Tax-Free Exit

Most tax rules take your money. This one might let you keep up to $10 million of it.

QSBS — short for Qualified Small Business Stock — is one of the most generous, least understood tax breaks in the U.S. code. It was designed to reward founders, early employees, and investors who take real risks building small, high-growth companies.

If you qualify, you can sell your shares after five years and pay zero federal capital gains tax on up to $10–15 million of profit.

That’s not a loophole. That’s law — Section 1202 of the Internal Revenue Code.

And for founders who play their cards right, it can turn a life-changing exit into a tax-free one.

But there’s a catch: you only get it if your company is structured the right way from day one.

Miss an election, exceed an asset threshold, or reorganize carelessly, and the IRS will treat your exit like any other — taxable.

QSBS is the rare startup concept that sits at the intersection of tax, legal, and timing. It’s simple to explain after the fact, but surprisingly easy to screw up while you’re building.

This chapter breaks it down — not like a tax lawyer, but like a founder who’s been through it.

Why It Exists

Congress created Section 1202 in the early 1990s to spur innovation and small-business investment.

The logic was straightforward: if you’re risking time or money on a small company that could change the world, you shouldn’t be taxed like a short-term trader.

QSBS became the government’s way of saying: “Build something real in America — and if it works, you can keep more of what you earned.”

It sat mostly ignored for years, but in the startup era — where C-corps are the norm and valuations can explode overnight — it’s become a quiet wealth engine for founders who plan early.

What You’ll Learn

This chapter walks through everything you need to know to use QSBS to your advantage:

• What QSBS actually is — and why the rule exists in the first place.

• The five eligibility pillars you must meet to qualify.

• How to structure your company so founder stock counts as QSBS from day one.

• What can quietly disqualify you (and how to avoid those mistakes).

• Real-world examples of founders who used it — and those who lost it.

• Advanced strategies like stacking and 1045 rollovers that multiply the benefit.

Why Founders Should Care

If you sell your company for $20 million and your stock qualifies for QSBS, you could save roughly $4–6 million in federal taxes.

That’s not just a tax planning detail — that’s another round of funding in your pocket, or a few extra zeros in your exit wire.

It’s also one of the only tax advantages in the code that rewards both founders and early employees for building something that grows.

Handled right, QSBS can be the difference between rich and set for life.

Bottom Line

QSBS isn’t a loophole — it’s a reward for long-term belief.

Handled well, it can turn years of sweat equity into a tax-free exit.
Handled poorly, it disappears quietly, and you’ll never know what you lost until it’s too late.

So let’s make sure you get it right — starting with what QSBS actually is, and how it works behind the scenes.

Foundations: What QSBS Actually Is

Qualified Small Business Stock — better known as QSBS — lives inside Section 1202 of the Internal Revenue Code.

It’s the part of U.S. tax law that rewards people for building and investing in small, active businesses.

In plain English:
If you start or invest in a qualified U.S. C-Corp, and you hold your shares for at least five years, the IRS lets you exclude up to $10 million (soon $15 million) of your gain from federal capital-gains tax when you sell.

The catch? You only qualify if your company checks five very specific boxes — all tied to structure, timing, and scale.

Why This Exists

QSBS wasn’t written for venture capitalists or mega-exits — it was written for builders.

Back in 1993, Congress created Section 1202 to encourage people to take risks on small, innovative businesses.

The thinking was simple: if founders and investors are willing to fund new ideas and create jobs, they shouldn’t be punished with the same tax rate as someone trading stocks on Wall Street.

Fast forward three decades, and that small-business incentive has become one of the most powerful wealth-building tools for modern startups.

Early founders, angel investors, and even early employees can use it to turn startup equity into tax-free income — if they plan correctly.

The Core Concept

QSBS is about when and how you acquire your stock.

You only get the benefit if your shares are:

1. Issued by a U.S. C-Corp (not an LLC or S-Corp).

2. Acquired at original issue — meaning directly from the company, not bought from someone else.

3. Issued when the company’s total assets were under $50 million (rising to $75M for stock issued after mid-2025).

4. Used in an active business — not a holding company, real estate firm, or financial institution.

5. Held for at least five years before sale.
   
   

Meet all five, and your future capital gains — up to $10M or 10× your investment (whichever is greater) — can be excluded from federal tax.

In Practice

Say you and a co-founder incorporate your startup as a C-Corp in 2025.

You each buy 5 million shares for $5,000 total, when the company has less than $1 million in assets.

You hold your shares for six years, build something real, and sell for $20 million.

Normally, you’d pay 20% in long-term capital-gains tax — roughly $4 million gone to the IRS. But because your shares qualified as QSBS, the first $10 million of your gain is excluded.

You pay $0 in federal capital-gains tax.

Same sale, very different outcome.

Why Founders Benefit Most

Founders have a unique advantage — they’re often issued stock at formation, when valuation is negligible and all the eligibility boxes are easy to check.

That early moment — when you’re filing your incorporation docs, setting up your cap table, and issuing founder shares — is when QSBS is either won or lost.

Convert to an LLC later, exceed the $50M asset limit too soon, or fail to document your original issuance properly, and you can’t fix it later.

The IRS doesn’t allow “retroactive qualification.”

The 2025 Update

A quick note on the numbers:

For stock issued after June 30, 2025, the thresholds and exclusions increase —

• Asset limit: $75 million (up from $50M)

• Exclusion cap: $15 million or 15× basis (up from $10M / 10×)

That means founders forming or issuing stock after mid-2025 could see an even bigger upside — assuming Congress keeps the provision intact.

Key Takeaways

• QSBS = Section 1202 of the tax code — a rule designed to reward building small, active companies.

• Five boxes to qualify: C-Corp, original issue, under $50M (soon $75M), active business, 5-year hold.

• The benefit: up to $10–15 million tax-free federal gain.

• Founders qualify early. Incorporate right, issue stock correctly, and your five-year clock starts now.

• You can’t retroactively qualify. Structure matters from day one.

Core Mechanics: How the Exclusion Works

QSBS sounds magical: hold your stock for five years and pay no federal tax on up to $10–15 million of gains.

But the magic only works because the math — and the paperwork — line up perfectly.

Let’s unpack how it actually functions, rule by rule.

The 5 Pillars of QSBS Eligibility

You only get the exclusion if your stock meets every one of these requirements. Miss one, and the benefit vanishes.

Meet all five, and you’re eligible for the exclusion.

How the Exclusion Is Calculated

Under Section 1202, you can exclude 100% of your gain from federal capital-gains tax on the greater of:

• $10 million, or

• 10× your original investment basis
  (rising to $15 million / 15× for stock issued after June 30, 2025).
  
  

That means whichever number is larger — $10 million or ten times what you put in — is what you can exclude from federal tax.

Example 1 — The Founder Sale

You start a C-Corp and buy founder stock for $10,000 when assets are well under $50 million.

Five years later you sell your company for $12 million.

Your gain: $11,990,000.

Your exclusion: the greater of $10 million or 10× $10,000 ($100,000).
→ You exclude $10 million, and only $1.99 million is taxable.

Example 2 — The Angel Investor

An angel invests $500,000 in a seed round, buying new preferred shares directly from the company.

Ten years later, that stake sells for $6 million.

Gain = $5.5 million.

Exclusion = 10× basis = $5 million (less than $10 million cap).
→ $5 million of the gain is tax-free; the remaining $500k is taxed.

Timing Matters

• The clock starts at issuance. For founders, that’s the date the stock certificate is issued.

• Early-exercised options (paired with an 83(b) filing) can start the clock immediately.

• Transfers — like gifting to a trust or spouse — keep the original holding period if done correctly.

• Mergers or conversions can restart the clock if not structured carefully.
  
  

When in doubt, confirm the start date with your legal team — the five-year test is binary: you either make it or you don’t.

What Disqualifies QSBS

The rules are surprisingly strict. Here’s what can break eligibility:

• Entity conversions — switching to an LLC or S-Corp before the five years are up.

• Stock redemptions — buying back founder shares within two years of issuance.

• Asset growth — crossing $50 million before the shares are issued.

• Industry exclusions — finance, investing, insurance, hospitality, and professional-services firms don’t qualify.

• Secondary purchases — buying existing shares instead of newly issued ones.
  
  

Once you break eligibility, there’s no patching it later. The IRS treats the stock as ordinary, taxable capital gains.

Quick Reference: The Math Behind QSBS

(Assumes 100 % exclusion, no state taxes.)

Takeaway

QSBS isn’t complicated once you see the levers:

Structure right, issue early, document clearly, and hold five years. Miss any of those, and the IRS treats your exit like everyone else’s.

Real-World Applications: Founders, Employees & Investors

QSBS isn’t just a theoretical tax rule — it’s a real lever that shapes how founders form companies, how employees exercise options, and how early investors structure deals.

Let’s look at how each group can actually use it (and how they often break it without realizing).

For Founders

Founders are the biggest beneficiaries of QSBS — mainly because they’re there from day one, when all the boxes are easiest to check.

How it usually works:

1. You incorporate as a U.S. C-Corp while your company is still worth next to nothing.

2. You buy founder shares for a nominal price (say, $0.001 per share).

3. The company’s total assets are well under the $50M limit.

4. You hold those shares for five years or more.

Result: your founder stock qualifies as QSBS. Sell for $10M, pay $0 federal capital-gains tax.

What to watch for:

• Don’t convert to an LLC or S-Corp. That kills eligibility instantly.

• Don’t redeem or repurchase your own stock within two years of issuance.

• Keep records — formation docs, stock purchase agreements, and your 83(b) filing — all prove original issue.
  
  

  Founder tip: Because your basis is nearly zero, the exclusion is worth the full $10–15 M.
  That’s life-changing money for getting the setup right.

For Early Employees

Employees can also qualify — but only if they turn their options into stock early enough.

Here’s the sequence:

1. You’re granted stock options (usually ISOs).

2. You early-exercise before the shares vest, converting them into actual stock.

3. You file an 83(b) election within 30 days.

4. The QSBS clock starts the day those shares are issued.
   
   

Wait until after vesting or a liquidity event, and you’ve lost your shot — because the five-year timer never started.

Example:
An engineer joins a startup in 2025, early-exercises 50k options at $0.10, and files an 83(b).
Six years later, the company sells for $100 per share.
Gain: $4.995M.
QSBS exclusion: 100 %.
Federal tax owed: $0.

Common mistakes:

• Not filing 83(b) → the IRS treats the gain as ordinary income.

• Exercising after a funding round → valuation spikes, bigger tax bill, no QSBS window.

• Leaving before the five-year mark → no exclusion.
  
  

Pro move:
If you join early and believe in the company, early-exercise immediately and start the QSBS clock while the value is low.

For Investors

Angel and seed investors can also qualify — as long as their shares come directly from the company.

Checklist for investors:

• Invest in original issue stock (not secondary shares).

• Confirm the company is a C-Corp under the $50M asset cap at the time of your round.

• Hold for five years.

• Avoid investing in excluded industries (finance, real estate, law, etc.).
  
  

Example:
You invest $250k for 5 % of a startup at formation.
Eight years later, it sells for $12M.
Your gain is $11.75M → first $10M tax-free, last $1.75M taxed normally.

VC reality:
Venture funds often can’t claim QSBS directly (the entity is disqualified), but limited partners sometimes can if the fund passes through gains. That’s why sophisticated angels and family offices pay attention to 1202 status during due diligence.

Common Ways People Lose QSBS (Across the Board)

• Converting the company to an LLC or S-Corp.

• Exceeding $50M in assets before the issuance closes.

• Redeeming or repurchasing shares within two years.

• Holding stock less than five years.

• Operating in an excluded industry (finance, real estate, consulting, hospitality, etc.).
  
  

Once any of these happen, the exemption is gone — permanently.

Takeaway

QSBS isn’t reserved for one type of stakeholder.

It’s a system that rewards anyone who helped build the company early — founders, employees, or investors — as long as the stock was structured and held correctly.

If everyone on your cap table understands that, you’re not just building a company.

You’re building a tax-efficient wealth engine.

Strategy & Planning: How to Maximize QSBS

Most founders don’t miss out on QSBS because they didn’t qualify.

They miss out because they didn’t plan.

This section is about turning QSBS from “nice trivia” into an intentional part of your company’s setup — from day one through exit.

1. Structure Smart from the Start

QSBS is won (or lost) in your company’s first few weeks.
Once shares are issued, the eligibility clock starts — and it can’t be restarted or back-dated.

Here’s the cleanest setup path:

a. Incorporate as a C-Corp early.
LLCs and S-Corps can’t issue QSBS. You can convert later, but the stock you already issued won’t qualify. The sooner you’re a Delaware C-Corp, the better.

b. Keep your gross assets under $50M (or $75M post-2025).
The limit applies at issuance. If you raise a monster round that pushes assets above the cap before issuing new shares, those shares are out.

c. Document everything.
Formation documents, stock purchase agreements, 83(b) elections, and board approvals all prove “original issue.” If you ever need to show eligibility, paper trails matter more than memories.

2. Start the Five-Year Clock Early

The five-year holding period is a hard rule — no exceptions.

If you start it late, you simply wait longer to sell.

Founders: Your clock starts the day your stock certificate is issued (usually the day of incorporation).

Employees: If you have options, you can early-exercise to start the clock right away. File your 83(b) within 30 days.

Investors: The clock starts when your wire clears and the shares are officially issued by the company — not when you sign the SAFE.

Pro move:
Time your incorporation, stock grants, and early exercises strategically so you hit the five-year mark before an expected exit. Many late-stage acquisitions fail QSBS purely because someone exercised too late.

3. Don’t Accidentally Disqualify Yourself

Most QSBS disqualifications aren’t dramatic — they’re paperwork or timing issues.

Avoid these common killers:

• Converting to an LLC or S-Corp before sale.

• Redeeming founder stock (buying it back) within two years of issuance.

• Exceeding asset limits before a new round’s shares are issued.

• Operating in an excluded industry — finance, insurance, real estate, professional services, hospitality.

• Failing to track 80% “active business use.” Too many passive assets or investments can void eligibility.

If you’re not sure whether an action will break QSBS, assume it might — and call your CPA before signing anything.

4. Use Stacking to Multiply the Benefit

QSBS exclusions apply per shareholder — not per company.

That means multiple people (or entities) can each claim their own $10–15M exclusion if they hold qualifying shares.

Examples:

• You and your co-founder each exclude $10M individually.

• You gift shares to a spouse or family trust before the exit — they get their own $10M cap.

• Certain investors can hold through multiple pass-through entities to multiply exclusions legally.
  
  

Handled right, a $30M sale could be entirely tax-free across multiple holders.
Handled wrong, it’s one $10M cap total.

Always involve tax counsel before transferring stock — QSBS stacking is powerful but delicate.

5. Roll It Forward with Section 1045

If you sell your QSBS before the five-year mark, all is not lost.

Section 1045 lets you roll the proceeds into another QSBS-eligible investment within 60 days. That restarts the clock but keeps your deferral alive.

It’s a way to stay compliant while freeing up capital to reinvest in the next deal — a move many angels and serial founders use quietly.

6. Align Tax Planning with Corporate Moves

Major corporate events — fundraising, mergers, recapitalizations — can all affect QSBS.

Before any of these, ask one question:

“Will this impact our QSBS eligibility?”

If you’re merging, make sure it’s structured as a stock-for-stock reorganization that preserves original issue.
If you’re raising, issue all founder and key-employee stock before your valuation crosses $50M.
If you’re considering a redemption, wait until you’re safely outside the two-year window.

A little foresight here can save millions later.

Mini Checklist: How to Preserve QSBS

• Form as a U.S. C-Corp.

• Issue founder stock early.

• File 83(b) within 30 days.

• Keep assets under the $50M / $75M limit at issuance.

• Track five-year holding periods for everyone on the cap table.

• Avoid redemptions and conversions.

• Document everything.

Takeaway

QSBS isn’t something you “find out about later.”

It’s something you plan into your company — before the first round, before the first hire, and long before an exit.

Get the foundation right early, and your future self will thank you every time the IRS doesn’t.

Integration & Broader Context

QSBS doesn’t live in a vacuum.

It sits at the intersection of entity choice, equity planning, and long-term tax strategy — which means it connects directly to almost every big financial decision you’ll make as a founder.

Understanding how it interacts with the rest of your tax world is what turns this from a lucky break into a deliberate advantage.

QSBS + 83(b): The Ultimate Duo

If you’re a founder, filing an 83(b) election is your first real move in the QSBS game.

Here’s why:
When you receive restricted stock (like founder shares that vest over time), you can choose to pay tax now — while the value is near zero — instead of later when it’s worth a lot more.

That election locks in your low basis and starts the five-year QSBS clock immediately.

Skip it, and you pay ordinary income tax when the stock vests — and your QSBS holding period doesn’t even begin until then.

It’s the single most common mistake we see from founders who thought they “qualified.”

In short:
File 83(b) early, start your QSBS timer, and never have to say, “We could’ve saved millions.”

QSBS + R&D Credits: The Two-Sided Tax Strategy

QSBS helps you at the finish line.

R&D credits help you at the starting line.

While you’re building, R&D credits reduce the payroll or income taxes your startup owes on qualified research expenses.

When you finally sell, QSBS eliminates capital gains taxes on the upside.

Together, they form a clean end-to-end strategy:

• R&D credits protect your cash flow now.

• QSBS protects your exit later.

Founders who plan both from day one are effectively shielding both sides of the startup lifecycle — money in, money out.

QSBS + AMT and NIIT: The Hidden Taxes

QSBS wipes out federal capital gains tax, but it doesn’t make you invisible to every tax.

• AMT (Alternative Minimum Tax):
  Not triggered by QSBS itself, but can apply to incentive stock options (ISOs) before conversion. Plan your exercises carefully.
  
  

• NIIT (Net Investment Income Tax):
  Adds 3.8% for high earners. QSBS exclusions generally avoid it for the exempt gain, but state-level tax rules can differ.
  
  

• State Taxes:
  Many states (including California and New York) don’t automatically conform to federal QSBS rules.

  Translation: the IRS may exempt your $10 M gain; your state might still want a cut.
  
  

Talk to your CPA early to map which parts of your exit are truly tax-free — and which just sound like it.

QSBS + Entity Choice

QSBS only applies to C-Corps, which is why most venture-backed startups choose that structure from day one.

But even if you start as an LLC for flexibility, there’s a smart moment to convert.

The trick: convert before your valuation or asset base rises above $50M (or $75M post-2025).

Convert too late, and you’ll be locked out forever.

The right time to flip is early in your growth curve — after early traction but before your first big round.

QSBS + M&A: Don’t Lose It on Exit

When a startup gets acquired, eligibility can get messy fast.

How the deal is structured determines whether the IRS sees your gain as qualifying QSBS or ordinary capital gain.

To preserve the benefit, aim for:

• A stock sale, not an asset sale.

• A stock-for-stock reorganization, if rolling into a new parent company.

• No redemption of founder stock before the deal closes.
  
  

The key question for your counsel:

“Will this deal preserve our QSBS exclusion for each shareholder?”

Ask it early — by the time you’re signing a term sheet, it’s often too late to restructure.

Legislative Watch

QSBS isn’t permanent policy. It’s popular with startups, less so with budget hawks.

There have been proposals in recent years to reduce the 100% exclusion to 50% for high-income earners or tighten the asset test.

None have passed yet, but founders should assume the rules could change.

The best defense is documentation — if your stock already qualifies and your five-year clock is running, you’re grandfathered under current law.

A Mental Model for Founders

If you remember one thing, remember this:

QSBS = C-Corp + < $50M Assets + Active Business + 5 Years + Original Issue.

If those five stay true from formation to exit, the IRS owes you nothing on the first $10–15 M of your gain.

Mini Takeaway

QSBS isn’t an isolated trick — it’s a pillar of a larger founder tax strategy.

Pair it with 83(b), R&D credits, and smart entity planning, and you’re not just building a company.

You’re building a tax architecture that compounds your outcome when everything finally works.

Key Takeaways

Founders don’t need to memorize tax code sections. They just need to know which levers matter — and when to pull them.

Here’s what to remember about QSBS:

1. QSBS is Section 1202 of the tax code — and it’s worth understanding.

It’s one of the few laws that rewards you for taking risk.

Meet the criteria, and you can exclude up to $10–15 million of your capital gains from federal tax when you sell.

2. Eligibility is earned, not claimed.

You can’t retroactively “make your stock QSBS.”

You qualify by setting things up right — C-Corp structure, original issue, under $50M assets, active business, and a 5-year hold.

Miss any one of those, and the benefit disappears.

3. File your 83(b) and start the clock early.

That single filing locks in your low basis, starts your five-year countdown, and often determines whether you’ll ever see a QSBS exemption.

It takes five minutes. It can save you millions.

4. Keep the company eligible.

After formation, don’t break the rules:

• Avoid converting to an LLC or S-Corp.

• Don’t redeem shares too soon.

• Track your asset size and business activity ratio.

• Document everything.
  
  

QSBS is won by staying boring — structure clean, records tight, and entity consistent.

5. Everyone on the cap table can win.

QSBS applies per shareholder.

That means founders, employees, and early investors each get their own exclusion — and families or trusts can multiply it further with proper planning.

If your company wins, you all win — tax-efficiently.

6. Use it as part of a broader strategy.

QSBS is the endgame.

Combine it with R&D credits, early 83(b) filings, and solid documentation, and you’ve built a tax framework that protects you while building and when exiting.

7. Don’t wait until you’re selling to care.

By the time your company is getting acquisition offers, it’s too late to fix QSBS eligibility.

The right time to plan is the week you incorporate.

The second-best time is right now.

Founder Tip

If you’re forming a new company:

File your 83(b) the same week you incorporate, confirm you’re a C-Corp, and keep your asset base under $50 million until after all founder shares are issued.

That’s it — you’ve locked in the foundation of QSBS.

The paperwork takes an afternoon.

The payoff can be $10 million (or more) in tax-free gains five years later.

Bottom Line

QSBS is one of the few corners of the tax code that actually rewards builders.

It’s not a loophole or a gimmick — it’s policy designed to encourage innovation.

Get the setup right early, and five years later it could mean the difference between wiring millions to the IRS or keeping it to reinvest, hire, and build again.

Your cap table tells the story of who believed in your company.

QSBS decides how much of that belief you get to keep.