For founders, early employees, and investors in startups, the Qualified Small Business Stock (QSBS) exclusion remains one of the most powerful tax incentives in the Internal Revenue Code. Originally enacted to encourage investment in small businesses, this provision allows eligible taxpayers to exclude a significant portion – or even all – of the gain from the sale of qualified stock.

Recent legislative changes have expanded and modernized the QSBS rules, introducing tiered gain exclusions and higher eligibility thresholds. Here's what you need to know.

What Is QSBS?

QSBS refers to stock that meets specific requirements under Section 1202 of the Internal Revenue Code. If certain conditions are met, a taxpayer may exclude a portion of the gain realized on the sale of QSBS from federal income tax.

Key Requirements

To qualify for the exclusion:

• The stock must be in a C corporation.
• The corporation must be a qualified small business (assets not exceeding a certain threshold).
• The stock must be originally issued to the taxpayer (not purchased on the secondary market).
• The taxpayer must hold the stock for a minimum period before selling.
• The stock must be in a qualified trade or business.

What’s New: Tiered Gain Exclusion (Effective for Stock Acquired After Enactment)

Previously, the exclusion was all-or-nothing: 100% of the gain could be excluded if the stock was held for at least five years. Under the new rules, the exclusion is tiered based on a holding period:

• 50% exclusion after three years
• 75% exclusion after four years
• 100% exclusion after five years

This change provides more flexibility for investors who may need to exit earlier, while still rewarding longer-term holders with full exclusion.

Note: These tiered rules apply only to stock acquired after the date of enactment. Stock acquired earlier remains subject to the previous rules.

Expanded Caps and Eligibility

Two major thresholds have been increased:

• The per-issuer gain exclusion cap is now $15 million, up from $10 million. This cap will be indexed to inflation starting in 2027.
• The aggregate gross asset test for a company to qualify as a small business has been raised from $50 million to $75 million, also indexed to inflation.

These changes broaden the scope of companies and investors who can benefit from QSBS treatment.

Example: Startup Windfall

Let’s say a person acquires QSBS in a startup in 2026. The company grows rapidly, and this personsells the stock in 2031 for a $30 million gain. Under the new rules:

• If the stock is held for five years or more, the entire $30 million gain could be excluded (subject to the $15 million per-issuer cap).
• If sold after four years, 75% of the gain would be excluded.
• If sold after three years, 50% of the gain would be excluded.

This tiered structure allows Alex to make more nuanced decisions about timing the exit.

Planning Considerations

These updates introduce greater flexibility but also more complexity. Investors and advisors should:

• Carefully track acquisition dates and holding periods
• Monitor issuer-level caps and asset thresholds carefully
• Consider the timing of stock acquisitions to determine which rules apply

Final Thoughts

The QSBS exclusion remains a rare and valuable tax benefit – now with more generous caps and greater flexibility for early exits. As always, consult with a qualified tax advisor to ensure compliance and maximize the benefit.