6 Rules for Exercising Stock Options to Qualify for QSBS
Word is spreading about the qualified small business stock (QSBS) exclusion. QSBS allows potentially up to 100% tax exclusion of gain from the sale of stock in certain small businesses, including many technology start-ups. Gain may be excluded, if all requirements are met, from income for both federal regular tax and alternative minimum tax (AMT). If your company stock meets the requirements, you may be able to reduce or eliminate federal tax on some or all gains from the sale of your shares, or you may be able to defer tax on any gains using a QSBS rollover.
If you don’t know about QSBS yet, keep reading. The key rules related to individual taxpayers are summarized below. While QSBS rollovers to defer taxable gain are not covered in this article, all of the rules below also apply to QSBS stock with gain you might later decide to roll over.
All that said, the rules for the QSBS exclusion are highly technical—you’ll need to review them carefully for your specific situation to see if you qualify.[1]
Rule #1: A Domestic C Corporation Must Issue the Stock
The first requirement to be considered qualified small business stock: A domestic C corporation must issue the stock. Most major U.S. corporations are organized as C corporations, as are most venture capital-backed start-up companies.
Your shares must be “original issue” shares, meaning you purchased them directly from the company or you received them directly from the company as compensation. If you bought shares on a secondary market or from another person who acquired them directly from the company, those shares would not qualify as QSBS because you did not purchase them directly from the company.
Rule #2: The Company Must Be “Small”
For stock issued on or before July 4, 2025, the gross assets of the company must be $50 million or less at all times before, and immediately after, the company issues stock. For stock issued after July 4, 2025, the One Big Beautiful Bill Act (OBBBA) increased this threshold to $75 million, indexed for inflation starting in 2027. This expanded limit allows more growth-stage companies to qualify. The company must also be an “active business,” with 80% or more of its assets used in a “qualified trade or business.” The idea here is that the company must be an operating business and not an investment vehicle.
Rule #3: The Company Can’t Be in an Excluded Industry
The definition of a “qualified trade or business” excludes certain industries, such as services (including health, law, engineering, architecture, accounting, consulting, performing arts, and athletics), hospitality, banking, finance, farming, and mining. Most technology companies would meet the definition of a “qualified trade or business.” If the company purchases its own stock (share buyback) around the time it issues stock, the QSBS exclusion may not be allowed.
To understand whether the company meets these requirements related to the company’s finances, share purchase history, and issuance history, you may consider consulting with your company’s chief financial officer or other finance team members.
Rule #4: You Must Hold the Stock for Five Years
If you received common stock from the company as a founder or employee, so-called “restricted stock,” your holding period counter starts when you receive the shares. Each new stock grant starts a new counter when you receive those shares. For stock acquired on or before July 4, 2025, you must hold for more than five years to receive any exclusion. For stock acquired after July 4, 2025, the OBBBA introduced a tiered exclusion: 50% of the gain is excluded after three years, 75% after four years, and 100% after five years.
However, stock options do not qualify for the QSBS tax exclusion. You must exercise your stock options, purchasing shares from the company, and then hold the shares to qualify for the exclusion.
The holding period counter begins at exercise of the option, when you actually purchase the shares, not the date your stock option was granted. This is important: You must exercise your stock options and hold your shares for a minimum of three years (for a partial exclusion) or five years (for the full 100% exclusion) to qualify for QSBS treatment. Not being aware of this seemingly small difference between stock and stock options could result in different tax outcomes.
Rule #5: You Can Exclude Up to $10 Million in Gain
How much money could overlooking the five-year rule cost you? It may be significant, depending on your circumstances. The amount of taxable gain you can exclude from income is limited to the greater of:
- For stock acquired on or before July 4, 2025: $10 million per taxpayer, or 10 times the cost basis of shares sold in the tax year.
- For stock acquired after July 4, 2025: $15 million per taxpayer (indexed for inflation beginning in 2027), or 10 times the cost basis of shares sold in the tax year.
Cost basis is what you paid for your shares; for example, the price you paid to acquire the shares when you exercised stock options. Typically, your cost basis will be small, and the $10 million limit will apply.
Yes, you read that right: Up to $10 million of gain (or $15 million for post-OBBBA stock) can be excluded from income tax for a married couple filing a joint tax return. And potentially even more can be excluded using advanced income tax planning techniques. In some cases, it’s possible to receive multiple $10 million gain exclusions using trusts and other related techniques, subject to complex IRS rules, documentation requirements, and potential limitations. Note that if you hold both pre- and post-OBBBA QSBS in the same company, you don’t get both caps stacked on top of each other, but selling your pre-OBBBA shares first may allow you to maximize the combined exclusion.
The per-issuer gain exclusion rule applies per company. If you’re holding stock in multiple companies, the maximum applies to each company.
Rule #6: When You Acquired the Stock Matters
Another important set of rules deals with when you acquired company stock.
For stock acquired on or before July 4, 2025, the exclusion percentage depends on when you acquired the stock:
- The 100% gain exclusion applies to stock acquired after September 27, 2010.
- For stock acquired between February 18, 2009, and September 27, 2010, 75% of gain is excluded from income.
- For stock acquired between August 11, 1993, and February 17, 2009, 50% of gain is excluded from income.
- No exclusion is available for stock acquired before August 11, 1993.
For stock acquired after July 4, 2025, the exclusion percentage depends on how long you hold the stock:
- 50% of gain is excluded for stock held more than three years.
- 75% of gain is excluded for stock held more than four years.
- 100% of gain is excluded for stock held more than five years.
- No exclusion is available for stock held three years or less.
Final Thoughts on QSBS
The QSBS exclusion has been in federal tax law and available for more than 30 years. It became permanent in 2015 with the Protecting Americans from Tax Hikes Act (the PATH Act). In 2018, it received renewed attention after the Tax Cuts and Jobs Act reduced the federal corporate tax rate to 21%, enhancing the attractiveness of C corporations. Most significantly, on July 4, 2025, the One Big Beautiful Bill Act (OBBBA) expanded QSBS benefits more substantially than any legislation since Section 1202’s original enactment, raising the gain exclusion cap, increasing the gross asset threshold, and introducing tiered exclusions that allow partial benefits after just three years. The OBBBA also restored immediate expensing of domestic research and experimental expenditures, reversing a TCJA provision that had been causing some companies to fail the gross assets test.
Many states follow the federal tax treatment of QSBS (or don’t have a state income tax), but there are important exceptions. Small business stock sales are generally taxable and may be treated differently in California. Pennsylvania, Alabama, and Mississippi also do not generally provide a QSBS tax exclusion. New Jersey, previously a non-conforming state, enacted legislation in June 2025 bringing it into conformity with Section 1202 for tax years beginning on or after January 1, 2026. Massachusetts and Hawaii offer a QSBS exclusion with some modification to the federal requirements.
The QSBS income tax exclusion is an important consideration when deciding whether to exercise your stock options. The potential to reduce or eliminate certain taxes, if eligibility requirements are met, may be meaningful in some cases.
Other factors to consider are how successful you expect the company to be and how this investment relates to your overall financial plan; you are deciding to invest in the company and should view an exercise of stock options in that context. The cost to exercise your options is another factor because you will pay cash now at the exercise price to buy shares but won’t be able to sell your shares for at least three years (for a partial exclusion on post-OBBBA stock) or five years (for the full 100% exclusion) if you want to qualify for QSBS tax treatment.
The rules defining what stock qualifies for the QSBS tax exclusion are detailed and complicated. If you think you have stock that may be QSBS eligible, consider consulting with an experienced tax attorney, a certified public accountant (CPA), or a financial planner who is knowledgeable about QSBS. If your option shares don’t qualify for QSBS tax treatment, learn about taxation for non-qualified stock options and incentive stock options.
Exercising stock options and investing in private company shares involves risk, including concentration risk, liquidity constraints, company-specific performance risk, and potential loss of invested capital, as well as varying tax outcomes depending on individual circumstances.
Savant Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you’d like to explore how we can help you evaluate your financial situation and planning considerations, schedule a complimentary consultation.
[1] https://www.law.cornell.edu/uscode/text/26/1202
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment or tax advice from Savant. Please consult your investment or tax professional regarding your unique situation.
Bruce R. Barton
Managing Partner / Financial Advisor
CFP®, CFA®, MBA