Qualified Small Business Stock: The Tax Break Tech Founders and Early Employees Need to Know

(6 minutes to read)

If you’re a founder or early employee at a startup, there’s a tax provision that could result in significant federal tax savings, and many people in tech have never heard of it. It’s called qualified small business stock, or QSBS, and it’s found in Section 1202 of the Internal Revenue Code.

Section 1202 allows eligible shareholders in certain small C corporations to exclude up to $10 million, or potentially much more, in capital gains from federal income tax when they sell their stock. For tech professionals who join early-stage companies and later experience a successful exit, the tax savings can be enormous for some taxpayers. Yet despite its significance, QSBS is rarely discussed in the equity compensation conversations that dominate personal finance for people in tech.

That needs to change. Whether you’re a founder who incorporated a C corporation, an early employee who received stock options or restricted stock, or an investor who put money into a startup, you should understand how QSBS works, whether your stock qualifies, and what planning strategies can help you take full advantage of it.

What Is QSBS?

At its core, Section 1202 is an incentive designed to encourage investment in small businesses. Congress enacted it in 1993 and has expanded it several times since, most recently through the One Big Beautiful Bill Act (OBBBA) signed into law on July 4, 2025.

Here’s the basic idea: If you hold stock in a qualifying small business and you meet certain requirements, you can exclude some or all of the capital gain from the sale of that stock from your federal income tax. For stock acquired after September 27, 2010, the exclusion can be as much as 100% of the gain, meaning zero federal capital gains tax on what could be a very large amount of money.

The maximum gain you can exclude is the greater of $10 million or 10 times your adjusted basis in the stock (i.e., what you paid for it or its value at the time you received it). For stock issued after July 4, 2025, the OBBBA increased the dollar-based limit to $15 million, indexed for inflation beginning in 2027.

To put that in perspective: if you’re a founder who invested $100,000 for stock in your company and later sold it for $5 million, the entire $4.9 million gain could be excluded from federal tax, a savings of roughly $1.16 million at the current 23.8% combined federal rate on long-term capital gains and net investment income tax. (This assumes you hold the stock long enough to qualify for the full 100% exclusion.)

Eligibility Requirements

Not all stock qualifies. Section 1202 has specific requirements at both the company and shareholder levels.

Company-Level Requirements:

The issuing company must be a domestic C corporation. (An LLC that has elected to be taxed as a C corporation under the “check-the-box” rules can qualify.) At the time the stock is issued, the corporation’s aggregate gross assets, meaning cash plus the adjusted basis of other property, cannot exceed $50 million. For stock issued after July 4, 2025, that threshold increases to $75 million, indexed for inflation beginning in 2027. During substantially all of the shareholder’s holding period, at least 80% of the company’s assets must be used in an active qualified trade or business.

Importantly, certain types of businesses are excluded. The list is long: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage, banking, insurance, financing, leasing, investing, farming, mineral extraction, and hotel, motel, and restaurant businesses.

If you’re working in tech — building software, hardware, or other technology products — your company is almost certainly not in an excluded category. But if you’re a founder in fintech, insurtech, or another sector that touches financial services, the classification deserves a closer look.

Shareholder-Level Requirements:

You must be a non-corporate taxpayer (i.e., an individual, trust, or estate, not a corporation). You must have acquired the stock at original issuance, meaning directly from the company in exchange for cash, property (other than stock), or services. And you must hold the stock for the required period.

The Holding Period

For stock issued before July 5, 2025, you need to hold it for more than five years to claim the 100% exclusion. The OBBBA introduced a tiered structure for stock issued after July 4, 2025:

Held more than 3 years: 50% exclusion

Held more than 4 years: 75% exclusion

Held more than 5 years: 100% exclusion

This tiered approach is a significant change. It means that even if your company is acquired or goes public before you’ve held the stock for five years, you can still capture a partial exclusion, something that wasn’t available under the prior rules.

The math deserves a closer look, though. The non-excluded portion of your gain under the 50% or 75% tiers is taxed at a 28% federal capital gains rate, not the standard 15% or 20% rate, plus potentially the 3.8% net investment income tax. In practice, if you sell post-OBBBA QSBS after four years and exclude 75% of the gain, the remaining 25% faces an effective federal rate of up to 31.8%. The partial exclusion is still a meaningful benefit, but in many scenarios, waiting one more year for the full 100% exclusion produces a significantly better result. Whether that’s feasible depends on the timing of your exit, which is not always in your control.

How QSBS Applies to Tech Professionals

For founders and early employees at venture-backed startups, QSBS is particularly relevant in several scenarios.

Founders: If you incorporated as a C corporation (as most venture-backed startups do) and the company’s gross assets were under $50 million (or $75 million for stock issued after July 4, 2025) when you received your shares, your founder stock is potentially QSBS. Given that founders typically acquire stock at a very low price, sometimes fractions of a penny per share, the 10-times-basis alternative cap might be less useful than the $10 million (or $15 million) dollar cap. The dollar cap is usually the binding constraint for founders with low-basis stock.

Early employees who exercise stock options: When you exercise incentive stock options (ISOs) or non-qualified stock options (NSOs), you acquire stock directly from the company. If the company qualifies as a QSBS issuer at the time of exercise, the stock you receive may be QSBS. Your basis is typically the exercise price you paid plus, in the case of NSOs, the ordinary income recognized on exercise.

This is a point that a lot of people miss: Holding stock options is not the same as holding stock. You must actually exercise your options and hold the resulting shares for the QSBS holding period to begin. The five-year counter (or three-year counter for post-OBBBA stock) starts when you are holding shares, not when you were granted options. If you wait to exercise until just before a sale, you will not have held the shares long enough to qualify for the exclusion. For early employees at companies with QSBS potential, the timing of your exercise is a planning decision that deserves serious attention.

Restricted stock with an 83(b) election: If you received restricted stock and filed an 83(b) election within 30 days, you are treated as owning the stock from the date of the grant. This is important for QSBS purposes because the holding period begins at grant (not vesting), potentially allowing you to meet the five-year requirement sooner. Without an 83(b) election, the holding period for restricted stock generally doesn’t begin until the stock vests.

Planning Strategies

Consider filing an 83(b) election. For early employees receiving restricted stock, the 83(b) election serves a dual purpose. It starts the clock on your QSBS holding period at grant rather than vesting, and it can reduce the total tax on the stock if the company’s value increases between grant and vesting. The 83(b) election must be filed with the IRS within 30 days of the stock grant. Miss this deadline and the opportunity is gone. The good news is that the IRS now offers Form 15620 as a standardized form for making the election, and electronic filing is available through the IRS website. This is a welcome change from the old process of drafting your own letter and mailing it via certified mail.

Stacking exclusions for married couples. Each taxpayer gets their own QSBS exclusion. If you’re married, you and your spouse can each potentially exclude up to $10 million (or $15 million for post-OBBBA stock) in gain from the same company, effectively doubling the exclusion. To take advantage of this, both spouses need to be shareholders. Gifting QSBS to a spouse before a sale is one common approach. Note that the gifted stock retains its QSBS status and the holding period carries over.

Gifting to family members and trusts. Similar to the spousal strategy, gifting QSBS to children, other family members, or trusts can multiply the number of exclusions available. Each recipient gets their own per-issuer cap. This can be particularly powerful if you anticipate gains well in excess of the individual exclusion limits.

Section 1045 rollovers. If you need to sell QSBS before meeting the full holding period requirement but have held the stock for at least six months, Section 1045 allows you to defer the gain by reinvesting the proceeds into other QSBS within 60 days. This is a useful tool when the timing of an exit doesn’t align with your holding period.

QSBS eligibility is highly technical and frequently scrutinized by the IRS. Documentation gaps, valuation issues, business activity changes, or technical missteps can result in partial or complete disqualification of QSBS treatment. Professional tax review is critical.

State Tax Considerations

One important caveat: QSBS is a federal provision. States are free to follow it, partially follow it, or ignore it entirely. The majority of states do conform to the federal QSBS exclusion, including several with significant tech workforces: Colorado, Oregon, Virginia, Georgia, Illinois, and Utah, among others. States with no income tax, such as Texas, Florida, Nevada, and Washington, are effectively favorable as well. (Washington imposes a 7% capital gains tax on gains above $250,000, but gains excluded under Section 1202 are exempt.)

California, notably, does not conform to Section 1202, meaning your QSBS gain, even if fully excluded from federal tax, is still subject to California income tax. Given that many tech professionals live and work in California, this is a significant consideration. Other states that do not follow the federal exclusion include Alabama, Mississippi, Pennsylvania, and the District of Columbia (which decoupled from the federal QSBS exclusion in late 2025). Some states, like New Jersey, have recently enacted conformity starting in 2026. Hawaii and Massachusetts offer only partial conformity, so the state-level benefit may be smaller than the federal exclusion.

If you’re in a state that doesn’t follow Section 1202, the state tax on your gain could still be substantial. This is worth factoring into your overall exit planning.

Why This Matters Now

OBBBA’s changes — the higher gross asset threshold, the increased dollar cap, and the tiered holding period — make QSBS more accessible and more valuable than ever. More companies now qualify. More shareholders can benefit. And the tiered holding periods provide meaningful tax savings even for exits that happen before the five-year mark.

If you’re working at a startup, planning to start a company, or investing in early-stage businesses, understanding QSBS and planning around it should be a priority. The planning decisions, like whether to incorporate as a C corporation, when to exercise options, and whether to file an 83(b) election, need to be made early, often well before an exit is on the horizon. When implemented correctly and when all requirements are met, these strategies may result in meaningful federal tax savings. That’s not a hypothetical. It’s how Section 1202 was designed to work.

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 want help determining whether your stock qualifies as QSBS and building a plan to maximize your tax savings, schedule a complimentary consultation.