What Is Qualified Small Business Stock (QSBS)? Definition and Examples

Section 1202 is the part of the federal tax code that defines qualified small business stock and lets holders exclude its gain. That is why advisers treat QSBS and Section 1202 as one thing. It is also why the QSBS tax question is always a federal one first. The rule is for taxpayers other than corporations: individuals, trusts and estates. It also covers individuals who hold through a partnership or an S corporation, a company whose profits are taxed to its owners. A corporation that sells the same shares gets nothing from it.

The idea is a trade. The government gives up tax on the upside of a small company. In return, money and work go into the company early, when the risk is high. So every condition points at that early moment. The company must be small when it issues the shares. The shares must come from the company itself, and a purchase from another holder does not count. And the money or work must stay in for years.

The rule has been rewritten several times since 1993. The latest change came with the One Big Beautiful Bill Act, enacted on July 4, 2025. It kept the old rules for stock acquired on or before that date. Stock acquired afterward gets a new, more generous set. The date you acquired the shares decides which set applies. For an option, that is the day you exercise it and pay for the shares. The day the option was granted does not count.

When you sell qualifying shares, you report the sale as usual and subtract the excluded part of the gain. On the federal return, that is a negative adjustment with code Q on Form 8949, the IRS form for reporting sales of stock and other investments. There is no application and no ruling in advance. You claim the exclusion yourself, and your records and the company’s have to support it if the IRS asks.

The Exclusion Percentage

For stock acquired after July 4, 2025, the exclusion grows with the holding period, the time you own the shares. You exclude 50% of the gain after three years, 75% after four and 100% after five. For stock acquired earlier, there is one threshold: you must hold the shares more than five years. The percentage then depends on the purchase date. It is 100% for stock acquired after September 27, 2010, 75% for stock acquired after February 17, 2009, and 50% for anything earlier.

The Part That Is Not Excluded

Below 100%, the rest of the eligible gain does not get the ordinary 20% rate for long-term gains. It is section 1202 gain, taxed at a maximum of 28%, as IRS Topic 409 puts it. The 3.8% net investment income tax, an extra federal tax on investment income above set income levels, can apply on top. The excluded part is not income at all, so neither tax touches it. The alternative minimum tax (AMT) is a second tax calculation that adds back certain breaks, called preference items. For stock acquired after September 27, 2010, the exclusion is not one of them. For older stock, 7% of the excluded amount still is.

The Cap

The exclusion is limited per company and per taxpayer. Each year, you may exclude gain on one company’s stock up to the greater of two amounts. The first is a per-issuer cap: $15 million for stock acquired after July 4, 2025, or $10 million for earlier stock. Both are reduced by what you excluded in earlier years. The second is ten times your adjusted basis in the shares sold that year. Basis is what you paid for the shares, adjusted for tax purposes. The $15 million figure is indexed for inflation from 2027. Gain above the cap is taxed as an ordinary long-term capital gain.

So QSBS leaves the rate on a gain as it is. It removes part or all of the gain from income. How much depends on dates set when you bought the shares.

Qualified small business stock is mostly held by the people who were there first. They include founders who bought common stock at formation and employees who exercised options while the company was small. They also include seed and early-round investors who bought preferred stock, the class sold in funding rounds, directly from the company. The cap table of a successful startup, its list of who owns what, often shows QSBS and non-QSBS shares of the same class side by side. That happens because the size test is applied on each issuance date.

Gross assets are the company’s cash plus the tax basis of everything else it holds. A company that has just raised a large round counts that cash. The ceiling is $75 million, or $50 million for stock issued on or before July 4, 2025. Once the company’s balance sheet passes it, the shares it issues from then on do not qualify. Shares issued earlier keep their status.

That is the point where QSBS and pre-IPO shares part ways. A late-stage company raising billions is far past the asset ceiling, so its new shares fail. A share bought from an existing holder on the secondary market fails a different test. It was not acquired at original issue, meaning directly from the company, whatever its status was in the seller’s hands. So most positions bought shortly before an initial public offering (IPO) are not QSBS. That holds whether you buy directly or through an SPV, a vehicle that pools investors’ money for one deal.

If you are an employee, check which kind of equity you hold. Shares from exercised options or settled RSUs (restricted stock units, a promise of shares delivered later) can qualify. The clock and the asset test start when the shares are issued to you. The date the award was granted does not count. The detailed tests are on QSBS requirements.

An early investor buys $500,000 of preferred stock directly from a Delaware C corporation. The round closes in September 2025, and afterward the company holds $40 million of assets. Years later, the investor sells the shares for $10.5 million, a gain of $10 million. The cap is the greater of $15 million and ten times basis ($5 million), so the whole gain is eligible. The columns below differ only in how long the investor held the shares.

Three years of holding take about a third off the bill. Five years take all of it. The cap matters on larger exits. Suppose the same $500,000 had grown to $40.5 million. At five years, $15 million of the $40 million gain would be excluded. The other $25 million would be taxed as an ordinary long-term gain, roughly $5.95 million at 20% plus 3.8%.

• Assuming every startup share qualifiesOn the issuance date, the company must have been a C corporation under the asset ceiling. It must also have run a qualified business for substantially all of your holding period. A share in an LLC or an S corporation never qualifies.
• Counting from the grant dateAn option is only a right to buy stock. The holding period and the asset test start when the shares are issued on exercise.
• Buying on the secondary marketShares bought from another holder are not acquired at original issue. They do not qualify, whatever their status was in the seller’s hands.
• Selling a month earlyUnder the old rules, five years means more than five years. Under the new ones, a sale at two years and eleven months gets nothing. A sale at three years gets half.
• Ignoring redemptionsA redemption is the company buying back its own stock. If it bought back stock from you or a related person around the issuance date, your shares can lose their status.
• Not collecting the paperworkYou claim the exclusion yourself. Without the company’s records of its gross assets and activities, the claim is hard to defend.

Qualified small business stock (QSBS)

Stock of a domestic C corporation, issued directly to the holder when the company’s gross assets were within the Section 1202 ceiling. Its gain can be partly or fully excluded from federal tax.

Section 1202

The section of the Internal Revenue Code that defines QSBS and sets the exclusion percentage, the per-issuer cap and the company tests.

C corporation

A company taxed under subchapter C of the tax code. It pays its own income tax, separately from its shareholders.

Original issue

Acquiring stock from the company itself, for money, for property other than stock or as pay for services. Stock bought from another holder does not count.

Aggregate gross assets

The company’s cash plus the tax basis of its other property. Tested before and immediately after each issuance of stock.

Basis

What you paid for an asset, adjusted for tax purposes. Your gain is the sale price minus your basis.

Per-issuer cap

The limit on gain you may exclude for one company: the greater of $15 million ($10 million for older stock) or ten times your basis in the shares sold.

Section 1202 gain

The part of an eligible gain that is not excluded. It is taxed at a maximum of 28%.

Net investment income tax (NIIT)

An extra 3.8% federal tax on investment income for taxpayers above set income levels.

Alternative minimum tax (AMT)

A second federal tax calculation that adds back certain tax breaks. For stock acquired on or before September 27, 2010, 7% of the QSBS exclusion is added back.

Pre-IPO shares

Shares of a company that has not yet listed. Bought on the secondary market, they are not QSBS.

For the tests one by one, see QSBS requirements. For the tax on equity pay before any sale, see how RSUs are taxed, ISO vs NSO and AMT.

Every percentage, cap and date was checked against the US Code and the IRS on October 1, 2026. They reflect federal law as amended on July 4, 2025. The worked example is illustrative arithmetic on those rules and uses no market data. State tax treatment differs and is not covered.