Imagine selling a block of stock for a $5 million profit and keeping every single penny of it. While the federal government typically claims a significant portion of capital gains—often 20% plus the 3.8% Net Investment Income Tax—a specific corner of the tax code exists to reward those who take risks on early-stage companies. This provision, known as Section 1202 or Qualified Small Business Stock (QSBS), represents perhaps the most powerful wealth-building tool available to the American workforce today.

For many startup employees, equity compensation feels like “lottery tickets” that might one day have value. However, without proper planning, those tickets come with a heavy tax burden. Understanding QSBS allows you to transform your equity into a tax-free windfall, provided you and your employer meet several strict criteria. Because the rules are complex and the stakes often involve seven-figure tax savings, you must navigate the details long before an exit occurs.

Last updated: February 2026. Financial regulations and rates change frequently—verify current details with official sources.

The Essentials of Section 1202

At its core, Section 1202 of the Internal Revenue Code allows non-corporate taxpayers to exclude a massive portion—often 100%—of the capital gains realized from the sale of qualified small business stock. The government created this incentive to encourage long-term investment in domestic small businesses, essentially subsidizing the risk you take when you join a fledgling company instead of an established giant.

The amount you can exclude is capped at the greater of two figures:

• $10 million (cumulative per issuer).
• 10 times your “adjusted basis” in the stock (essentially what you paid for it).

If you received shares as a founding employee for a nominal price, the $10 million limit usually applies. If you invested significant capital into the company, the 10x basis rule might allow you to shield even more. For example, if you invested $2 million into a startup that qualifies for QSBS and later sold those shares for $25 million, you could potentially exclude up to $20 million of that gain from federal taxes.

The Core Requirements for QSBS Eligibility

Not every startup share qualifies for this treatment. To secure the 100% tax exclusion, the stock must meet five primary tests. Failing even one of these criteria can disqualify your shares and leave you with a standard tax bill at the time of sale.

1. The C-Corporation Requirement

The company must be a domestic C-corporation both when it issues the stock and during substantially all of the period you hold the stock. If your startup is organized as an LLC or an S-corporation, the shares do not qualify. Many startups begin as LLCs for tax flexibility and later convert to C-corps to attract venture capital. In these cases, the QSBS “clock” only starts ticking on the date of conversion. You must ensure the company maintains its C-corp status throughout your tenure.

2. The $50 Million Gross Asset Test

The “small business” part of QSBS is defined by the company’s assets. At the time the stock is issued to you, the company’s aggregate gross assets must not exceed $50 million. This includes the cash the company just raised. If you join a company during its Series C or D round and the company already has $60 million on its balance sheet, any shares issued to you from that point forward will not qualify as QSBS. However, if you received shares when the company had only $10 million in assets, those specific shares remain qualified even if the company later grows to a multi-billion dollar valuation.

3. The Original Issuance Requirement

You must acquire the stock directly from the company in exchange for money, property, or services (your labor). You cannot buy QSBS on a secondary market from a former employee or another investor and expect to keep the tax benefits. The exclusion is designed to reward those who provide capital or labor directly to the business. If you exercise stock options, the “issuance” happens at the moment of exercise, provided the company still meets the asset test at that time.

4. The Active Business Requirement

The company must use at least 80% of its assets in the active conduct of one or more “qualified trades or businesses.” The IRS specifically excludes certain industries from QSBS eligibility. Generally, if the business relies on the reputation or skill of one or more employees—such as law firms, medical practices, or financial services—it is disqualified. Most technology, manufacturing, and retail startups easily pass this test, but real estate, farming, and mining businesses do not.

5. The Five-Year Holding Period

This is the most common hurdle for employees. You must hold the stock for at least five years before selling it to claim the exclusion. The clock begins when you legally own the shares. For restricted stock, this usually means the date you make an 83(b) election or the date the shares vest. For stock options, the clock only starts once you exercise the options and own the underlying shares.

How the 100% Exclusion Changes Your Wealth

To see the practical impact of Section 1202, consider Sarah, a software engineer who joined an early-stage AI startup. When she joined, the company had $2 million in assets. She was granted options for 200,000 shares. She exercised those options early, when the total value was low, and held the shares for six years. The company eventually went public, and Sarah sold her shares for $6 million.

Without QSBS, Sarah would face a 20% long-term capital gains tax plus the 3.8% Net Investment Income Tax (NIIT). On her $6 million gain, she would owe approximately $1,428,000 in federal taxes. Because her shares qualify as QSBS, her federal tax liability on that gain is $0. This effectively increases her take-home wealth by nearly 25% simply because she understood and documented her eligibility. You can find more details on current capital gains rates at the IRS website.

“In this world, nothing is certain except death and taxes.” — Benjamin Franklin, Statesman and Inventor

While Franklin’s observation remains largely true, Section 1202 is one of the few instances where the tax code provides a legitimate “exit ramp” from that certainty. By aligning your career with early-stage companies, you aren’t just earning a salary; you are positioning yourself for a tax-advantaged wealth event.

The Critical Importance of the 83(b) Election

If you receive restricted stock (common for founders and very early employees), the five-year QSBS clock usually doesn’t start until the stock vests. This can be a disaster if you work at a company for four years, it gets acquired, and your last batch of shares only vested six months prior. Those shares wouldn’t meet the five-year holding period.

You can solve this by filing an 83(b) election with the IRS within 30 days of receiving your grant. This election tells the IRS you want to be taxed on the value of the shares today, even though they haven’t vested yet. If the shares are worth very little today, the tax hit is negligible, but the QSBS clock starts immediately for the entire grant. This is one of the most vital steps you can take to ensure your entire equity package qualifies for the tax break.

Avoiding Common Errors

The complexity of Section 1202 leaves plenty of room for mistakes that can invalidate your tax break. Vigilance is required from the moment you sign your offer letter until the day you sign the sale documents.

• The LLC Trap: Many founders start as LLCs to pass through losses. If the company stays an LLC for three years before converting to a C-corp, those three years do not count toward your five-year QSBS holding period. Furthermore, if the company’s value exceeds $50 million at the moment of conversion, the shares might never qualify.
• The Significant Redemptions Rule: The IRS wants to prevent companies from “refreshing” QSBS status by buying back old shares and issuing new ones. If the company redeems (buys back) more than a de minimis amount of stock from you or related parties within certain windows, it can disqualify the QSBS status of all shares issued around that time.
• Secondary Sales: If you sell some of your shares to a private equity firm in a secondary round before the five-year mark, those shares will not qualify for the exclusion. While this provides liquidity, you must weigh the immediate cash against the loss of the tax benefit.
• Wait for the Clock: Selling even a few days before the five-year anniversary of your acquisition or exercise date will result in a 0% exclusion. You must be precise with your dates.

State Tax Variations

While the federal government offers a 100% exclusion, your state might not be so generous. State tax treatment of QSBS is a patchwork of “conforming” and “non-conforming” laws. Most states follow the federal lead and offer the exclusion. However, notable exceptions exist.

California, for instance, does not recognize the QSBS exclusion. If you live in San Francisco and sell your startup shares for a $10 million gain, you will owe 0% in federal tax, but you could owe up to 13.3% in California state income tax. Other states, like Pennsylvania and New Jersey, also have historically decoupled from federal QSBS rules. Always check the specific laws of the state where you reside at the time of the sale. You can research state-specific tax burdens through resources like Bankrate’s state tax guide.

When DIY Isn’t Enough

While you can track the basics yourself, certain scenarios demand professional tax and legal intervention. QSBS is a high-audit area because the dollar amounts are so large. If you are in any of the following situations, consult a CPA or tax attorney who specializes in startup equity:

• Multi-Million Dollar Exits: If your gain exceeds $1 million, the cost of a professional opinion letter is a small price to pay for peace of mind during an audit.
• Complex M&A: If your company is being acquired in a stock-for-stock swap, your QSBS status might “roll over” into the acquiring company’s shares, but the rules for this are incredibly dense.
• Section 1045 Rollovers: If you sell your shares after only holding them for six months but before the five-year mark, you can potentially “roll over” your gain into new QSBS of another company within 60 days to defer the tax. This is a highly technical maneuver.
• Hedging Strategies: If you enter into “shorts” or “puts” against your company stock, you may inadvertently stop the QSBS holding period clock or disqualify the shares entirely.

The “10x Basis” Strategy for Large Gains

For most employees, the $10 million cap is the ceiling. However, if you are a founder or an early investor who “bought” your shares by contributing property or significant cash, the 10x basis rule can be life-changing. If you contributed IP valued at $5 million into a C-corp in exchange for stock, your basis is $5 million. Under Section 1202, you could potentially exclude up to $50 million in gains (10 times your $5 million basis).

This is why high-net-worth individuals often prefer contributing assets to a C-corp rather than an LLC. The upfront tax complexity is higher, but the back-end “shield” is significantly larger. For more on investment strategies and basis, you can visit the FINRA Investor Education pages.

Section 1045: The “Restart” Button

What happens if you have a “qualified” share but the company is bought out after only three years? Normally, you would lose the QSBS benefit because you didn’t hit the five-year mark. However, Section 1045 provides a safety valve. It allows you to sell your QSBS, and as long as you have held it for more than six months, you can reinvest the proceeds into a different qualified small business within 60 days. This defers the gain and allows you to keep the QSBS clock running. Once your total holding time (Company A time + Company B time) hits five years, you can sell the Company B shares and claim the exclusion.

Frequently Asked Questions

Do RSUs qualify for QSBS?
Yes, Restricted Stock Units (RSUs) can qualify, but the five-year holding period clock does not start until the shares are actually delivered to you (usually at vesting). Unlike restricted stock, you cannot file an 83(b) election for RSUs. This makes RSUs a less “QSBS-friendly” form of equity compared to restricted stock or early-exercisable options.

What if my company goes public?
Going public does not disqualify your QSBS. If you held the shares for three years while the company was private and then the company went public, you simply need to hold those shares for two more years as a public company to satisfy the five-year requirement. The $50 million asset test is only measured at the time the stock is issued, not when it is sold.

Does QSBS apply to the Alternative Minimum Tax (AMT)?
For stock acquired after September 27, 2010, the 100% exclusion also applies to the AMT. This means the excluded gain is not added back as a preference item, effectively making the gain completely tax-free at the federal level. For older shares (50% or 75% exclusion), a portion of the gain is still an AMT preference item.

Can I gift QSBS to my children?
Yes. If you gift QSBS to another person, the recipient “inherits” your holding period and your status. This can be a powerful estate planning tool, as it may allow multiple family members to each claim their own $10 million exclusion, though you should consult a tax professional to navigate “stacking” rules and gift tax implications.

Actionable Next Steps

Your path to a tax-free exit starts with documentation. Do not wait for an acquisition to start looking for these details. Take the following steps today:

1. Review your grant paperwork: Confirm the date you acquired the stock and whether the company was a C-corp at the time.
2. Request an Officer’s Certificate: Ask your company’s CFO or legal counsel for a letter stating that the company met the $50 million gross asset test and the “active business” test at the time your shares were issued.
3. Check your 83(b) records: If you had restricted stock, find your stamped IRS receipt for your 83(b) election. This is the “birth certificate” for your QSBS clock.
4. Monitor your calendar: Set an alert for the five-year anniversary of your exercise or vesting date. Do not sell a day early.

QSBS is one of the most significant subsidies the US government offers to workers. By choosing to build the next generation of companies, you are performing a service to the economy. Section 1202 is your reward. Treat this equity with the care it deserves, and you may find yourself in the rare position of keeping every dollar you’ve worked so hard to earn.

This is educational content based on general financial principles. Individual results vary based on your situation. Always verify current tax laws and regulations with official sources like the IRS or CFPB.