Entrepreneurs - Qualified Small Business Stocks (QSBS): A great financing vehicle, Changes in Latest Federal Budget
- greenwoodphilip
- Aug 29
- 8 min read
The "One Big Beautiful Bill Act" (OBBBA), which came into effect on July 4, 2025, shakes up the rules for Qualified Small Business Stock (QSBS) under IRC Section 1202. It's all about a new tiered system for capital gains exclusions based on how long you hold the stock, upping the cap on gains you can exclude per issuer, and increasing the corporate gross asset limit. These updates apply to QSBS bought after the law kicked in, aiming to boost investments in growing companies. The OBBBA makes QSBS a more adaptable tax strategy, offering tax breaks from earlier cash-out opportunities and lowering the risks for early-stage investments. By increasing the gross asset threshold, more companies can issue QSBS, helping later-stage startups bring in investors. Keeping detailed records is crucial for companies with stock issued under both the old and new QSBS rules.
The Foundation of QSBS — Section 1202 Principles
The Intent of Section 1202
Section 1202, which came about in 1993, is all about encouraging people to invest in small, fast-growing companies in the U.S. It gives non-corporate investors a sweet deal: they can exclude a big chunk of capital gains when they sell qualifying stock. At first, you could exclude 50%, but now it's up to 100%, showing that lawmakers are still backing investments in startups.
Corporate-Level Requirements
If you want your company to qualify as QSBS, here's what you need to know:
Entity Type: Your company has to be a domestic C corporation. S corporations, LLCs treated as partnerships, and other types won't work. But if an LLC decides to be taxed like a C corporation, it can issue QSBS.
Gross Assets: When you issue stock and right after (including any cash you get from it), your company's total gross assets shouldn't be more than $50 million. This cap goes up to $75 million for shares issued after July 4, 2025.
Active Business Requirement: While the investor holds the stock, at least 80% of your company's assets (by value) need to be actively used in a qualified trade or business.
Excluded Businesses: Some business types can't go for QSBS, like:
Those offering services in areas like health, law, accounting, financial services, consulting, and sports.
Businesses that mainly rely on the reputation or skills of one or more employees.
Banking, insurance, financing, leasing, investing, and farming businesses.
Places like hotels, motels, or restaurants.
No Significant Stock Redemptions: Your company shouldn't do "significant" stock buybacks within certain timeframes. This usually means buying back more than 5% of the company's total outstanding stock value within a year before and after issuing the stock. There's a stricter rule for redemptions from the taxpayer or related folks.
Shareholder-Level Requirements
Even if a company meets the necessary requirements, individual shareholders need to follow these rules to get tax perks.
Original Issuance: You have to get the stock directly from the company when it's first issued. You can't buy it from another shareholder on the secondary market. The stock should be received in return for money, property, or services given to the company.
Holding Period: To enjoy any gain exclusion, you need to hold onto the stock for a certain minimum time, which depends on when you got it:
For stock acquired after July 4, 2025:
Held for 3 years: 50% exclusion
Held for 4 years: 75% exclusion
Held for 5 or more years: 100% exclusion
For stock acquired on or after September 28, 2010 (and before July 5, 2025): You need to hold the stock for more than five years to get a 100% exclusion.
Shareholder Type: The investor should be a non-corporate taxpayer, like an individual, a trust, or a partnership. C corporations can't claim the QSBS tax exclusion.
Summary of the OBBBA Changes to the Section 1202 Stock
The OBBBA alterations enhance both the accessibility and value of the QSBS tax exemption. The OBBBA's core changes are summarized in the table below, providing a direct comparison between the prior law and the new regulations.
An Example
InnovateTech is a local C corporation that's been around for two years, with total assets worth $25 million. They're not part of any excluded industries like professional services or hospitality, and they're using at least 80% of their assets to actively run their business, which is all about developing cutting-edge software. InnovateTech is looking to raise $10 million in a Series A funding round. Since their total assets are under the new $75 million limit, the stock they issue in this round will qualify for the updated QSBS benefits. An angel investor, "Sarah," invests $1 million for a 10% equity stake in the company.
The introduction of a tiered holding period and an increased gain cap offers Sarah a variety of flexible exit strategies, unlike the previous law's singular, all-or-nothing five-year requirement.
Exit after 3 years: InnovateTech is acquired for $100 million. Sarah's stake is valued at $10 million, resulting in a $9 million gain on her initial $1 million investment. Under the new QSBS rules, she can exclude 50% of this gain.
Taxable Gain: $4.5 million
Excluded Gain: $4.5 million
The remaining taxable gain is subject to a 28% tax rate, resulting in an effective federal tax rate of 15.9% on her total gain.
Exit after 4 years: InnovateTech is acquired for $150 million. Sarah's stake is now valued at $15 million, leading to a $14 million gain. Having held her stock for four years, she can exclude 75% of the gain.
Taxable Gain: $3.5 million
Excluded Gain: $10.5 million
The effective federal tax rate on her total gain is reduced to 7.95%.
Exit after 5 years or more: InnovateTech is acquired for $200 million. Sarah's stake is valued at $20 million, resulting in a $19 million gain. Since she held the stock for more than five years, she can exclude 100% of the gain.
Taxable Gain: $0
Excluded Gain: $19 million
In this scenario, the entire $19 million gain remains well below the new per-issuer cap of $15 million or 10 times her adjusted basis ($10 million). Even if a sale occurs before the five-year mark, Sarah benefits from significant tax advantages, which considerably reduce the risk of her investment and enhance the company's appeal to a broader spectrum of investors.
Strategic Implications and Planning Opportunities
The OBBBA's updates to Section 1202 introduce new strategies for startups. A tiered holding period now allows founders and employees to sell stock after 3-4 years for tax-free gains, improving on the previous five-year rule. For founders with restricted stock, making a Section 83(b) election remains crucial to start the QSBS holding period upon stock grant, ensuring early tax exclusions.
The tiered exclusion reduces risks for early-stage investments by shortening the time for tax benefits, offering partial exclusion at three or four years. Increasing the asset threshold from $50 million to $75 million expands eligible companies, enhancing venture capital activity and allowing investments in more mature startups while retaining QSBS tax advantages.
This higher asset threshold also allows businesses to operate longer as pass-through entities before converting to a C corporation, maximizing gain exclusion under the 10x basis rule. Companies must monitor QSBS compliance, managing working capital and investment securities for smart growth and tax benefits.
OBBBA retains IRC Section 1045, enabling taxpayers to defer QSBS sale gains by reinvesting in new QSBS within 60 days, maintaining its role in tax deferral. The new tiered system offers strategic choices, allowing taxpayers to choose between a Section 1045 rollover or a partial gain exclusion based on stock holding duration, providing flexibility in managing tax liabilities.
QSBS is significant for estate planning among high-net-worth individuals. The increase in the per-issuer gain exclusion cap to $15 million, along with gifting strategies, enhances "stacking," allowing substantial tax-free gains, making QSBS strategies more attractive for wealth transfer.
Despite its benefits, the QSBS exclusion is criticized for favoring high-income earners and lacking evidence of economic growth stimulation. A Yale Budget Lab study forecasts an $81.5 billion impact on the U.S. Treasury over the next decade. Critics argue that strategies like gifting and stacking can be exploited for tax avoidance. Nonetheless, the OBBBA extends these benefits, reflecting a political inclination towards supporting capital formation in startups. Understanding the QSBS exclusion is essential, as it remains a crucial element of the American tax system.
Conclusions
The changes to Section 1202 by the OBBBA bring a big update to the QSBS tax rules. With the new tiered holding period, it's now easier for founders and investors to make early exits, giving them more flexibility and access to cash. The increased gain cap and the bigger corporate eligibility threshold mean more chances for tax savings, especially with the 10x basis rule in play.
This new law turns QSBS from a strong but stiff tax benefit into a more adaptable and widely useful tool for raising capital. However, because of the complex rules and strict compliance needs, getting advice from tax and legal pros is more important than ever. Whether you're a company looking for investment or an individual or fund planning your portfolio, staying on top of QSBS compliance and documentation is key to making the most of these great new benefits.
CITATIONS
bakertilly.com Changes to section 1202, Qualified Small Business Stock, in the One Big Beautiful Bill Act
jonesday.com Qualified Small Business Stock Benefits Expanded in New Tax Bill | Insights | Jones Day
paulhastings.comQualified Small Business Stock Tax Benefits Expanded for Early-Stage Companies and Investors | Paul Hastings LLP
hklaw.com Special Qualified Small Business Stock Issues Applicable to Pooled Investment Fund Partnerships | Insights | Holland & Knight
klgates.comAmendments to Section 1202 Tax Exclusion for Sale of Qualified Small Business Stock Provide a Lift to Startups and Angel Investors - K&L Gates
insightplus.bakermckenzie.com United States: The One Big Beautiful Bill Act (OBBBA) sweetens incentives for startups and other qualified small businesses - Baker McKenzie InsightPlus
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