Unlocking Value with the Qualified Small Business Stock Exemption

by Dan O’ConnorExcendio Advisors

Introduction

Qualified Small Business Stock (QSBS) under Internal Revenue Code §1202 is one of the most powerful tax incentives available to founders, early employees, and investors. QSBS allows individuals to exclude up to 100% of capital gains from federal tax on the sale of qualified shares — a benefit that can translate into millions of dollars of tax savings at exit.

Yet, despite its potential, QSBS often remains underutilized. Early decisions around incorporation type, capitalization, or the timing of equity issuance can determine eligibility — and sometimes eliminate it cold. Investors may similarly overlook how QSBS can significantly enhance after-tax returns and reshape deal economics.

Now, the landscape has changed with the enactment of the One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025. OBBBA expands §1202 with three significant changes:

  • Tiered Gain Exclusion: 50% for 3-year holdings, 75% for 4-year holdings, and 100% for 5+ year holdings — replacing the old “all-or-nothing” rule.
  • Higher Gain Cap: Increased to $15 million (from $10 million), with inflation indexing beginning in 2027 (tax years beginning after 2026).
  • Raised Asset Test: Eligibility threshold lifted to $75 million in gross assets (from $50 million), also indexed starting in 2027.

These changes apply only to QSBS issued or acquired after July 4, 2025. Stock issued earlier remains governed by the legacy rules.

For entrepreneurs and investors preparing for exit — whether through acquisition, IPO, or secondary sales — QSBS continues to be a high-impact planning tool. But under OBBBA, the difference between a proactive strategy and missed opportunity can mean millions in lost after-tax value.

Why QSBS Matters Now

QSBS has always been a powerful planning tool, but the enactment of OBBBA in 2025 makes it more urgent than ever. For founders, employees, and investors, the ability to exclude millions in capital gains can transform both personal wealth outcomes and enterprise valuation. Today’s environment makes QSBS particularly important for several reasons:

  1. Valuation Driver
    After-tax proceeds directly influence negotiating leverage in M&A and IPO scenarios. Companies with stakeholders positioned to capture QSBS benefits often command higher valuations because more of the transaction value flows to shareholders rather than the IRS.
  2. Capital Gains Shield
    QSBS uniquely offers the possibility to eliminate a significant portion — up to 100% — of federal capital gains tax. Under OBBBA, even shorter holding periods (3 or 4 years) still allow partial exclusions, reducing risk for those unable to reach a full 5-year horizon.
  3. Early-Stage Incentive
    By rewarding those who back companies in their early growth phases, QSBS continues to channel capital toward innovation. Founders who can demonstrate QSBS eligibility gain a competitive advantage in attracting angel investors, family offices, and VCs.
  4. Liquidity Event Planning
    OBBBA’s tiered exclusions make exit timing a valuation lever. Boards and investors must now weigh earlier liquidity against maximized tax-free returns — sometimes delaying an exit by months can mean millions in savings.
  5. Governance & Readiness Signal
    Documenting QSBS eligibility requires rigorous governance and compliance. Companies that track eligibility proactively show operational maturity, which buyers and investors reward with smoother diligence and stronger deal terms.
  6. Reinvestment Flywheel
    Tax-free proceeds can be redeployed into new ventures or funds, compounding long-term wealth creation. For serial founders and professional investors, QSBS effectively multiplies the impact of every successful exit.

📌 Bottom Line: QSBS under OBBBA is not just about saving taxes. It’s a strategic valuation lever — shaping wealth creation, deal dynamics, fundraising competitiveness, and long-term reinvestment capacity.

Quick Comparison — QSBS (§1202)

Item Legacy QSBS Rules (Pre-OBBBA) New QSBS Rules (OBBBA, July 4, 2025+)
Exclusion % 100% after 5 years 50% (3 yrs), 75% (4 yrs), 100% (5+ yrs)
Gain Cap Greater of $10M or 10× basis Greater of $15M or 10× basis, inflation-indexed (2027+)
Gross Assets Threshold ≤ $50M at issuance ≤ $75M at issuance, inflation-indexed (2027+)
Who Qualifies Non-corporate taxpayers (founders, investors, employees) Same, but benefit scales with holding period
Effective Date Applies to stock issued before July 4, 2025 Applies to stock issued/acquired on or after July 4, 2025

Key Requirements

Not every company or investor automatically qualifies for the powerful benefits of QSBS. To claim the exclusion under §1202, both the issuing corporation and the shareholder must meet specific requirements. These rules are not just technical hurdles — they shape corporate structure, capitalization strategy, and investor outcomes. Expanded detail below:

  1. Issuer Structure
    • The company must be a domestic C-Corporation.
    • Partnerships, LLCs, and S-Corps do not qualify.
    • Strategic Implication: Many startups begin life as LLCs or S-Corps for pass-through tax simplicity but converting too late can permanently disqualify equity for QSBS treatment. Boards should weigh near-term tax savings against long-term QSBS value creation early in the company’s life cycle.
  2. Gross Asset Limitation
    • Pre-OBBBA: ≤ $50M in gross assets at issuance.
    • Post-OBBBA: ≤ $75M at issuance, indexed for inflation starting in 2027.
    • Strategic Implication: The threshold is a bright line test. If a funding round pushes assets above the limit before new stock is issued, that stock is disqualified. Timing capital raises around stock issuance is therefore critical.
  3. Active Business Requirement
    • At least 80% of assets must be used in a qualified trade or business.
    • Excluded industries: finance, professional services (law, consulting, accounting), hospitality, and certain extractive industries.
    • Strategic Implication: Most technology, life sciences, manufacturing, and product-based businesses qualify. But pivoting into an excluded business line can disqualify the company’s QSBS status, creating hidden risks for founders and investors.
  4. Original Issuance Rule
    • Stock must be acquired directly from the corporation (purchase, option exercise, equity grant).
    • Secondary market purchases from other shareholders generally do not qualify.
    • Strategic Implication: This rule favors early-stage participants and employees who acquire shares at issuance. Later secondary investors may face a different after-tax outcome, which affects deal negotiations and valuation.
  5. Holding Period
    • Minimum holding is required: 3 years = 50% exclusion, 4 years = 75%, 5+ years = 100%.
    • Strategic Implication: Liquidity planning must consider QSBS timelines. Exiting at 4 years and 10 months versus waiting 2 more months to cross the 5-year threshold can change shareholder outcomes by millions.
  6. Exclusion Limit
    • Greater of $10M (legacy) / $15M (OBBBA, 2025+) per taxpayer, per issuer, or 10× investor’s basis in the stock.
    • Strategic Implication: For low-basis founders, the $15M cap is often the limit. For higher-basis investors such as later-stage VCs, the 10× basis test can provide far greater benefit.
  7. Documentation & Governance
    • Requires careful recordkeeping: cap tables, stock issuance dates, asset levels, industry classification.
    • Strategic Implication: Investors increasingly expect companies to maintain QSBS documentation proactively. Demonstrating discipline in eligibility tracking signals governance maturity and can be a differentiator during M&A diligence.
  8. State Conformity
    • Not all states conform to federal QSBS rules. Some tax gains that are excluded federally.
    • Strategic Implication: Companies and investors must check state rules when modeling after-tax outcomes. For example, California does not conform, meaning federal exclusions may still be taxable at the state level.

📌 In short: These requirements are more than IRS checkboxes. They are strategic levers that directly influence entity structure, fundraising strategy, investor negotiations, and long-term wealth creation. QSBS planning must be integrated into corporate strategy from the earliest stages.

Why This Matters for Founders & Investors

QSBS under OBBBA is more than a tax perk — it is a strategic valuation lever that shapes wealth creation, deal dynamics, fundraising competitiveness, and investor positioning. Expanded detail below:

  1. Enhanced After-Tax Returns
    • Tactical: A qualifying founder or investor can exclude up to $15M (or 10× basis) of gain from federal tax.
    • Strategic: The difference between qualifying and not qualifying can represent millions in retained wealth. This extra capital can fund future ventures, provide personal liquidity, or accelerate generational wealth transfer.
  2. Valuation & Negotiating Leverage
    • Tactical: Buyers and investors evaluate not only pre-tax multiples but also what sellers actually keep after taxes.
    • Strategic: Demonstrating QSBS eligibility makes a company more attractive by improving net outcomes for shareholders. This can strengthen negotiating leverage, potentially increase valuations, and generate more competitive bidding in M&A processes.
  3. Fundraising Advantage
    • Tactical: Startups that highlight QSBS eligibility differentiate themselves in crowded markets.
    • Strategic: Angels, family offices, and VCs may prefer QSBS-qualified deals because after-tax returns are structurally superior. For founders, QSBS becomes a governance signal that demonstrates foresight and positions the company as investor ready.
  4. Liquidity Event Strategy
    • Tactical: OBBBA’s tiered holding periods mean timing matters: 3 years = 50% exclusion, 4 years = 75%, 5+ years = 100%.
    • Strategic: Boards must weigh earlier liquidity against maximized after-tax proceeds. In some cases, waiting a few months to cross a threshold can translate into millions in savings and better alignment with investor expectations.
  5. Governance & Investor Readiness
    • Tactical: QSBS requires disciplined recordkeeping — tracking cap tables, stock issuances, and compliance with asset and industry tests.
    • Strategic: Proactive documentation signals operational maturity. Companies with clear QSBS governance reduce diligence risk, streamline transactions, and inspire greater confidence from investors and acquirers.
  6. Wealth Preservation & Reinvestment Flywheel
    • Tactical: Tax-free proceeds can be redeployed without federal erosion.
    • Strategic: Serial founders and active investors create a compounding reinvestment cycle — funding more ventures, creating more jobs, and multiplying enterprise value creation across multiple companies.
  7. Alignment of Interests
    • Tactical: Employees and early investors directly benefit from QSBS treatment.
    • Strategic: Highlighting QSBS eligibility aligns founder, employee, and investor interests, fostering loyalty and long-term commitment to the venture’s success.

📌 In short: QSBS is not simply a tax savings tool. It reshapes capital allocation, strengthens valuation, enhances fundraising competitiveness, aligns stakeholder interests, and fuels long-term wealth creation. For founders and investors, failing to plan for QSBS is not just a missed tax opportunity — it is a missed strategic opportunity.

Case Example

Consider a founder selling $20M of stock:

  • Legacy Rules: After 5+ years, 100% exclusion. Roughly $4M federal tax savings compared to a standard 20% capital gains rate.
  • OBBBA Rules:
    • 3 years → ~$2.8M tax owed (50% excluded; remainder taxed at 28%).
    • 4 years → ~$1.4M tax owed (75% excluded; remainder taxed at 28%).
    • 5+ years → Up to $15M excluded; any excess taxed at standard long-term capital gains/NIIT rates.

Broader Implications

  • Investors: An angel investing $1M and exiting at $10M can potentially exclude the full $9M gain under both old and new rules — a structural boost to venture returns.
  • Employees: Option holders who exercise early benefit most; even at a 4-year liquidity event, partial exclusions deliver meaningful tax savings compared to non-QSBS equity.

📌 Insight: Exit timing and equity structure now directly shape after-tax outcomes. A few months’ delay or a proactive conversion to a C-Corp can shift proceeds by millions and materially affect wealth outcomes for founders, employees, and investors alike.

Call to Action

QSBS under OBBBA should be seen as more than a tax incentive — it is a strategic signal. For buyers and investors, the way a company approaches governance, capitalization, and eligibility planning reveals foresight, discipline, and valuation maturity. Gaps in QSBS planning, by contrast, can weaken negotiating leverage and erode exit value.

👉 Connect with Excendio for a strategic conversation on QSBS diligence. We’ll help you frame the right questions, sharpen your perspective, and approach negotiations with clarity about how QSBS readiness impacts valuation, deal dynamics, and long-term wealth creation.

Excendio ensures that founders, investors, and boards view QSBS not as a compliance checklist, but as a strategic filter — one that separates well-prepared companies worth paying for from those whose gaps diminish valuation.