On July 4, 2025, President Trump signed into law H.R. 1 — commonly referred to as the One, Big, Beautiful Bill (OBBB) — introducing substantial reforms to the Qualified Small Business Stock (QSBS) tax exclusion under Section 1202 of the Internal Revenue Code. These changes aim to enhance access to capital, incentivize startup investment, and modernize eligibility thresholds — and, generally speaking, offer founders and early-stage investors even more favorable tax treatment on startup equity.
Below is a summary of how QSBS works generally, the key updates to the QSBS treatment requirements following enactment of the OBBB, and the resulting implications for founders, investors, and legal and tax advisors.
1. What Is QSBS?
QSBS refers to “Qualified Small Business Stock” under Section 1202 of the Internal Revenue Code. It allows eligible holders of certain startup equity to exclude up to 100% of the capital gains from federal tax when they sell their shares, subject to a cap. In other words, if your stock qualifies and you sell it after the applicable holding period, you could legally pay zero federal capital gains tax on that exit.
2. How the Exclusion Works
Normally, when you sell stock at a gain, that gain is taxed at capital gains rates (generally up to 20% for long-term federal tax, plus the 3.8% net investment income tax, and possibly additional state tax). With QSBS, Section 1202 allows you to exclude the gain entirely, meaning that gain never even enters into your taxable income (up to the statutory limits of course).
It is important to note that this exclusion is not a deferral or credit; it is a true exclusion. The gain is treated as if it never happened for federal tax purposes, provided the conditions are met. This can translate to dramatic tax savings compared with ordinary stock investments.
Example 1 — $2 Million Gain
- You invest $100,000 in QSBS-eligible startup shares.
- Five years later, you sell those shares for $2.1 million.
- Your gain is $2 million.
- Without QSBS: You might owe up to ~$476,000 in federal tax (23.8% x $2,000,000).
- With QSBS: You exclude the full $2 million from federal tax. Your federal tax bill is $0 on that gain.
Example 2 — $20 Million Gain and the Exclusion Cap
- You invest $1 million in QSBS shares.
- Seven years later, you sell for $21 million.
- Your gain is $20 million.
- Exclusion limits: You can exclude up to the greater of (i) $15 million (under OBBB) or (ii) 10x your basis ($10 million). Here, $15 million applies.
- Result: $15 million excluded from federal tax; the remaining $5 million is taxable.
Example 3 — Multiple Investments in the Same Company
- You invest $250,000 in QSBS shares in 2026 and another $250,000 in 2027.
- Both blocks of shares qualify separately for QSBS treatment, each with its own holding period.
- In 2031, you sell both positions for a combined $12 million.
- Result: Because the total gain falls below the $15 million per-issuer cap, the entire $11.5 million gain may be excluded from federal tax.
3. QSBS and the OBBB
The OBBB has introduced a number of key changes to the requirements to qualify for QSBS treatment. However, it is important to note that these changes only apply to stock issued or acquired on or after the date of the enactment of the OBBB. Meaning if your stock was issued or acquired prior to the OBBB enactment (i.e., prior to July 4, 2025), that stock would remain subject to pre-OBBB requirements. If your stock was issued on or after the OBBB’s enactment, here are some key changes to the QSBS requirements and how they could affect your business and related transactions.
A. Introduction of a Tiered Gain Exclusion Structure
For QSBS issued on or after July 4, 2025, the OBBB introduces a new tiered structure for the federal capital gains exclusion:
- 50% exclusion after a 3-year holding period;
- 75% exclusion after 4 years; and
- 100% exclusion after 5 years.
This replaces the previous rule, which simply required a flat 5-year holding period for 100% exclusion rather than allowing equity holders to benefit from increasing QSBS treatment sooner. The reform offers greater flexibility to early investors and may make shorter holding periods more attractive in certain exit scenarios.
Implication: Investors may realize partial tax benefits earlier, which could impact transaction structuring, liquidity planning, and exit timing.
Example:
- You invest $500,000 in eligible stock.
- Four years later, you sell for $2 million (a $1.5 million gain).
- Since you held 4 years, you exclude 75% of the gain ($1,125,000). The remaining $375,000 is taxed.
B. Increase to the Per-Issuer Gain Exclusion Cap
Prior to OBBB, eligible holders could exclude up to $10 million or 10 times their tax basis in the applicable stock, whichever was greater. For stock issued on or after July 4, 2025, the maximum gain exclusion has increased from $10 million to $15 million per issuer. Additionally, the higher threshold will be adjusted for inflation beginning in 2027. The alternative limitation of 10 times the taxpayer’s basis in the stock remains unchanged.
Implication: Investors now have a broader opportunity to exclude larger gains, enhancing the tax efficiency of early-stage equity investments.
C. Expansion of Qualified Small Business Gross Asset Limit
The threshold for a company to qualify as a “qualified small business” has been raised from $50 million to $75 million in gross assets, also subject to inflation indexing starting in 2027.
Implication: More companies will meet the QSBS eligibility requirements, and existing companies may have a longer runway to raise capital and grow without disqualifying their stock.
4. Effective Date and Transition Rules
As mentioned above, these changes to the QSBS requirements apply only to QSBS issued on or after July 4, 2025. Stock issued prior to this date remains subject to the pre-OBBB rules. Where an investor holds both pre- and post-OBBB QSBS in the same company, careful tax planning is advised to optimize the timing and order of sales in relation to the new $15 million cap.
It is also important to note that certain requirements under Section 1202 remain intact — such as the “active business requirement”, which means that the issuing company must be engaged in an active trade or business, with at least 80% of assets used in qualifying operations. Additionally, the QSBS shares must be of original issuance (i.e., acquired directly from the underlying company), meaning shares acquired via secondary sale would not qualify. Instruments such as SAFEs (Simple Agreements for Future Equity) or convertible promissory notes are subject to more of a gray area from the IRS, so for any investors planning on receiving QSBS treatment for any of these instruments, it is important that you consistently treat these instruments as equity as opposed to debt in any tax filings and consult with your tax and legal specialists when preparing and entering into such convertible instruments.
5. Strategic Planning Considerations
Given the significant changes, companies and investors should consider the following:
- Exit Planning: Evaluate shorter holding periods (3–4 years) for strategic liquidity or transaction opportunities.
- Tracking and Documentation: Maintain accurate records of stock issuance dates, basis, and corporate asset levels to support QSBS qualification.
- Section 1045 Rollover Opportunities: Assess the potential to defer gains and preserve QSBS treatment through rollovers.
- State Tax Implications: Note that many states do not conform to federal QSBS rules. Planning should address potential state-level taxation.
6. Takeaway
QSBS remains one of the most powerful tax planning tools available for startup founders and investors. With the OBBB reforms, the benefits are now even more flexible and generous. Whether you are issuing stock, investing, or preparing for an exit, careful planning can mean the difference between paying millions in taxes or paying nothing at all.
Bowery Legal can help founders and early employees understand the new rules, navigate the eligibility requirements, and maximize the benefit of QSBS in their equity and tax planning strategies. If you have questions, don’t hesitate to reach out to our team.