From Startup to Scale: How Businesses Can Use Qualified Small Business Stock to Capture Significant Tax Advantages

Frequently trivialized by founders and investors, the Qualified Small Business Stock (“QSBS”) exclusion under Section 1202 of the Internal Revenue Code (“Section 1202”) continues to be overlooked and underutilized.[1] But with recent tax legislation making sweeping changes to Section 1202[2], it has never been more important for businesses and shareholders to engage in strategic QSBS planning. If QSBS eligibility is properly considered and structured, stockholders can exclude up to 100% of the gain on the sale of qualifying stock—potentially translating into millions of dollars in tax savings. By avoiding legal and governance missteps, small and mid-sized businesses can strategically and beneficially use QSBS from early formation through scaling.

Initially, to qualify for the federal capital gains exclusion under Section 1202, five requirements must be met by both the business and the shareholder: (i) the stock must be issued by a domestic C-corporation; (ii) the business’s aggregate gross assets must not exceed, at a minimum, $50 million immediately before and after the stock is issued[3]; (iii) the stock must be acquired by the shareholder directly from the business at original issuance; (iv) the stock must be held for at least three years before being sold; and (v) at least 80% of the business’s assets must be used in the active conduct of a qualified trade or business. While the requirements seem straightforward, maintaining compliance over years of growth, fundraising, and operations requires deliberate legal planning.

Since the stock must be issued by a C-corporation, if a business plans to scale, seek investment, or pursue an eventual sale, starting as a C-corporation is typically the most reliable path for QSBS eligibility.  Although it is often instinctive to choose an LLC for tax simplicity, forming as an LLC or S-corporation and converting later to a C-corporation can regularly complicate or even foreclose QSBS benefits. By adopting a C-corporation early, businesses are more attractive to institutional and angel investors, gain more flexibility in issuing multiple classes of stock, and avoid restrictions on the number or type of shareholders.

Next, although monitoring a business’s asset levels may seem straightforward, the legal landscape of such becomes significantly more complex as the business grows. Monitoring asset levels requires strategic planning around fundraising, asset purchases, and valuation events. Not only do convertible notes, SAFEs, preferred stock issuances, and investor negotiations carry QSBS implications, but the structure and timing of these financing events can also impact the QSBS eligibility of both current and future shareholders.

Furthermore, the stock must be acquired directly from the business at original issuance, and this third requirement is strictly enforced. Proper documentation—including stock purchase agreements, board consents, 83(b) elections, and accurate capitalization tables—is essential. We regularly see due diligence disputes arise from incomplete stock ledgers, unapproved stock issuances, inconsistent capitalization tables, missing board consents, and incorrect par values or share classifications.

Additionally, the recent legislative changes to Section 1202 greatly affect the fourth requirement concerning the holding period. The revisions expand access to QSBS benefits and offer more flexibility for liquidity events. The new law introduced a graduated exclusion schedule—absent under prior law—based on how long the stock has been held: (i) a 50% gain exclusion for a three-year holding period; (ii) a 75% gain exclusion for a four-year holding period; and (iii) a 100% gain exclusion for a five-year holding period, which remains unchanged from prior law.

Finally, the 80% active business requirement should be monitored early and revisited regularly. Businesses with significant passive income, investment holdings, or non-operating assets risk violating this rule. As with all of the QSBS eligibility requirements, well-documented board actions, stockholder approvals, and compliance procedures safeguard QSBS status and reduce the risk of disputes.

Although small and mid-sized businesses often assume QSBS is merely a tax issue, in reality it is fundamentally a corporate law issue that touches tax, governance, transactional planning, and litigation risk. A full-service business law firm can provide: (i) transactional support, including business formation, equity structuring, contract drafting and review, and fundraising; (ii) governance and compliance assistance, including board matters, capitalization table management, and corporate recordkeeping; and (iii) litigation prevention and resolution, including shareholder disputes, fiduciary duty claims, and indemnification issues that may jeopardize QSBS or threaten an exit.

In conclusion, QSBS can be one of the most valuable tools available to small and mid-sized businesses preparing for growth or an eventual exit. But the benefit is only available when a business plans strategically, maintains rigorous governance practices, and protects itself from transactional and litigation risks over the long term. By addressing QSBS considerations from startup through scale, businesses can position themselves to capture significant tax advantages. If you would like assistance structuring your business for QSBS eligibility, preparing for a capital raise, or planning for an exit, our law firm has a track record of providing comprehensive support for businesses seeking to maximize the tax advantages associated with QSBS.

[1] See 26 U.S.C. § 1202.

[2] On July 4, 2025, the One Big Beautiful Bill Act was signed into law that included changes to Section 1202.

[3] The changes to Section 1202 raised the aggregate gross asset limitation to $75 million for stock issued after July 4, 2025—the date of enactment of the One Big Beautiful Bill Act.