What Is QSBS? Section 1202 Rules for Founders in 2026

QSBS is stock in a US C corporation that can qualify for a federal capital gains exclusion under Section 1202. For stock acquired after July 4, 2025, holders can exclude 50% of gain after three years, 75% after four and 100% after five, up to the greater of $15 million or 10 times basis.

This is general information, not tax advice. Founders and investors should confirm their own position with a tax adviser. The operative text is 26 U.S.C. § 1202.

What changed in QSBS rules for stock issued after July 4, 2025?

The [2025 tax law](https://www.govinfo.gov/content/pkg/PLAW-119publ21/html/PLAW-119publ21.htm) added a shorter tiered holding period and raised both the per-issuer cap and the gross assets limit.

The new rules apply only to stock acquired after July 4, 2025. Earlier stock stays under the prior regime, as Gibson Dunn's analysis explains.

How much tax does the tiered exclusion actually save?

Selling at three years saves far less than holding for five, because the taxable part of the gain is taxed at up to 28%.

The IRS states that the taxable part of a gain from selling Section 1202 stock is taxed at a maximum 28% rate. An illustrative calculation for a $10 million gain on stock acquired after July 4, 2025, ignoring state tax and the net investment income tax:

These are arithmetic examples, not a result anyone achieved. They show why the five-year mark still drives most planning.

Which stock qualifies as QSBS?

Six tests must all be met. Missing one usually ends the analysis.

Two timing rules catch founders. Under Section 83, unvested stock without an 83(b) election is generally treated as transferred when it vests, which delays the holding period. Our guide to founder vesting and acceleration covers the mechanics. Options generally start the clock on exercise, not on grant, because an option is not stock.

An LLC can convert to a C corporation and start QSBS eligibility from that point. Section 1202(i) treats contributed property as having a basis of at least fair market value, so appreciation before conversion does not count as excludable gain.

Which businesses are excluded from QSBS?

Section 1202(e)(3) excludes service businesses and several capital-heavy or regulated sectors.

The statute excludes:

The statute does not draw clear lines for software-enabled services, health platforms or fintech. A company that sells software is in a stronger position than one that sells clinical care or makes loans from its own balance sheet. Get written tax advice if your revenue model is near any of these categories. Research and startup activities can count as active use of assets under Section 1202(e)(2).

How does a fundraise affect QSBS eligibility?

Each round tests the gross assets limit again, and large cash balances or buybacks can create problems.

When does a round push a company over the $75 million limit?

Gross assets means cash plus the adjusted basis of other property. Valuation does not matter. A company valued at $300 million with $40 million in cash and modest other assets can remain under the limit. Stock issued in a round fails if gross assets exceed the limit immediately after the issuance, and the proceeds count.

In an illustrative case, a company with $60 million in gross assets raises $20 million. It has $80 million immediately afterward, so that round's stock is not QSBS. Stock issued earlier was tested at its own issuance and is not disqualified by that round.

Can too much cash on the balance sheet be a problem?

Yes. After a corporation has existed for two years, Section 1202(e)(6) says no more than 50% of its assets can count as active business assets through the working capital rule. Separately, the company fails the active business test in any period when more than 10% of the value of its assets, net of liabilities, sits in portfolio stock or securities. Check treasury policy with counsel before investing a large round in securities.

Do founder buybacks disqualify QSBS?

They can. Under Section 1202(c)(3), stock is disqualified if the issuer bought stock from the holder or a related person, beyond de minimis amounts, in the 4-year window that starts 2 years before issuance. Stock is also disqualified if the issuer's repurchases exceeded 5% of the aggregate value of its stock in the 2-year window that starts 1 year before issuance. Treasury Regulation 1.1202-2 sets out de minimis exceptions.

The practical point is structure. A founder secondary funded by the company is a redemption. A sale to a new investor is different. Review any founder liquidity proposal for QSBS before you sign the term sheet.

Does a SAFE or convertible note start the QSBS clock?

The law is unsettled for SAFEs. Frost Brown Todd's guide concludes a post-money SAFE should likely be treated as stock, which would start the holding period at issuance, but says no IRS or court authority settles the question. If a SAFE is not stock, the clock starts at conversion. A convertible note is debt, so assume the clock starts at conversion unless your adviser concludes otherwise.

If you are choosing an instrument, read SAFE vs convertible note. The Y Combinator SAFE documents are the common starting point. When preferred stock converts into common, Section 1202(f) treats the new stock as QSBS if the original qualified.

How does the $15 million QSBS cap work?

The cap applies per taxpayer, per issuer, and it equals the greater of $15 million or 10 times the basis of the stock sold.

For a founder with near-zero basis, the $15 million figure usually controls. For an investor, 10 times basis can be higher. An investor who paid $2 million, in an illustrative case, would have a $20 million limit on that stock.

For stock acquired after July 4, 2025, the dollar cap is reduced by eligible gain taken in earlier years. Once a taxpayer reaches the cap, later inflation adjustments do not add room.

Section 1202(h) preserves QSBS status and holding period on transfers by gift or at death, so gifting is part of many planning conversations. Section 1045 allows a non-corporate holder of QSBS held for more than 6 months to defer gain by buying replacement QSBS within 60 days. Both need professional advice.

Do states follow the federal QSBS exclusion?

Most do, but four states do not, and California's position is the most costly for founders.

A 2025 state survey by Frost Brown Todd lists California, Pennsylvania, Mississippi and Alabama as non-conforming, and notes that New Jersey conforms for tax years beginning January 1, 2026. A California resident who excludes the full gain federally can still owe California tax on all of it. State rules change, so check current law for your state of residence.

What QSBS records should a startup keep?

Keep evidence at each issuance. Reconstructing it years later is expensive and sometimes impossible.

Later-stage investors and acquirers often ask whether stock qualifies. Build the file now:

Put these documents in your investor data room so they are ready for diligence. Then model what each round does to ownership with the dilution calculator.

Frequently Asked Questions

What is QSBS in simple terms?

QSBS is qualified small business stock under Section 1202 of the US tax code. If a non-corporate holder acquires eligible C corporation stock at original issuance and holds it long enough, part or all of the federal capital gain can be excluded, up to a per-issuer cap.

How long do I need to hold QSBS after the 2025 changes?

For stock acquired after July 4, 2025, the exclusion is 50% after 3 years, 75% after 4 years and 100% after 5 years. Stock acquired on or before July 4, 2025 follows the earlier rules and needs more than 5 years of holding.

Can a Delaware C corporation with a foreign founder issue QSBS?

A domestic C corporation can issue QSBS regardless of where a shareholder lives, but the exclusion only has value to someone who would otherwise pay US tax on the gain. A foreign founder should check US and home-country tax treatment with an adviser. A non-US parent company does not qualify as an issuer.

Does venture funding disqualify a startup from QSBS?

Not by itself. Each issuance must meet the gross assets test, and the company must keep meeting the active business requirement. Stock can stop qualifying at a later round once gross assets exceed the limit, while earlier stock stays tested at its own issuance date.

Do SaaS companies qualify for QSBS?

Many software companies pursue QSBS treatment, but the statute does not name software as a qualified trade. The analysis depends on what the company actually sells and whether it falls into an excluded category such as consulting, financial services or health services. Get written advice if the model is borderline.

Do I pay state tax on QSBS gain?

It depends on where you live. California, Pennsylvania, Mississippi and Alabama do not follow the federal exclusion according to a 2025 state survey, so residents can owe state tax on gain excluded federally. Confirm the current rule for your state before a sale.