The QSBS Rules Changed. Here’s What Founders and Early Employees Need to Know

For years, qualified small business stock, better known as QSBS, has been one of the most valuable tax benefits available to startup founders, early employees, and angel investors.

Now, the rules have expanded.

In 2025, new legislation increased both the size of companies that may qualify for QSBS treatment and the amount of gain that eligible shareholders may exclude from federal taxes. It also introduced phased-in benefits for certain newly issued shares.

For people building or investing in startups, these changes matter more than they may realize. It’s not just because they may reduce taxes someday, but because many QSBS decisions need to happen years before a liquidity event ever appears on the horizon.

By the time most people start thinking about QSBS, some of the best planning opportunities are already gone.

What Is QSBS?

Qualified small business stock is a provision under Section 1202 of the Internal Revenue Code that allows eligible shareholders to potentially exclude up to 100% of federal capital gains taxes on qualifying stock sales.

If all requirements are met, a founder, employee, or investor may be able to sell qualifying shares after an acquisition or IPO and exclude millions of dollars in gains from federal taxation.

For many startup employees, this becomes one of the largest tax-planning opportunities of their careers.

Yet, despite its value, QSBS is widely misunderstood. Some people assume all startup stock qualifies automatically. Others hear about QSBS too late, after key decisions around exercising options or structuring ownership have already been made.

The reality is that QSBS eligibility depends on a long list of technical requirements involving both the company and the shareholder.

Why QSBS Exists 

Congress originally enacted QSBS in 1993 to encourage investment in small businesses and reward people willing to take early-stage risk.

Startups are uncertain by nature. Founders often spend years building companies with little guarantee of success. Early employees frequently accept lower salaries in exchange for equity upside. Investors deploy capital into businesses where failure rates are high.

QSBS was designed to offset some of that risk.

The basic idea is simple: If you help build or fund a qualified small business over the long term, the tax code may reward you if the company succeeds.

As startup valuations and fundraising rounds have grown dramatically over the past decade, especially in venture-backed technology companies, the recent expansion of QSBS rules has become even more relevant.

What Changed in 2025?

The 2025 legislation expanded QSBS eligibility in several important ways, but one detail is critical: These new rules generally apply only to shares issued or acquired after July 4, 2025.

That distinction matters because older shares generally continue operating under the prior QSBS framework.

The company asset threshold increased. Historically, a company generally needed to have less than $50 million in gross assets immediately before and after stock issuance for shares to potentially qualify as QSBS.

For shares issued after July 4, 2025, that threshold increased to $75 million.

Beginning after 2026, the new threshold is also indexed for inflation.

At first glance, this may not sound like a major change, but it significantly expands the number of startups that may now qualify.

Many venture-backed companies raise capital much faster than they did 10 or 15 years ago. Reaching a $50 million asset threshold earlier in the life cycle has become increasingly common, especially in AI, biotech, fintech, and software businesses.

The higher limit gives growing companies more flexibility to remain QSBS-eligible while continuing to scale operations and raise additional capital.

For employees joining later-stage private companies, this may create eligibility opportunities that previously would not have existed.

The shareholder exclusion limit increased. The second major change involves the amount of gain an eligible shareholder may exclude.

For shares issued before July 4, 2025, the general exclusion limit remains $10 million or 10x cost basis, whichever is greater.

For shares issued after July 4, 2025, that exclusion limit increased to $15 million or 10x cost basis.

Beginning after 2026, the new exclusion amount is also indexed for inflation.

For founders or early employees with meaningful ownership stakes, especially those participating in larger exits, this can create substantial federal tax savings.

The holding period rules changed for newer shares. Previously, shareholders generally needed to hold QSBS-eligible shares for more than five years to receive the full federal exclusion. That five-year rule still exists for full exclusion treatment. However, for shares issued or acquired after July 4, 2025, the rules now phase in benefits earlier:

• 3 years: 50% exclusion
• 4 years: 75% exclusion
• 5 years: 100% exclusion

This is a meaningful shift, particularly for employees or founders who may not ultimately stay with a company for a full five-year period before liquidity occurs.

Importantly, shares issued before July 4, 2025, generally continue following the prior framework.

For shares acquired before September 27, 2010, older exclusion percentages and alternative minimum tax (AMT) rules may still apply, depending on the acquisition date.

The Company Rules Matter First

One of the most common misunderstandings around QSBS is assuming eligibility depends entirely on the shareholder.

It does not.

The company itself must first qualify as a “qualified small business” under Section 1202.

Generally, this means the company must:

• Be a domestic C corporation
• Maintain gross assets below the required threshold at issuance
• Use at least 80% of its assets in an active qualified trade or business
• Issue stock directly from the company

Certain industries are excluded from QSBS treatment entirely. This can include many businesses in:

• Health services
• Law
• Accounting
• Consulting or brokerage services
• Financial services
• Banking or insurance
• Investing or financing activities
• Farming or extractive industries
• Hotels, restaurants, and similar hospitality businesses

The rules can become highly technical depending on the nature of the company’s activities and how assets are used.

QSBS eligibility is not necessarily “set it and forget it.” A company may lose eligibility if it no longer satisfies certain requirements during a substantial portion of the shareholder’s holding period. Large share repurchases, excessive passive investments, or major business model changes can all potentially create issues.

That is why documenting QSBS eligibility early matters. Founders and employees should not assume that the stock automatically qualifies simply because the company is venture-backed or privately held.

The Shareholder Rules Matter Too 

Even if the company qualifies, the shareholder must still satisfy their own set of requirements. Generally, the shareholder must:

• Acquire shares directly from the company at original issuance
• Hold the shares for the required holding period
• Hold qualifying stock as an eligible non-corporate taxpayer
• Properly document exercises, transfers, and elections

This is where many mistakes happen.

For employees with stock options, the holding period often does not begin until the options are exercised and converted into actual shares.

Someone may spend eight years at a startup but only exercise shortly before an acquisition, leaving them without enough holding period to fully qualify for QSBS treatment.

That distinction becomes incredibly important.

Early exercise decisions may significantly impact future tax outcomes. So can entity structure decisions, trust planning, gifting strategies, and even where someone lives when liquidity occurs.

State Taxes Still Matter

One important nuance many people miss is that QSBS primarily applies to federal capital gains taxes.

Some states conform fully to QSBS rules. Others do not, or may not automatically conform to more recent federal changes.

California is one of the better-known examples and currently does not provide the same QSBS exclusion treatment at the state level.

That means someone could still face a significant state tax bill even if federal taxes are largely excluded.

This is one reason why exit planning often involves more than simply confirming QSBS eligibility. Residence planning, timing decisions, charitable strategies, and diversification planning can all become part of the broader conversation.

Why Planning Early Is So Important

QSBS is not something to think about during the acquisition process.

In many cases, the most important decisions happen years before liquidity ever occurs.

The timing of an option exercise may determine when the holding period begins.

The type of entity holding the shares may impact exclusion limits. The company structure itself may determine whether the stock qualifies at all.

Once an acquisition is announced or an IPO process begins, flexibility often shrinks quickly.

That is why some of the best planning happens quietly, long before the outcome feels real.

The Bigger Picture 

QSBS is an incredible planning opportunity, but the real objective is not simply minimizing taxes.

The bigger goal is turning concentrated startup equity into lasting financial security.

For many founders and early employees, a liquidity event represents the first time they have ever faced decisions involving this much money. Questions around exercising options, diversifying stock, managing taxes, supporting family, or deciding what comes next suddenly become very real.

Good planning helps reduce the chances of making rushed decisions during a compressed and emotional period.

Once the liquidity event arrives, some opportunities disappear permanently.

In many cases, the people who benefit most from QSBS are not necessarily the ones who know the most about tax law. They are simply the ones who started planning early enough for the rules to work in their favor.