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- Avail Investment Partners
- Sep 17
- 7 min read
Introduction
Qualified Small Business Stock (QSBS) refers to certain shares of a U.S. C‑corporation that qualify their holders for exclusion of federal long‑term capital gains tax. Congress enacted the QSBS regime in 1993 to channel capital and talent toward new ventures by reducing after‑tax exit frictions for founders and investors. In short: it’s a carrot for building something new, not a loophole to retrofit onto every business.
Example: simple $10 million exit example (pre‑2025 rules): Assume you founded a qualifying C‑Corp, held founders’ stock for more than five years, and sell for a $10 million long‑term gain. Without QSBS, the gain may be taxed at up to 20% long‑term capital gains plus 3.8% NIIT or ~$2.38 million of federal tax. With QSBS, up to $10 million of gains can be excluded and federal tax could be $0.
Eligibility Pre-OBBBA and How to Document
There are specific requirements to be able to receive QSBS treatment:
The issuing company must be a domestic C-corporation
The stock must be acquired at original issuance (for cash, property other than stock, or services)
At issuance, the issuer’s aggregate gross assets must not exceed $50 million
Gross assets are defined as the amount of cash plus the adjusted basis of other property held by the corporation.
This is not to be confused with the company’s valuation if it has raised outside capital.
During substantially all of the holding period, the corporation must use at least 80% of its assets (by value) in an active, qualified business
The shareholder must hold the stock for more than five years
The exclusion per taxpayer per issuer is capped at the greater of $10 million or 10× the shareholder’s aggregate adjusted basis in the QSBS sold
The company cannot be one of the excluded businesses: health, law, engineering, accounting, consulting, financial services, brokerage, farming, extraction (oil & gas, mining), and hotels/restaurants.
Note: Some states conform to the federal exclusion, and your capital gain would also be excluded from state taxes; always check state rules.
Acceptable documentation to claim QSBS treatment can be cap tables, board minutes approving issuances, 83(b) elections (if applicable), valuation files, and counsel/CPA memos that track gross‑assets status, qualified trade/business status, and the timing of issuances (especially around conversions and priced rounds). If you are unsure if your business qualifies, there are CPAs, attorneys and firms that can provide a QSBS attestation.
What Changed in 2025 in the One Big Beautiful Bill (OBBBA)
Congress made updates to the QSBS rules in the OBBBA. The following take effect for stock issued after July 4, 2025.
The capital gain exclusion increased from $10 million to $15 million per taxpayer
There are now partial exclusions of capital gains based on number of years the stock is held
3 years: 50% exclusion
4 years: 75% exclusion
5 years: 100% exclusion
The gross assets ceiling was increased from $50 million to $75 million
Example: $20 million exit with post‑7/4/2025 stock:
Three years: 50% excluded; $10MM taxed at 23.8% or $2.38MM of federal capital gain tax owed
Four years: 75% excluded; $5M taxed for $1.19M of federal capital gain tax owed
Five years: 100% excluded; no federal capital gain tax owed.
Annual Operating Taxes: Why Pass-Through Entities Often Win Year to Year
For businesses, the choice between a C-corp and a pass-through entity balances long-term QSBS tax benefits against continuous "double taxation." While QSBS offers a potentially large capital gains exclusion at exit for C-corp shareholders, the structure also taxes profits at the corporate level and again if distributed to owners. In contrast, a pass-through entity avoids this double tax drag, as profits are taxed only once at the owner's individual rate.
For high-growth startups that primarily reinvest profits, the C-Corp structure can be tax-efficient until exit, where the QSBS exclusion can be significant. However, for profitable, mature businesses that distribute earnings, a pass-through entity often proves more tax-efficient over time. Beyond taxes, the decision hinges on other factors like industry, external funding needs, equity compensation plans, and reinvestment strategy, all of which should be evaluated with qualified counsel.
Example: a business that makes $1 million in pre-tax profit. For a better comparison we assume the C-Corp distributes the entire profit as a dividend and assume Married Filing Jointly (MFJ) and ignored the potential S-Corp election for simplicity.
| C-Corp | LLC (non-SSTB) |
Income | $ 1,000,000 | $1,000,000 |
Corporate Tax (21%) | $210,000 | $0 |
Dividend Tax (0-23.8%) | $128,013 | $0 |
Self-employment Tax | $0 | $48,618 |
Ordinary Income Tax | $0 | $203,987 |
Total Federal Tax | $338,013 | $252,605 |
Effective Tax Rate | 33.8% | 25.3% |
Converting from a Pass-Through to a C-Corp: Mechanics, Basis and the 10x Rule
Converting a pass-through entity, such as an LLC, to a C-corporation typically involves either a state-law statutory conversion into a corporation or a Section 351 exchange, where owners contribute the LLC's assets (or interests) to a new C-corporation in exchange for stock. Founders receive newly issued C-corporation shares during the conversion, and these shares can qualify as Qualified Small Business Stock (QSBS) if the corporation meets other requirements, including the gross-assets test at issuance.
A significant benefit of converting a valuable LLC is the application of the fair market value (FMV) basis rule for QSBS, which allows the stock's basis to be treated as no less than the property's FMV at the time of conversion. This FMV step-up can lead to a substantial increase in the 10x Basis Limitation, which is the greater of $10 million or 10 times the aggregate adjusted basis of the stock. For example, if the QSBS basis based on FMV is $14 million, the per-issuer cap on excludable gain would be $140 million, subject to other QSBS requirements.
Before converting, several factors require careful consideration, including state conformity, employee equity plans and options, the active-business test, and annual tax implications. It is important to remember that converting restarts the QSBS holding period for the new stock, although limited tacking rules may apply.
QSBS Stacking Using Trusts
For Qualified Small Business Stock (QSBS), the gain exclusion limit applies on a per-taxpayer, per-issuer basis, which presents a strategic opportunity for sophisticated wealth planning. By properly structuring gifts to separate irrevocable non-grantor trusts for family members, multiple taxpayers can be created, each with their own QSBS exclusion cap. A family of four, for example, could potentially multiply the exclusion by spreading shares among four such trusts, though such a strategy requires careful gift and estate tax planning. Crucially, grantor trusts are typically disregarded for income tax purposes and do not create these additional QSBS taxpayers.
Successful implementation on a company's cap table demands meticulous execution, including ensuring trusts hold original-issue stock, maintaining proper issuance and assignment documentation, obtaining trustee consents, and securing contemporaneous valuations. While founders can retain a degree of influence through trustee selection, distribution standards, and trust protectors, these controls must be carefully balanced to ensure the trusts are respected as separate taxpayers. Given the technical and complex nature of these structures, engaging qualified legal and tax counsel is essential for successful and compliant execution.
QSBS Rollovers: Extending the Clock and Exceeding the Cap
QSBS rollovers under Section 1045 allow investors to defer capital gains tax from the sale of Qualified Small Business Stock (QSBS) by reinvesting the proceeds into new QSBS within 60 days. This provides two key strategic benefits, which require careful planning and execution.
Bridging the 5-Year Holding Period
If a founder sells their company before holding the QSBS for the required five years, they can roll the gain into new QSBS to avoid immediate tax liability. The original holding period "tacks" onto the new stock, allowing the founder to meet the five-year requirement later.
The search fund strategy: Many founders form a new C-Corp (a "search fund") to hold the rollover proceeds. This new entity can rely on a two-year working-capital safe harbor while it looks for a new investment, as long as it meets the QSBS active-business test for at least six months.
Example—Exit at 3.5 years: A founder sells their company for an $8 million gain after 3.5 years. By reinvesting the gain into a new search fund's QSBS within 60 days, they defer the tax. Their 3.5-year holding period is tacked onto the new stock. The search fund holds cash under the safe harbor while searching for a new business. After another 1.5 years, the total holding period is five years, and the fund's eventual sale can qualify for the exclusion. If a qualified business is not found and the search fund is dissolved, the 5-year holding period would be satisfied and the capital gain would be excluded.
Rolling Over Excess Gain
The QSBS exclusion cap applies on a per-issuer, per-taxpayer basis. After maximizing the cap for one company (e.g., $10 million or 10x basis), investors can use a Section 1045 rollover to defer the excess gain into a new company (Issuer B). This allows them to pursue another full QSBS exclusion cap on a future exit.
Different company, different cap: Because the cap is tied to the issuer, a rollover into a new qualified business stock gives the investor a fresh exclusion cap.
Example—Rolling the excess: An investor with a $1 million basis sells QSBS in Company A for an $18 million gain after seven years. The first $10 million is excluded. The investor then reinvests the $8 million excess into QSBS of Company B within 60 days. That gain is deferred, and the original holding period tacks to Company B's stock. Upon a future exit of Company B, the investor can claim another full QSBS exclusion for the rolled-over gain and any new appreciation.
Important Rollover Mechanics
60-day window: The reinvestment must occur within 60 days of the sale.
Basis adjustment: The deferred gain reduces the basis in the replacement shares.
Holding period: The holding period of the original QSBS tacks to the replacement shares.
Documentation: Detailed records and proper elections on tax returns are crucial for a valid rollover.
A rollover should be done with the assistance of professionals to ensure all requirements are met.
Conclusion
For businesses aiming to leverage the powerful QSBS exclusion to minimize federal tax at exit, proactive and precise planning is essential. Eligibility is not a given; it must be cultivated from the earliest stages of a company's life through careful attention to details like entity formation, original issuance, and the gross-assets test. A strategic path often involves starting as a pass-through entity to manage early-stage finances, converting to a C-Corp when a funding or exit event is on the horizon, and employing advanced strategies such as trust structuring or Section 1045 rollovers to maximize the exclusion. Ultimately, a founder's ability to navigate these complexities determines whether they capture the full benefit of this valuable tax provision.
Sources
Important Disclosures
Avail and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
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