Qualified Small Business Stock
The main purpose Section 1202 of the Internal Revenue Code is to encourage investment in early-stage businesses by allowing non-corporate taxpayers to exclude gains realized from the eventual sale of stock. The term the statute uses for stock eligible for this tax benefit is Qualified Small Business Stock (QSBS). Only a Qualified Small Business (QSB) can issue QSBS, and a QSB meets all of the following requirements:
- A domestic C corporation;
- An entity with cash and other assets not more than $75 million (indexed for inflation) on an adjusted basis, where the taxpayer acquired the stock on original issuance form the corporation;
- Engaged in any business not excluded from eligibility (as described below); and
- An entity that’s actively running a trade or business where at least 80% of its assets are deployed to run the business and not for investment.
QSBS can only be acquired directly from the issuing company for cash, services or property, so secondary market purchases do not count. Only non-corporate taxpayers can acquire and hold QSBS, but syndicates such as private equity and venture capital firms do qualify if they are organized as tax partnerships.
Section 1202’s exclusion from gross income comes with a limitation equal to the greater of (a) $15 million or (b) ten times the aggregate adjusted bases of all QSBS disposed of during the taxable year. In most cases, the former prong serves as the upper limit.
The QSBS regime is subject to a tangle of statutory provisions that do not come with corresponding IRS regulations to clarify them, making for ambiguities that can sometimes frustrate taxpayers and their advisors. As we detail below, two of those ambiguities revolve around the treatment of married taxpayers filing jointly and the conveyance of QSBS to non-grantor trusts. For tax partnerships making investments in QSBS, the application of the QSBS exclusion to carried interests has always been a subject of speculation and debate among tax practitioners. And when evaluating the list of excluded businesses, tax attorneys have often turned to IRS Private Letter Rulings to achieve comfort when making difficult judgment calls about enterprises that edge close to the ineligible categories, such as medical testing laboratories.
BEFORE OBBBA: Pre-July 2025
| Tiered Gain Exclusion Based on Holding Period | Investors were required to hold qualified small business stock (QSBS) for over 5 years to qualify for any gain exclusion. |
| Increased Per-Issuer Gain Exclusion Cap | Greater of $10 million or 10 times each taxpayer’s basis. |
| Increased Aggregate Gross Assets Threshold | To qualify as a small business, the company’s aggregate gross asset limit used to be $50 million. |
| Section 1045: Rollover provision |
This section was important to understand to achieve QSBS treatment on shares that haven’t been held for the full 5 years. Rule: if a taxpayer owned stock that qualifies as QSBS for more than 6 months but less than 5 years at the time of liquidation, that taxpayer can reinvest the proceeds within 60 days into stock of another QSB to maintain its treatment and receive the exemption after the holding period of 5 years, which includes the aggregate holding period for the stock of both QSBs. |
AFTER OBBBA: Post-July 2025
| Tiered Gain Exclusion Based on Holding Period |
Phased approach to gain exclusion eligibility based on holding period:
This allows investors to benefit from partial exclusions earlier. |
| Increased Per-Issuer Gain Exclusion Cap | Greater of $15 million or 10 times the taxpayer’s basis, indexed for inflation starting in 2027. |
| Increased Aggregate Gross Assets Threshold | To qualify as a small business, the company’s aggregate gross asset limit is now $75 million. |
| Section 1045: Rollover provision | No change |
The OBBBA does not change or clarify any provisions leading to any of the ambiguities we described above, including two of them we expand upon below: “stacking” of non-grantor trusts and a generous interpretation of how the QSBS exclusion applies to married taxpayers filing jointly.
Stacking of Non-Grantor Trusts:
“Stacking” is one popular strategy to take advantage of the ambiguity in the QSBS statute and the lack of regulations to clarify interpretation and enforcement. Since the QSBS exclusion from gross income is per-taxpayer, enterprising planners devised the stacking technique to multiply the amount of eligible taxpayers who can take the full exclusion. Unlike grantor trusts, non-grantor trusts are treated as separate taxpayers from the grantor, meaning that under a strict interpretation of the statute, every non-grantor trust can claim its own maximum exclusion if it owns QSBS. Furthermore, the QSBS rules allow a taxpayer to gift QSBS to non-grantor trusts without spoiling tax compliance. Add these two features together and the stacking playbook appears: form multiple non-grantor trusts and gift QSBS to each trust to carefully calibrate eligibility to exclude the entire gain within a block of QSBS from gross income.
The stacking strategy, of which the IRS is fully aware, has its caveats. Section 643(f) provides a statutory line of attack, while substance-over-form and other common law doctrines can give the IRS an equitable argument to dismantle multiple non-grantor trusts designed to maximize QSBS exclusion. But taxpayers should be able to “stack” at least one non-grantor trust to allow for two maximum QSBS exclusions instead of one while avoiding recharacterization or disallowance upon IRS scrutiny.
The Married Filing Jointly Question:
Based on the curious drafting of the QSBS statute, practitioners often confront a statutory interpretation question about whether married taxpayers filing jointly may claim two or only one QSBS exclusion if both taxpayers own stock (or even only one of them in a community property state). The statute clearly states that married taxpayers filing separately are entitled to only half a maximum exclusion each but says nothing explicit about married taxpayers filing jointly. Therefore, it is unclear whether married taxpayers who file jointly and each possess legal ownership over QSBS (whether by community property rules or otherwise) are limited to a single exclusion (consistent with married taxpayers who file separately) or each have a separate exclusion (consistent with single taxpayers). Accordingly, a common way taxpayers maximize the utility of the QSBS exclusion is transferring a portion of QSBS from one spouse to the other by gift.
What This Means for You As Our Clients:
The QSBS program was already one of the most powerful incentives in the entire Internal Revenue Code. Although the tech industry has known about QSBS since its launch in 1993, the other eligible industries – a vast list that includes manufacturing, distribution, waste management, construction, facilities maintenance, pest control, disaster restoration, landscaping, and many more – are not nearly as aware that the incentive is available to them. Now that the OBBBA has made the program even more powerful, that lack of awareness should change.
Although the OBBBA made the Section 199A deduction for pass-through entities permanent, the TCJA’s reduction of the marginal rate imposed on C-Corp income made C-Corps a more attractive form of incorporation, especially because C-Corps get an unlimited SALT deduction and enjoy the ability to deduct fringe benefits. Now that QSBS has been made even more favorable for taxpayers starting and investing in new businesses, C-Corps should be considered more closely when weighing the forms of incorporation for brand new enterprises. For founders who are looking for an exit to venture capital or an eventual IPO, C-Corps are now the overwhelming choice for tax classification.
When it comes to advanced tax planning around QSBS, Congress’s seemingly affirmative decision to let lie the ambiguous language around married taxpayers filing jointly and the allowance for non-grantor trust stacking effectively declares open season for those techniques. Both of those positions are subject to potential IRS challenge, as is the application of the exclusion to carried interest. But Congress leaving each of these issues unaddressed in OBBBA is the most significant invitation a taxpayer can receive to engage in this type of planning; if Congress considered these strategies problematic, Congress would have made clarifying the statutory language allowing them to happen a priority – and Congress did not. While the utility of citing to Congress’s inaction in court is still uncertain, a federal judiciary full of appointments from Republican Presidents projects to side with taxpayers on these issues at a higher clip than they would 25 years ago.
DISCLAIMER: This summary is not legal or tax advice and does not create any attorney-client relationship. This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm. Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.
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