This little known tax code could save founders and investors millions

Jamie Melzer
8 min readOct 28, 2020


What every founder, early employee, and investor should know about the venture industry’s best-kept tax secret; QSBS

Photo by Olga DeLawrence on Unsplash

While the venture industry has been taking advantage of this small business tax exemption for years, those new to the industry, like recent founders, or the gaggle of new early-stage investors enabled by platforms like AngelList, Republic, and recently Alto IRA might be hearing of QSBS for the first time.

A quick online search for “QSBS” will tell you that you can exclude up to $10mm in gains from a qualified small business investment held for at least five years, but there is much more to the tax code that is worth understanding.

If you are a founder, an early employee, an angel investor, advisor, or a general or limited partner in an early-stage VC fund (a pass-thru entity for everything covered in this article), here is what you should understand about QSBS:

The tax exemption on small business stock was first introduced in 1993 to incentivize investment into America’s small businesses, a primary driver of economic and job growth. The tax exemption was made permanent with the Protecting Americans Against Tax Hikes (PATH) Act on December 18, 2015, and while it could be revised in the future, it would take an act of Congress to do so.

QSBS Defined

Qualified small business stock or “QSBS” is defined by Section 1202 of the Internal Revenue Code (IRC) as stock in a domestic C corporation issued after the date of enactment of the Revenue Reconciliation Act of 1993 (August 10, 1993). The stock must be acquired by the individual taxpayer (or a pass-thru entity, but not a corporation) at the original date of issue (not in a secondary offering) in exchange for money, property (excluding stock), or as compensation for services (this includes advisory shares, but excludes underwriting). The company must have assets of less than $50mm at the time of the equity issuance and immediately thereafter (including cash received from the issuance), be an active business for the duration of the investment, and the individual must hold the stock for at least five years. Lastly, the company must be a qualified trade or business.

I will go into more detail on each of these qualifiers later in this article, but first…

What are the tax benefits of QSBS?

The gain from the disposition (sale or exchange) of QSBS is an “eligible gain” with up to 100% of the gain excluded from federal taxes (and most states) up to certain amounts. The maximum eligible gain is the greater of $10M cumulatively or 10x the adjusted basis in the stock per year. These two numbers sound divergent but in actuality may provide the taxpayer a way to ladder sales and thus receive significantly more than just a one time $10m or 10x benefit. Below are a few examples:

  1. An individual investment of $2M sold for $20M after five years will have an eligible gain of $18M (10x the $2M investment less the basis), all of which would be tax free at the Federal level and perhaps state level, depending on the state.
  2. An investment of $200K sold for $20M after five years will have an eligible gain of $10M (because $10M > 10x), with the remaining basis adjusted gain of $9.8M taxed at the federal capital gains tax rate (subject to specific workarounds described below).

If you find yourself in the enviable position of having gains above $10M or 10x in a single investment, there are a few potential workarounds, such as transferring stock or staggering sales.

It is first necessary to clarify that the $10M cap is aggregate per company and can be taken all at once or over several years of sales. There is no $10M per year cap — an investor can sell multiple QSBS investments in the same year, and all of the gains (subject to the per company cap) are eligible for exclusion.

The 10x cap is per company, per year. Meaning, if you have a 100x gain on an investment (and the 100x is >$10M such as in Example 2 above), you can stagger the sales over ten years, realizing 10x per year without ever hitting the cap.

Additionally, shares can be transferred tax-free to another party (such as a trust, partner in a partnership, or relatives, but excluding spouses) such that each taxpayer can take advantage of the greater of $10M or 10x maximum eligible gain. Transfers are retroactive (the five-year clock does not reset), so you can wait to see which investments will exceed the maximum eligible gain.

Even if you aren’t expecting millions of dollars in gains, QSBS tax treatment is important to understand and take advantage of as it can save you over 23.8% per investment. And thanks to compounding, this can add up over time.

At this time, the long term capital gains tax rate is 20%. There is also a 3.8% investment (“Obamacare”) tax, which is also excluded from QSBS tax treatment. Additionally, QSBS acquired after Sept 27, 2010 is fully exempt from any Alternative Minimum Tax (AMT) calculation.

Below is a more comprehensive (but not exhaustive) list of qualifiers, disqualifiers, and other factors relating to Section 1202 of the IRC.

Qualifications for small business stock


The issuing entity must be a domestic C corporation at the time of issuance and substantially all periods through disposition. Foreign companies may be able to issue qualifying stock out of a US C-Corp subsidiary to qualify.

Note for founders; this is a significant reason why VC’s won’t invest in an LLC. You should plan to convert to a C corporation before raising your first priced round.

Assets and Active Conduct

The corporation must have assets of less than $50M at all times from August 10, 1993, through the equity issue date and immediately thereafter. The $50M threshold refers to cash (including cash received from the equity issuance) and the tax basis of other property held by the corporation. It does not take into account valuation, so even a company valued at $200M may qualify for QSBS. Assets may exceed $50M at the time of disposition without disqualifying the QSBS status.

Note, if an individual invests in multiple rounds, only the equity acquired in rounds below the $50M asset threshold is eligible for QSBS tax treatment.

The active business requirement stipulates that the company must use 80% of assets (by value) to conduct business during substantially all of the holding period. Active conduct can include “start-up activities” and expenses or R&D expenditures and does not require gross income from such activities. Cash held for working capital or to be invested in the business within two years is treated as used in active conduct, however, once a company has been in business for at least two years cash held for these purposes cannot exceed 50% of the assets of the company.


The taxpayer must hold the stock for at least five years from the issuance date. The issuance date refers to a priced equity offering or the date on which a convertible note converts into equity. For stock options, the issuance date refers to the exercise date, not the grant date. This is important for early employees to understand for both the 5-year holding period as well as the $50M asset threshold as they may want to exercise options while the equity still qualifies as QSBS.

Note, there is a way for QSBS holders to create an “adjusted basis” for additional stock purchased that would otherwise be QSBS eligible if not for the five year holding requirement. That’s a more complicated situation, which we have not gone into in this article.

The issuance date determines what percentage of the gain is eligible for exclusion and whether the Alternative Minimum Tax (AMT) applies. Below is a summary of QSBS tax treatment by the issuance date.

  • Stock issued/acquired between 8/11/93 and 2/17/09 is eligible for 50% gain exclusion, subject to 7% AMT.
  • Stock issued/acquired between 2/18/09 and 9/27/10 is eligible for 75% gain exclusion, subject to 7% AMT.
  • Stock issued/acquired after 9/28/10 is eligible for 100% gain exclusion with 0% AMT.

Other Factors

Transfers: As previously discussed, a portion or all of a QSBS holding can be transferred tax-free to another party (by gift, death, or transfer from a partnership to a partner). In this case, the transferee is treated as having acquired the stock in the same manner and the same timing as the transferer. Meaning, transfers are done retroactively and the new holder does not lose QSBS status, and the 5-year countdown does not reset. Transfers can be useful for estate planning and can effectively increase the maximum eligible gain taken per company. Spouses are carved-out, however, there are several possible workarounds which we don’t address in this article.

Acquisitions: If a QSBS corporation is acquired using stock as consideration, the new stock will continue to be treated as QSBS in the hands of the taxpayer. Additionally, the new stock will be treated as if issued on the acquired company’s original issuance date. Meaning, an investor does not lose QSBS status upon a stock acquisition, and the 5-year countdown does not reset.

Rollovers: Section 1045 of the tax code allows for qualified rollovers of QSBS held for more than six months from issuance but less than the five-year requirement so long as sales proceeds are reinvested in another QSBS within 60 days. In the case of a qualified rollover, the 5-year countdown does not reset.

Documentation: The safest way to ensure that you can take advantage of the QSBS exemption is to keep detailed records of your investments, including exact investment sizes, equity closing, conversion, or options exercise dates and the timing and size of any subsequent sales. Having a record of company assets following each closing (like a pro forma balance sheet) helps to prove that an investment was made below the $50M asset threshold. You can also ask a company to put in writing whether they qualify at the time of investment. And if you are structuring the terms of the deal, you can include a best efforts clause in the term sheet and closing docs (eg. management will use its best efforts to stay in compliance with the QSBS guidelines for the duration of the investment).

Exclusions and Disqualifiers:

The following types of businesses are specifically excluded from Section 1202 tax treatment:

  • Professional services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services
  • Banking, insurance, financing, leasing, investing, or similar businesses
  • Farming, mining, or natural resources extraction
  • Hospitality (hotels, motels, restaurants, or similar businesses)

Note that most early-stage tech companies are qualified businesses under Section 1202.

Certain company actions, including certain types of share repurchases, can disqualify it for QSBS treatment.

Offsetting short positions held by the taxpayer can also disqualify the gain (though this seems unlikely for these types of investments).

In summary, if you are a founder, an early employee, an angel investor, advisor, a general or limited partner in an early-stage VC fund, or anyone who makes investments into small businesses, having a basic understanding of the QSBS tax code can have a meaningful impact on your tax-adjusted returns.

I hope that this overview of QSBS has been a useful resource, and if so please “like” or share with friends. I should disclose that I am not an accountant or a lawyer and I don’t pretend to be either on TV. If you are in a position to take advantage of QSBS tax treatment, I strongly encourage you to consult a tax professional. Investing in early-stage companies involves considerable risk. Nothing in this article constitutes investment advice.

Thank you to @JasonCalacanis for first alerting me to the QSBS tax treatment, and to Alex Taub, founder of the awesome new professional social networking app Upstream, and Joshua Seigel of @AcronymVC for the overview and reviewing this article.