Investing in small businesses can be a rewarding venture, both financially and personally. One of the most attractive incentives for investors with this interest is the Qualified Small Business Stock (QSBS) exclusion. Section 1202 of the Internal Revenue Code (IRC) offers significant tax benefits for non-corporate taxpayers investing in QSBS, making it an appealing option if you’re looking to support innovative startups and small enterprises.
Conversely, if you are the holder of the issuing company, QSBS can attract investors looking for tax-efficient investments and potentially enhance the perceived value of your company’s stock and its credibility. Investing in these opportunities could provide your small business with the resources to scale and compete in its market.
What is QSBS?
QSBS refers to shares issued by a qualified small business. Under the tax code, the issuing business must be a domestic C corporation and generally must meet an ‘aggregate gross assets’ threshold at the time of issuance. For QSBS acquired on or before July 4, 2025, that threshold is $50 million; for QSBS acquired after July 4, 2025, the threshold increases to $75 million. QSBS generally must be acquired at original issuance (for example, directly from the company in exchange for cash, property (other than stock), or as compensation for services).1
QSBS Issuer Gross Asset Thresholds
| QSBS Acquisition Date | Maximum Gross Assets at Issuance |
|---|---|
| On or before July 4, 2025 | $50 million |
| On or after July 5, 2025 | $75 million |
Gross assets are generally measured using adjusted tax basis and tested immediately before and after stock issuance.
Key benefits of QSBS for investors
The primary allure of QSBS lies in its tax advantages. Here are some key benefits:
- Capital gains exclusion: QSBS may allow eligible investors to exclude a portion — and in some cases up to 100% — of gain from federal tax. For QSBS acquired on or before July 4, 2025, a more-than-five-year holding period is generally required to qualify for the exclusion (with the percentage depending on acquisition date). For QSBS acquired after July 4, 2025, the law introduced a tiered benefit: a 50% exclusion after at least three years, a 75% exclusion after at least four years, and a 100% exclusion after at least five years.The exclusion is subject to limits that generally apply on a per-taxpayer, per-issuer basis. For QSBS acquired on or before July 4, 2025, the limit is generally the greater of $10 million or 10 times the taxpayer’s basis in the stock. For QSBS acquired after July 4, 2025, the fixed-dollar limit increases to $15 million (or 10 times basis, if greater). State tax treatment varies and not all states conform to the federal QSBS exclusion.1
- Deferral of gains: If an investor sells QSBS before meeting the applicable holding period, Section 1045 may allow a deferral of gain if the proceeds are reinvested into a replacement QSBS within 60 days.
- Alternative minimum tax (AMT): Under current QSBS rules, eligible gain that is excluded under Section 1202 is generally not subject to AMT for stock eligible for the 100% exclusion, though AMT treatment can vary for older QSBS issued in earlier periods. acquired after Sept. 27, 2010, the gains are not subject to the AMT of 3.8% in 2025.
QSBS Holding Periods and Federal Gain Exclusion
| QSBS Acquisition Date | Holding Period | Federal Gain Exclusion |
|---|---|---|
| On or before July 4, 2025 | More than 5 years | Up to 100% |
| On or after July 5, 2025 | At least 3 years | 50% |
| On or after July 5, 2025 | At least 4 years | 75% |
| On or after July 5, 2025 | At least 5 years | 100% |
Excluded gain is subject to per-issuer limits and other QSBS requirements. The taxable portion of gain for partial exclusions may be subject to a higher capital gains rate and net investment income tax.
Eligibility criteria
To benefit from QSBS, both the investor and the issuing company must meet specific criteria. The non-corporate taxpayer who wants to invest in QSBS must acquire the stock at its original issue, not on the secondary market. In addition to being a C Corp in the U.S. with gross assets not exceeding the applicable threshold, generally $50 million for QSBS acquired on or before July 4, 2025, and $75 million for QSBS acquired after that date.1
How to leverage QSBS
As an investor, QSBS can be a strategic tool to help maximize returns while minimizing tax liabilities. For example, if QSBS was purchased for $1 million and later sold for $15 million, the amount you may be able to exclude depends on when the QSBS was acquired. If it was acquired on or before July 4, 2025, the fixed-dollar cap is generally $10 million (or 10 times basis, if greater). If it was acquired after July 4, 2025, the fixed-dollar cap increases to $15 million (or 10 times basis, if greater), potentially allowing a larger exclusion.1
Alternatively, you could gift some QSBS to family members or create certain types of irrevocable trusts to “stack” multiple exclusions (combining different exclusions or spreading the benefits across multiple entities).
Each separate taxpayer may have their own per-issuer exclusion limit, subject to QSBS requirements and anti-abuse rules. The fixed-dollar cap is generally $10 million for QSBS acquired on or before July 4, 2025, and $15 million for QSBS acquired after July 4, 2025 (or 10 times basis, if greater).
QSBS Federal Gain Exclusion Limits
| QSBS Acquisition Date | Maximum Excludable Gain (Per Issuer, Per Taxpayer) |
|---|---|
| On or before July 4, 2025 | Greater of $10 million or 10× adjusted basis |
| On or after July 5, 2025 | Greater of $15 million or 10× adjusted basis |
The exclusion limit applies per issuer and per taxpayer, subject to IRS rules and anti-abuse provisions.
To leverage QSBS, holding period matters. For QSBS acquired after July 4, 2025, partial exclusions may be available after three or four years, with the full 100% exclusion generally available after five years. Also, consider investing in multiple qualified small businesses to help mitigate risk and increase the potential for higher returns. Lastly, stay informed on changes in tax laws and regulations that may impact QSBS benefits.
Potential risks for investors
Investing in QSBS can offer substantial tax benefits, but it’s not without risks, including:
- Business and liquidity risk: Small businesses, especially startups, are inherently risky. There’s no guarantee that the business will succeed or that its stock value will appreciate. Additionally, QSBS investments are typically in private companies, meaning the stock is not publicly traded. This can make it difficult to sell the stock quickly or at a favorable price. Liquidity can be limited, and holding periods matter for tax benefits. For QSBS acquired after July 4, 2025, some level of exclusion may be available after three or four years, but the maximum benefit generally requires a five-year holding period.
- Returns risk: Small businesses can experience significant fluctuations in their financial performance and stock value as well as market valuation. This volatility could impact the performance of investments. Diversifying investments across different sectors and asset classes can help mitigate the risk of concentration in a portfolio. Economic downturns and changes in market conditions can also adversely affect small businesses more than larger, established companies.
- Regulatory and compliance risk: The tax benefits associated with QSBS are subject to specific IRS regulations. If the issuing company or the investor fails to meet these requirements, the tax benefits may not be available. Changes in tax laws and regulations can also impact the advantages of QSBS.
Make informed decisions
QSBS offers a unique opportunity for investors to support small businesses while enjoying substantial tax benefits. As an investor or QSBS issuing company, it’s important to understand the eligibility criteria and strategic advantages to make informed decisions that align with your financial goals. Keep in mind that carefully evaluating the investing risks is also crucial.
Whether you’re looking at investing in QSBS or are considering issuing QSBS shares for your business, you’ll want to be sure it fits into your financial plan as well as your tax strategies. Talk to your Mercer Advisors wealth advisor who can consult with our investment management and tax planning and preparation teams to provide guidance.
If you’re not a Mercer Advisors client and want to learn more about QSBS and other financial strategies that could align with your goals, we can help. Our integrated wealth management solution includes tax planning, estate planning, insurance, financial planning, investment management, and more. Your hand-picked wealth advisor coordinates with specialists in these areas. Let’s talk.
