Qualified small business stock

Qualified small business stock (QSBS) is stock issued by early-stage companies that meet certain criteria.

It allows founders and early investors to potentially receive a 100% exemption on federal capital gains taxes, up to $10 million or 10 times their original investment amount (whichever is higher).

The QSBS rules can be found in Section 1202 of the Internal Revenue Code. Read the SeedLegals guide to QSBS and find out how to use it.

Most startups qualify for QSBS by nature of being an early-stage startup. Here’s a summary of the rules (for more detail, go to our QSBS guide for founders):

• The company must be a C corporation (not S corporation or LLC).


• The company’s assets must not exceed $50 million.


• The company must not be in an excluded business (excluded businesses include healthcare, law, and financial services).


• The company must be an active business with 80% of its assets used in the operations of its qualified business.

The QSBS rules can be found in Section 1202 of the Internal Revenue Code.

SAFEs can potentially qualify as QSBS, but there is some uncertainty around this. QSBS can only apply to "stock," and it’s not certain whether the Internal Revenue Service (IRS) classifies a SAFE as "stock". This distinction is important because of the requirement to hold QSBS for five years to achieve the full benefit. If a SAFE is considered "stock," the five-year clock starts from the moment the investor enters into the SAFE. If not, the clock only starts from when the SAFE converts to equity in the company at the point it’s issued to the investor.

So, it depends on how the IRS classifies it. The Y Combinator SAFE, for instance, is intended to be treated as "stock," but this characterization isn’t binding on the IRS. If you’re a SAFE investor and want to ensure you get QSBS relief sooner, you should consider converting the SAFEs into stock as soon as possible. This way, you reduce the uncertainty around whether the SAFE itself is treated as "stock”.

It’s important to check you qualify before issuing QSBS to your investors, your employees or yourself. Your investors might expect representations and warranties in the investment documents which state the stock they’ll be receiving meets QSBS requirements.

We’ve written this article on QSBS for investors which you can share with any current or potential investors. It covers the benefits of QSBS and what they should do to qualify.

Yes, the $50 million gross assets limit for QSBS does include the funding you’re receiving. So, if the company’s assets, including the new funds, are more than $50 million, the stock will not qualify as QSBS. But if you issue stock that qualifies as QSBS, and further down the line the company’s gross assets exceed $50 million, this doesn’t affect the QSBS status of the stock issued before.

If your fundraise takes you over the $50 million limit, you can deal with this by issuing stock in tranches. The company can issue a first tranche of QSBS that keeps the company below the $50 million limit. Then, a day or more after, it can issue a second tranche of non-QSBS which can take the company above the $50 million limit. This ensures you can issue as much QSBS as possible without risking its eligibility.