Section 1202 of the US tax code allows founders, early employees, and investors to exclude millions in capital gains from federal tax. Here is how it works, who qualifies, and what the recent law changes mean for Indian founders.
Among the tax benefits available to startup founders and early investors in the US, Qualified Small Business Stock stands apart in scale. Under IRC Section 1202, a qualifying shareholder who holds stock in a qualifying small business for the required period can exclude a significant portion of the capital gain from federal income tax when the shares are sold. For founders with meaningful equity in a successful company, this can represent a tax saving of several million dollars on a single exit.
It is also one of the least understood benefits in the startup ecosystem, partly because the eligibility rules are specific, and partly because the relevant law changed meaningfully in 2025 under the One Big Beautiful Bill Act.
Here is what QSBS is, who it applies to, what the OBBBA changed, and what it means specifically for Indian founders setting up US startups.
What QSBS is and why it exists
Section 1202 was enacted in 1993 to encourage investment in small businesses by offering a federal capital gains exclusion to investors who hold qualifying stock for a minimum period. The exclusion applies to gain realized on the sale or exchange of Qualified Small Business Stock issued by a qualifying C-Corp.
In its original form, the exclusion was partial and modest. Over the years Congress expanded it, and for stock acquired after September 27, 2010, the exclusion reached 100% of qualifying gain up to a cap. The 2025 OBBBA made further changes that expanded both the cap and the eligibility threshold.
The policy rationale is straightforward: by reducing the tax cost of a successful exit, the exclusion makes early-stage investment in small businesses more attractive, which in turn makes it easier for startups to attract capital, co-founders, and early employees willing to take equity rather than cash.
The eligibility requirements
QSBS eligibility depends on four things: the type of entity, the size of the company at the time of issuance, the nature of the acquisition, and the holding period.
Entity type
The company must be a domestic C-Corp at the time the stock is issued. S-Corps, LLCs, foreign corporations, and partnerships do not qualify. This is one of the structural reasons venture-track startups incorporate as Delaware C-Corps; the QSBS benefit is available to every US taxpayer on the cap table from day one without any additional steps.
Company size at issuance
Under the OBBBA, the company’s aggregate gross assets must not exceed $75 million at the time of stock issuance and immediately after. This is an increase from the prior $50 million threshold. For most early-stage startups, the gross assets test is easily satisfied at the time founder shares and early employee options are issued. The test is applied at issuance, not at the time of sale, so a company that has grown well beyond $75 million at exit can still have qualifying stock if it was under the threshold when the shares were issued.
Nature of the acquisition
The stock must be acquired at original issuance in exchange for money, property, or services. Stock purchased on the secondary market does not qualify. This means QSBS is a benefit for founders, early employees receiving option grants, and investors participating in primary financing rounds, not for later-stage purchasers acquiring shares from existing holders.
Industries that do not qualify
Section 1202 excludes certain industries from QSBS eligibility regardless of company size. These include professional service businesses in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. Hotel, motel, restaurant, and similar hospitality businesses also do not qualify, nor do farming businesses and businesses in the financial sector. Technology companies, manufacturers, retailers, and most other industries qualify.
The holding period requirement and the OBBBA changes
The pre-OBBBA rule
Before the OBBBA, the QSBS exclusion required a holding period of more than five years. Stock held for five years or less received no exclusion. Stock held for more than five years qualified for a 100% exclusion of gain up to the applicable cap.
What the OBBBA changed
The One Big Beautiful Bill Act introduced a tiered holding period structure that makes the exclusion available to shareholders who exit before the five-year mark:
- Stock held for at least three years but less than four years: 50% exclusion of qualifying gain
- Stock held for at least four years but less than five years: 75% exclusion of qualifying gain
- Stock held for five or more years: 100% exclusion of qualifying gain
This change is significant for founders and investors in companies that exit in the three-to-five-year range, which is common in the current M&A environment. Previously a three-year hold produced zero QSBS benefit. Under the OBBBA, it produces a 50% exclusion.
The new gain exclusion cap
The OBBBA also raised the per-taxpayer exclusion cap to $15 million of qualifying gain per issuer (up from $10 million under prior law). The alternative cap of ten times the taxpayer’s adjusted basis in the stock also remains available, whichever is greater. For a founder who paid $1,000 for their shares, ten times basis is $10,000, so the $15 million cap is the operative limit in almost all founder situations.
Effective date
The OBBBA changes apply to stock issued after the relevant effective date. Stock issued before the OBBBA was signed retains the prior law treatment. Before publishing, confirm the specific effective date with reference to the enacted legislation.
What the benefit actually looks like in dollars
A founder holds 1,000,000 shares with a cost basis of $0.001 per share, for a total basis of $1,000, in a qualifying Delaware C-Corp. The company is acquired five years after the stock was issued at $15 per share.
Without QSBS: total gain is approximately $14,999,000. At a 20% long-term capital gains rate plus 3.8% net investment income tax, the combined federal rate is 23.8%. Federal tax on the full gain is approximately $3,569,762.
With QSBS (100% exclusion, five-year hold): the full $14,999,000 gain is excluded from federal income tax, subject to the $15 million cap. Federal capital gains tax: $0 on the excluded portion.
The tax saving on this example is approximately $3.5 million in federal tax. On a larger exit or with a higher adjusted basis, the ten-times-basis alternative cap can produce an even larger exclusion.
State tax is separate and significant. Several states, including California, do not conform to the federal QSBS exclusion and tax the full gain at the state level regardless of the federal treatment. New Jersey and Pennsylvania are among the other major states that do not conform. Founders in non-conforming states owe state tax on QSBS gain even when the federal exclusion eliminates federal tax entirely.
The 83(b) connection: why filing it matters for QSBS
The 83(b) election and QSBS eligibility are connected in an important way that founders should understand before receiving their first stock grant. A dedicated blog covering the 83(b) election in full is available here.
The QSBS five-year holding period begins when the stock is acquired. For restricted stock subject to vesting, a timely 83(b) election causes the holding period to start at the grant date, covering the entire share grant from a single acquisition date. Without the 83(b) election, individual vesting events create separate acquisition dates for each tranche of shares as they vest, which means each tranche has its own holding period.
For a founder on a four-year vesting schedule who does not file the 83(b) election, the last tranche of shares to vest begins its QSBS holding period at the final vesting date, four years after the grant. If the company exits at year five from the grant date, that last tranche has only been held for one year from its acquisition date and does not qualify for any QSBS exclusion.
Filing the 83(b) election on day one creates a single clean acquisition date for all shares, ensuring the full grant runs the same holding period clock and that every share can qualify for QSBS treatment at the same time.
QSBS stacking
Founders and investors can potentially multiply the per-taxpayer exclusion by gifting QSBS shares to family members or certain trusts, each of whom can then claim their own per-taxpayer exclusion on sale. This practice, known as QSBS stacking, has been used by some founders to multiply the effective exclusion significantly beyond the individual cap.
The OBBBA made changes to the stacking rules that affect how and whether this strategy is available. The specific rules and their interaction with the OBBBA changes are detailed enough to require professional analysis before implementation. This is not a strategy to attempt without guidance from a tax attorney or CPA experienced in Section 1202.
What this means for foreign-based founders specifically
QSBS only benefits US taxpayers. An Indian resident who has not become a US person receives no benefit from the Section 1202 exclusion even if the stock otherwise qualifies in every other respect. The exclusion is a US federal income tax benefit and only applies to those subject to US federal income tax.
The benefit becomes relevant for Indian founders in two scenarios.
The first is if the founder moves to the US and becomes a US taxpayer before the exit. The QSBS holding period that began at the original stock grant continues to run regardless of the founder’s tax residency. A founder who received qualifying stock when they were an Indian resident and later becomes a US taxpayer before the exit can potentially claim the Section 1202 exclusion if the other requirements are met, including the holding period from the original grant date.
The second is the cap table effect. Even if the founder remains an Indian resident throughout, US co-founders, US angel investors, and US VC funds participating in early rounds all have their own QSBS eligibility on their shares. Incorporating as a Delaware C-Corp and issuing qualifying stock from day one means every US taxpayer on the cap table has access to the exclusion without any additional steps. This is a meaningful benefit to offer US co-founders and early investors at no cost to the company.
The practical implication: incorporating as a Delaware C-Corp and issuing shares at the earliest appropriate time, combined with the 83(b) election, preserves QSBS eligibility for every current and future US taxpayer on the cap table. Waiting to incorporate, choosing a non-qualifying entity, or missing the 83(b) election window can permanently foreclose this benefit for founders who later become US taxpayers.
Common mistakes worth avoiding
- Incorporating as an LLC or S-Corp and losing QSBS eligibility entirely. Neither entity type qualifies under Section 1202, and converting to a C-Corp after the fact does not retroactively qualify stock that was issued before the conversion.
- Letting gross assets grow beyond the qualifying threshold before issuing shares to key team members or early investors. The gross assets test is applied at issuance. Waiting to issue option grants until after a large funding round can push the company above the threshold and make newly issued shares ineligible.
- Purchasing shares on the secondary market and assuming they qualify. Secondary market purchases do not qualify as original issuance and are not eligible for the Section 1202 exclusion regardless of holding period.
- Assuming state tax treatment mirrors the federal exclusion. For founders in California, New York, New Jersey, Pennsylvania, and several other states, the full gain is taxable at the state level even when the federal exclusion eliminates federal tax. The state tax exposure should be modeled as part of any exit planning that relies on QSBS.
- Not maintaining documentation of original issuance and the company’s gross assets at the time of issuance. If the exclusion is claimed on a return, the IRS will expect evidence that the eligibility requirements were met at the time the stock was issued.
- Not filing the 83(b) election and inadvertently fragmenting the QSBS holding period across multiple vesting dates. This does not eliminate QSBS eligibility entirely but it complicates it and can exclude later-vesting tranches from the full holding period benefit.
Frequently asked questions
Does an Indian founder benefit from QSBS?
Not directly while they remain a non-US taxpayer. QSBS is a US federal income tax benefit and only applies to those subject to US federal income tax. However, if the founder later becomes a US taxpayer before exit, the holding period that started at the original grant date continues to run and may satisfy the five-year requirement. US co-founders, US investors, and early US employees all have their own QSBS eligibility from the same share issuance.
What did the One Big Beautiful Bill Act change about QSBS?
The OBBBA introduced a tiered holding period structure: 50% exclusion for three-to-four-year holds, 75% for four-to-five-year holds, and 100% for five-year-plus holds. It also raised the per-taxpayer gain exclusion cap to $15 million (from $10 million) and increased the qualifying company gross assets threshold to $75 million (from $50 million). These changes apply to stock issued after the OBBBA effective date.
Does my company need to still be small at the time of exit to qualify?
No. The gross assets test is applied at the time of stock issuance, not at exit. A company that was under the threshold when the shares were issued can qualify even if it has grown significantly by the time of sale.
Can employees with stock options benefit from QSBS?
Employees with options need to exercise them to receive actual shares. The QSBS holding period begins at exercise, not at the original option grant date. Early exercise combined with a timely 83(b) election starts the holding period clock as soon as possible and gives the shares the best chance of satisfying the five-year requirement before exit.
Does QSBS apply to investors in later financing rounds?
Yes, if the company still qualifies at the time of the later round issuance. The gross assets test applies at each issuance, so investors in Series A, B, or later rounds can potentially receive qualifying stock if the company’s gross assets are still under the threshold at the time of that issuance.
What states do not recognize the federal QSBS exclusion?
California, New Jersey, and Pennsylvania are among the major states that do not conform to the federal Section 1202 exclusion. Founders and investors in those states owe state income tax on QSBS gain even when the federal exclusion eliminates federal tax. State conformity should always be checked before relying on QSBS in exit planning.
Sources: IRC Section 1202 (QSBS); One Big Beautiful Bill Act (QSBS provisions, tiered holding period, and cap changes); IRS Form 15620, Section 83(b) Election; IRC Section 83(b).
QSBS is one of the most valuable tax benefits available in the US startup ecosystem, but it requires specific conditions to be met at the time of stock issuance, not at exit. Every situation is different, and the right approach depends on your entity structure, your tax residency, the company’s gross assets at issuance, and your planned holding period. This blog is intended as a general guide and should not be relied upon as legal or tax advice for your specific circumstances. The stacking strategies and state tax considerations in particular require professional analysis before implementation. If you want to understand how QSBS applies to your cap table or your personal equity position, Numera can help you work through it.