QSBS eligibility under Section 1202 provides startup investors with significant tax exclusions on capital gains, but qualification requires meeting strict corporate, financial, and operational criteria. Understanding these requirements ensures investors and founders structure their companies properly to maximize tax benefits.
Corporate Structure and Asset Requirements
Companies seeking QSBS status must meet specific organizational and financial requirements that determine whether a business can issue qualified small business stock to investors.
C-Corporation Structure and Domestic Entity Status
The company must operate as a C-corporation organized under United States federal or state law. This represents the most critical structural requirement for QSBS eligibility.
| Entity Type | QSBS Eligible | What to Do |
|---|---|---|
| C-Corporation | Yes | N/A - already qualified |
| S-Corporation | No | Convert to C-Corp before stock issuance |
| LLC | No | Convert to C-Corp before stock issuance |
| Partnership | No | Convert to C-Corp before stock issuance |
| Sole Proprietorship | No | Incorporate as C-Corp |
Foreign corporations, even those operating primarily in the U.S., cannot issue qualified small business stock. Companies incorporated in foreign jurisdictions must redomesticate to the United States before stock issuance.
Gross Assets Limitation
The company's gross assets must not exceed $50 million immediately after stock issuance. This threshold determines whether the business qualifies as a "small business" under Section 1202.
Key timing principle: The $50 million test applies only at the moment of stock issuance. Companies can grow beyond this threshold after issuance without disqualifying previously issued stock.
Example: A software startup has a $75 million post-money valuation but only $30 million in gross assets (mostly cash and servers). The stock qualifies as QSBS because gross assets are below $50 million at issuance.
Gross assets include cash, property, equipment, intellectual property, and investments valued at fair market value.
Active Business Test and Industry Restrictions
Beyond structural requirements, companies must actively use their assets in qualifying business operations and avoid restricted industries.
80% Active Business Use Requirement
The company must use at least 80% of its assets in the active conduct of one or more qualified trades or businesses during substantially all of the holding period.
Qualifying Active Uses:
- Research and development activities
- Product development and manufacturing
- Sales and marketing operations
- Employee compensation and benefits
- Office space and operational facilities
Non-Qualifying Passive Uses:
- Investment portfolios generating passive income
- Real estate held for appreciation
- Excess cash not needed for operations
- Securities trading activities
The IRS provides a working capital safe harbor allowing companies to hold cash for up to 24 months if designated for specific business purposes under a written plan. Requirements include:
- Written board resolution designating funds as working capital
- Specific business plan describing intended use
- Reasonable timeline (maximum 24 months) for deployment
- Actual use consistent with stated plan
Excluded and Qualifying Industries
Section 1202 excludes certain industries from QSBS eligibility:
| Excluded Industry | Examples |
|---|---|
| Professional Services | Law firms, accounting firms, consulting |
| Financial Services | Banks, investment funds, insurance companies |
| Hospitality | Hotels, restaurants, farms |
| Real Estate | REITs, property management firms |
| Resource Extraction | Oil and gas, mining operations |
Most technology companies qualify for QSBS regardless of sector. Software as a Service (SaaS), biotechnology, manufacturing, healthcare technology, and consumer products typically qualify.
Personal services exclusion: Businesses where the reputation or skill of specific employees is the principal asset cannot qualify. These include consulting firms built around named individuals, boutique advisory practices, and reputation-based agencies.
Stock Issuance and Holding Requirements
Beyond company-level requirements, QSBS eligibility depends on how and when investors acquire stock.
Original Issuance Requirement
Investors must acquire stock directly from the company in exchange for money, property, or services. Secondary purchases from other shareholders do not qualify for QSBS treatment.
| Acquisition Type | QSBS Eligible |
|---|---|
| Direct stock purchase from company | Yes |
| Founder stock at incorporation | Yes |
| Stock option exercise | Yes |
| Convertible note conversion | Yes |
| SAFE conversion | Yes |
| Secondary market purchase | No |
Five-Year Holding Period
Investors must hold QSBS for more than five years to claim the full tax exclusion. The holding period begins on the date of original issuance, not when the investor pays for the stock if payments occur in installments.
Timeline:
- Day 1: Stock issued by company (holding period begins)
- Years 1-4: Holding period continues (no Section 1202 benefits during this period)
- Year 5+: Stock becomes fully qualified for QSBS exclusion
Ongoing Compliance and Disqualifying Factors
Companies must maintain QSBS eligibility throughout the entire holding period. Ongoing compliance monitoring is critical to preserve tax benefits for investors.
Maintenance of Compliance
The 80% active business use requirement applies during substantially all of the investor's holding period. Companies should verify quarterly:
- Active business use percentages remain at 80% or above
- Industry classification remains in qualifying sectors
- Corporate status remains C-corporation and domestic
Common Disqualification Scenarios
| Disqualifying Factor | Prevention Strategy |
|---|---|
| Excess cash holdings | Deploy capital or use working capital safe harbor |
| S-corp/LLC structure | Convert to C-corp before stock issuance |
| Professional services model | Productize services or change business model |
| Secondary stock purchases | Only purchase directly from company |
| Early sale before 5 years | Plan for long-term hold or document investment intent |
| Redemptions > 5% | Monitor buyback programs near funding rounds |
Excess cash management strategies:
- Create board resolution designating funds as working capital within 60 days of funding
- Develop specific deployment plan (hiring, R&D, marketing, operational assets)
- Deploy capital within 24-month safe harbor window
Frequently Asked Questions
Can S-corporation stock qualify for QSBS?
No. The company must be structured as a C-corporation at the time of stock issuance. An S-corporation can convert to C-corporation status, and stock issued after conversion will qualify if all other requirements are met.
What happens if the company grows past $50 million in assets?
Stock already issued as QSBS remains qualified even if assets later exceed $50 million. The gross assets test only applies at the moment of issuance.
Do employees receiving stock options get QSBS benefits?
Yes, employees can receive QSBS benefits when they exercise stock options, provided the company qualifies and they hold the stock for more than five years. The holding period begins when exercised, not when granted.
How do convertible notes affect QSBS?
Convertible notes can convert into QSBS if the note was originally issued by a qualifying company. The holding period begins when the note converts to stock. Learn more about QSBS requirements and complete qualification.
Conclusion
QSBS eligibility requires companies to structure as domestic C-corporations, maintain gross assets below $50 million at stock issuance, operate qualifying businesses with active asset deployment, and sustain compliance throughout investors' five-year holding periods. Companies should implement compliance monitoring systems and provide clear documentation to shareholders regarding their qualified stock holdings.