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The QSBS Exemption (Section 1202): How Founders Pay $0 Tax on $10 Million
The QSBS Exemption (Section 1202): How Founders Pay $0 Tax on $10 Million
CORE INSIGHTS
- The Golden Ticket: If you invest in a “Qualified Small Business” (QSBS) and hold for 5+ years, 100% of your capital gains (up to $10M) are federally tax-free. IRC § 1202(a)
- The 10x Multiplier: The limit is the greater of $10M OR 10x your cost basis. If you invest $2M, your exemption cap jumps to $20M. IRC § 1202(b)
- Entity Matters: Only C-Corporations qualify. S-Corps, LLCs, and partnerships do NOT eligible. This single fact dictates startup structure.
For startup founders and early investors, IRC Section 1202 is the single most valuable line in the tax code. It turns a massive exit from a taxable event into a pure wealth transfer. But you must qualify on Day 1.
QSBS Eligibility Checklist
- Structure: Must be a Domestic C-Corporation. IRC § 1202(c)(2)
- Size: Gross assets < $50 Million at issuance.
- Original Issue: Must buy stock directly from the company (not secondary market).
- Industry: Tech, Manufacturing, Retail (OK). Law, Health, Consulting, Financial Services (Excluded). IRC § 1202(e)(3)
What-If Scenario: The $10 Million Exit
| Structure | Sale Price | Fed Tax (23.8%) | Net Proceeds |
|---|---|---|---|
| LLC / S-Corp | $10,000,000 | -$2,380,000 | $7.62 Million |
| C-Corp (QSBS) | $10,000,000 | $0 (Exempt) | $10.00 Million |
Visualizing the Tax Freedom
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*Figure 1: Net Wealth. The QSBS bar (Purple) keeps 100% of the gains.*
Strategic Action Steps
1
Start as C-Corp
If you plan to raise venture capital or exit big, form a Delaware C-Corp. Converting an LLC later is messy and restarts the 5-year clock.
If you plan to raise venture capital or exit big, form a Delaware C-Corp. Converting an LLC later is messy and restarts the 5-year clock.
2
Hold for 5 Years
This is non-negotiable. If you sell in Year 4, you owe full tax. If you must sell early, use a Section 1045 Rollover to move gains into another QSBS startup tax-free.
This is non-negotiable. If you sell in Year 4, you owe full tax. If you must sell early, use a Section 1045 Rollover to move gains into another QSBS startup tax-free.
3
Document Everything
Keep proof of the $50M asset test at the time of investment. The IRS will ask for this 10 years later when you file for the exemption.
Keep proof of the $50M asset test at the time of investment. The IRS will ask for this 10 years later when you file for the exemption.
The Bottom Line: Who Should Choose What?
- Choose C-Corp (QSBS): High-growth startups aiming for acquisition or IPO.
- Choose LLC: Lifestyle businesses, consultants, or real estate holding companies (pass-through losses are better).
What companies qualify for QSBS?
Domestic C-Corps with assets under $50M at issuance. Excludes “personal service” businesses like law firms, doctors, hotels, and finance.
What is the holding period?
You must hold the stock for at least 5 years. Selling earlier disqualifies you from the 100% exclusion unless you do a 1045 Rollover.
Disclaimer: This content is for informational purposes only. Section 1202 rules are strict. Consult a tax attorney.