How Starting a Business the Right Way Could Save You Millions in Taxes

One of the most powerful tools available to entrepreneurs is the Qualified Small Business Stock (QSBS) exclusion under Internal Revenue Code §1202. With proper planning, you may be able to avoid federal capital gains tax on up to $10 million — or 10 times your investment — when you sell.

What is QSBS?

QSBS is stock issued by a domestic C corporation that meets certain requirements under §1202. If you hold that stock for more than five years, you may be able to exclude 100% of the gain when you sell.

Key rules include:

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

• The company’s assets must not exceed $50 million at the time stock is issued.

• At least 80% of its assets must be used in an active trade or business.

• Certain industries — such as personal services, finance, hospitality, farming, and mining — are excluded.

• You must acquire the stock directly from the corporation at its original issuance.

• You must hold the stock at least five years.

• The exclusion is limited to the greater of $10 million or 10× your basis in the stock.

Why Entity Structure Matters

QSBS is only available for stock owned personally (or through a partnership). It is not available if your S corporation owns the stock.

For example:

• If you form an LLC or S corporation to operate your new business, you cannot qualify for QSBS.

• If you invest in a new C corporation directly, your shares may qualify, and each shareholder can claim their own QSBS exclusion.

This means that before you launch or acquire a business, you should consider whether starting as a C corporation provides long-term tax benefits.

Active Business Requirement

QSBS is designed to reward entrepreneurs who build and operate real businesses. The company must be actively engaged in a trade or business — hiring employees, creating products, providing services, or otherwise operating.

It does not apply if the company simply holds investments, rents property, or passively collects royalties. The “active business” test is one of the most important requirements under §1202(e).

Example: How Much Could You Save?

Suppose you invest $2 million in a new C corporation:

• If you sell your shares six years later for $25 million, your $23 million gain could be excluded from federal tax. That is a savings of more than $5 million in federal taxes.

• Even if your company sells for $100 million, you could still exclude $20 million (10× your basis) under §1202.

These savings are real, written into the tax code, and can create life-changing wealth at exit.

What About State Taxes?

One important caveat: California does not conform to the federal QSBS exclusion. In 2012, the California Court of Appeal struck down the state’s version of QSBS (Cutler v. FTB, 208 Cal.App.4th 1247). The legislature later repealed the statute (AB 1412, 2013). As a result, California entrepreneurs must still pay state income tax on the entire gain.

Even so, the federal exclusion can save millions, making QSBS a powerful tool for founders, investors, and business owners.

Key Takeaways for Entrepreneurs

• Consider forming a C corporation when launching or acquiring a new business.

• Hold your shares for at least five years to unlock QSBS benefits.

• Make sure the company is actively operating, not just holding investments.

• Each shareholder may qualify separately, multiplying the benefit.

• Be aware of state nonconformity — particularly in California.

Bottom Line

Starting or investing in a new business is exciting, but how you structure it matters. By planning ahead with QSBS in mind, you can potentially exclude millions in federal capital gains tax when you sell. This is one of the most significant tax benefits available to entrepreneurs — and it is only available if you get the structure right from the start.

Top 5 QSBS Myths (and the Truth Behind Them)

Myth 1: QSBS is only for tech companies.
✅ Truth: QSBS applies to any qualified small business in an active trade or business, not just tech startups. Excluded fields are mainly personal services, finance, real estate, and hospitality.

Myth 2: My LLC or S Corporation stock qualifies.
✅ Truth: Only C corporation stock qualifies. LLCs and S corporations are not eligible under §1202.

Myth 3: You need to sell the whole company to benefit.
✅ Truth: Even selling just your personal shares after 5 years can qualify, as long as the stock meets QSBS requirements.

Myth 4: QSBS gain is 100% tax-free.
✅ Truth: QSBS is a federal benefit only. Some states follow it, but California does not. You will still owe state tax there.

Myth 5: The exclusion is unlimited.
✅ Truth: The exclusion is capped at the greater of $10 million or 10× your investment. Smart planning may allow multiple shareholders to multiply the benefit.