Capital gains tax break for AI startup stock (QSBS)

In short

Internal Revenue Code Section 1202 lets you sell shares in certain small businesses without paying federal capital gains tax on part or all of the profit. For stock issued after July 4, 2025, you can exclude 50 percent of the gain after holding it for three years, 75 percent after four years, and 100 percent after five years. The total gain you can exclude from one company is capped at $15 million or ten times your cost basis, whichever is higher. The company must be a U.S. C-corporation with gross assets of no more than $75 million when the stock was issued, and at least 80 percent of its assets must be used in an active business that is not a service business. AI startups building software usually meet that test. Many states do not follow the federal rule, so you may still owe state tax on the full gain. Planning early, keeping records, and using gifts to family members can multiply the tax benefit.

What is the QSBS exclusion?

The qualified small business stock exclusion, or QSBS, is a tax break that reduces or eliminates the federal capital gains tax when you sell stock in a small C-corporation. Congress created it in 1993 to encourage long term investment in startups. 26 U.S.C. § 1202, H.R. Rep. No. 103-111

The break is only for individuals, trusts, and estates, not for corporate shareholders. It applies to common stock and certain preferred stock, as long as the shares were originally issued by the company to the shareholder, not bought from another investor in a secondary market. The amount of gain you can exclude depends on when you acquired the stock and how long you held it.

Over time, Congress changed the exclusion percentages. The One Big Beautiful Bill Act, signed on July 4, 2025, made the biggest changes in over a decade. It added a phased holding period for stock issued after that date and raised both the per issuer exclusion cap and the company size limit. EY, July 9, 2025

What changed under the One Big Beautiful Bill Act?

Before the 2025 law, stock acquired after September 27, 2010 could get a 100 percent exclusion after five years, with a $10 million cap and a $50 million company asset ceiling. The new rules apply to stock issued after July 4, 2025. Stock issued earlier keeps the old rules. 26 U.S.C. § 1202

The three main changes are in the table below.

The new tiered system means you do not have to wait five full years to get some benefit. After three years, you can exclude half the gain. That helps founders and employees who need to sell earlier. 26 U.S.C. § 1202(a)(1)(B), (a)(5), (c)(1)(B)

The gain that is not excluded under the 50 percent or 75 percent tier is taxed at a special 28 percent rate, not the usual 20 percent long term capital gains rate. Tax alert, RSM analysis

The higher cap and asset threshold mean more startups can stay qualified longer as they grow.

The law also broadened the active business test to include foreign research expenditures, and it allows full expensing of domestic research spending. Full expensing can lower the asset calculation and keep a company under the $75 million ceiling longer. Baker Tilly, July 15, 2025

Which companies and stock qualify for QSBS?

Five conditions must be met.

1. It must be a domestic C-corporation. S-corporations, LLCs taxed as partnerships, and other entities do not qualify. The company must be incorporated in the United States. 26 U.S.C. § 1202(d)(1)

2. The stock must be originally issued to you. You must buy the stock from the company when it first issues the shares, either for cash, property other than stock, or as payment for services. Buying shares from another shareholder on the secondary market does not count. 26 U.S.C. § 1202(c)(1)(B), 26 U.S.C. § 1202(f), 26 U.S.C. § 1202(f), 26 U.S.C. § 1202(f)

3. The company must be a qualified small business when it issues the stock. That means its total gross assets immediately after the stock sale cannot exceed the limit. For stock issued on or before July 4, 2025, the limit is $50 million. For stock issued after that date, it is $75 million, with inflation adjustments starting in 2027. Gross assets include cash plus the adjusted basis of all other property, with contributed property valued at fair market value. 26 U.S.C. § 1202(d)(2)

4. The company must be an active business. During substantially all of the time you hold the stock, at least 80 percent of the company’s assets by value must be used in the active conduct of a qualified trade or business. 26 U.S.C. § 1202(c)(2)(A), 26 U.S.C. § 1202(e)(1)(A)

5. The business itself must be a qualified trade. The law lists what is not qualified, including any trade or business involving health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset is the reputation or skill of its employees. Also excluded are banking, insurance, financing, leasing, investing, farming, oil and gas extraction, mining, and operating a hotel, motel, or restaurant. 26 U.S.C. § 1202(e)(3)

AI startups that develop and sell software, SaaS platforms, or other technology products generally fall on the right side of the line. As long as the core business is not consulting or a professional service, the company is likely a qualified trade. Law firm analysis

Many Delaware C-corporations in the AI space already structure their equity with QSBS in mind. The NVCA model investment documents now include QSBS representations and covenants. QSBS Expert

How do the exclusion percentages and holding periods work?

The percentage of gain you can exclude depends on two things, namely the date you acquired the stock and how long you held it.

The table below shows every acquisition window and the corresponding rules.

For the new post 2025 stock, if you sell after three years but before four, you exclude 50 percent. After four years but before five, 75 percent. After five years, 100 percent. The holding period is measured from the day the shares were issued to you or, in some cases, from the exercise of options. That is covered below.

The five year rule is the gold standard for the full exclusion. If you have stock from the 2010 to 2025 window, you cannot get any exclusion until you have held it five years. There is no early partial exclusion for those shares.

What is the per issuer cap on excluded gain?

Even if your gain is enormous, there is a ceiling on how much you can exclude from any single company over your lifetime. The cap is the larger of two numbers.

1. The dollar limit. For stock issued on or before July 4, 2025, the limit is $10 million. For stock issued after that date, the limit is $15 million, and it will rise with inflation starting in 2027. The limit is reduced by any gain you already excluded from that same company in earlier years. 26 U.S.C. § 1202(b)(4)

2. Ten times your adjusted basis in the stock you sold during the year. 26 U.S.C. § 1202(b)(1) Because the limit is the greater of the two, the 10x basis alternative often produces a much higher cap when your basis is large.

Consider a founder who exercises stock options early and pays ordinary income tax on the spread. That payment increases her basis in the shares. Suppose she pays $500,000 in tax and uses cash to exercise, giving her a total basis of $2 million. When she sells years later, the 10x basis rule allows her to exclude up to $20 million in gain from that same issuer, even if the dollar limit would have been $15 million. So the 10x cap rewards early exercise and basis packing.

With the new $75 million gross asset threshold, a founder could theoretically accumulate a very high basis and exclude up to $750 million in gain under the 10x rule, up from $500 million under the old $50 million ceiling. Baker Tilly, July 15, 2025 This extreme case is rare, but it illustrates how a high basis combined with the 10x rule can produce a large cap.

The cap applies per taxpayer, per issuer. That means if you and your spouse both hold QSBS, you each get a separate cap. Stacking, which we explain below, multiplies this effect across family members and trusts.

Does the QSBS exclusion affect the alternative minimum tax or the net investment income tax?

No. For stock acquired after September 27, 2010, the excluded gain is completely free of the alternative minimum tax (AMT). The 2025 law extended this rule to the 3 year and 4 year exclusion tiers as well. 26 U.S.C. § 57(a)(7), EY, July 9, 2025

The 3.8 percent net investment income tax (NIIT) also does not apply to gain excluded under Section 1202. 26 U.S.C. § 1411(c)(1)(A)(iii) That means for a high income taxpayer, the federal tax saved is the full 23.8 percent combined rate (20 percent capital gains plus 3.8 percent NIIT) on the excluded portion. A founder who excludes $15 million of gain saves roughly $3.57 million in federal tax. EY, July 9, 2025

Gain that exceeds the cap is taxed at the normal 20 percent rate plus the 3.8 percent NIIT. The excluded gain does not push the excess into a higher bracket that way.

How can you defer gain by rolling over into new QSBS?

If you sell QSBS that you have held for more than six months but less than the time needed for the exclusion you want, you can elect to postpone the tax. Internal Revenue Code Section 1045 lets you roll the gain into a new QSBS investment within 60 days. 26 U.S.C. § 1045(a)

The requirements are strict.

• You must be a non corporate taxpayer. Individuals, trusts, and estates can use the rollover. C-corporations cannot.
• The stock you sell must meet the QSBS definition and you must have held it more than six months.
• You must buy replacement QSBS (from a different company or the same company) within 60 days of the sale. The clock starts on the sale date. There is no extension.
• The replacement stock must itself be QSBS. The new company must meet the active business test when you buy it and for substantially all of the first six months you hold it. 26 U.S.C. § 1045(b)(1), (b)(4)(B)

When you elect the rollover, you do not pay tax on the gain now. Instead, you reduce the cost basis of the new stock by the amount of the deferred gain. When you later sell the replacement stock, the gain will be recognized at that time (subject to its own QSBS rules). Your holding period for the new stock includes the period you held the old stock. I.R.C. § 1223(13)

This rollover is a valuable tool for founders who want to move money from a startup that has reached the cap into a new venture without paying tax immediately. But this is only a deferral, not a permanent exclusion, unless you later hold the replacement stock long enough to qualify for the full QSBS exclusion.

What do recent court cases teach about claiming QSBS?

A federal court decision shows how easy it is to lose the QSBS benefit if paperwork is not perfect.

In Ju v. United States (2024), a researcher received shares in a biotech startup and later sold them. He claimed QSBS. The court held that he could not prove the company had less than $50 million in gross assets in the year the stock was actually issued. The taxpayer provided financial records from later years but not from the critical time. The court said the burden is entirely on the taxpayer to show that the asset limit was met at issuance. Ju v. United States, No. 22-1815 T

The practical lesson is to keep contemporaneous documentation. At the time of each stock issuance, record the company’s assets, the nature of the consideration paid, and the company’s active business status. Annual QSBS attestation services, such as those offered by Carta, can compile the necessary evidence year by year. Carta, Feb. 18, 2026

Converting an LLC or S-corp into a C-corp also demands care. If you simply exchange old equity for new C-corp stock, you may fail the original issuance requirement. The statute requires that you receive the shares for cash, property other than stock, or services. A stock for stock swap does not count, but stock acquired through conversion of other QSBS in the same corporation retains QSBS treatment. 26 U.S.C. § 1202(c)(1)(B) The safer path is to contribute new cash or property directly to the C-corp in return for shares.

Where does the state tax shoe drop?

The federal QSBS exclusion does not automatically flow through to your state tax return. Each state decides whether to follow the federal rule. If you live in or derived income from a state that does not conform, you will pay state tax on the full gain at the state’s capital gains rate.

The list of major non conforming states and their top rates is below.

Startup Law Blog, Jan. 15, 2026, LinkedIn/Ryan Wang, Massachusetts FY26 Budget, 1.501

California does not follow the federal QSBS exclusion. A founder who sells QSBS and excludes gain federally still owes California state tax on the full amount at up to 13.3 percent. Also, California does not recognize Section 1045 deferrals. Plan your residency carefully.

California also aggressively audits residency. In 2023, the Franchise Tax Board completed 520 residency audits on out of state filers, up 126 percent from 2019. The FTB uses a 19 factor test to determine if you still have the closest connections to California. LinkedIn/Ryan Wang Moving before an exit is not a silver bullet. You must establish genuine non residency well in advance.

How can families multiply the exclusion with stacking and packing?

The per taxpayer cap seems like a hard ceiling. But the cap applies separately to each taxpayer. By giving QSBS to multiple family members or trusts years before an exit, a founder can multiply the total tax free gain.

Stacking

Stacking means giving QSBS to other taxpayers so each can use their own $15 million or 10x basis exclusion. For example, a married couple who both hold shares can together exclude up to $30 million from the same company. If the couple also gifts shares to two adult children and two non grantor trusts, the total exclusion can reach $90 million or more. Startup Law Blog, Apr. 6, 2026

The gifts must be completed well before any sale is imminent. If you transfer shares after a letter of intent is signed, the IRS can argue the transfer was an anticipatory assignment of income, which would undo the stacking. Gifts made several years before a liquidity event are much harder to attack. Startup Law Blog, Apr. 6, 2026

Trusts are the most flexible stacking tool. To be safe, you should use non grantor trusts, meaning trusts that are separate taxpayers for income tax purposes. The IRS has not definitively said whether a grantor trust (where you pay the tax on the trust’s income) gets its own QSBS exclusion. Non-grantor trusts are the cleanest structures for QSBS stacking because the IRS has not issued guidance on that point. Startup Law Blog, Apr. 6, 2026

To lower the IRS risk, each trust should have different beneficiaries, distinct terms, and an independent trustee. Section 643(f) permits the IRS to collapse multiple trusts that appear created mainly for tax avoidance.

Some advanced structures use incomplete non grantor trusts (INGs) that are non grantor for income tax but remain incomplete gifts for gift tax purposes. However, California enacted SB 131 in 2023, which treats INGs as grantor trusts for California income tax, retroactive to January 1, 2023. That means an ING stacking strategy will not work for California state tax purposes. Tax alert, Tax analysis

Treasury has signaled that it is working on guidance to address trust stacking. As of May 2026, no proposed regulations have been released. Startup Law Blog

Packing

Packing is about increasing your adjusted basis in the stock, which boosts the 10x alternative cap. Two common methods.

• Contribute appreciated property (but not stock) to the C-corporation in exchange for shares under Section 351. The company takes the property with a carryover basis, and your basis in the shares equals your basis in the property contributed, not its fair market value. 26 U.S.C. § 358, 26 U.S.C. § 362
• Exercise stock options early (nonqualified options) and file an 83(b) election, paying ordinary income tax on the spread. The tax paid increases your basis. Even if the stock is worth little at the time, starting the five-year holding period early can help secure the QSBS exclusion. Morgan Stanley

Packing works best when combined with stacking. Multiple taxpayers each with a high basis can shield enormous gains.

How do you start the QSBS holding period as early as possible?

The five year clock starts when you are treated as owning the stock for tax purposes. Getting that start date right can mean the difference between a full exclusion and a large tax bill.

Restricted stock awards

If you receive restricted stock (shares that are subject to vesting), you have 30 days from the grant date to file a Section 83(b) election with the IRS. The election means you pay tax on the value of the shares immediately, but the holding period starts on the grant date, not the vesting date. If you miss the 30 day deadline, the clock does not start until the shares vest, potentially adding years to your waiting time. QSBS Expert

Stock options

For incentive stock options (ISOs), you cannot file an 83(b) election. The holding period begins only when you exercise the option and actually hold the stock. For nonqualified stock options (NSOs), you can exercise early (if the plan allows) and immediately file an 83(b) election. That starts the clock right away. IRS CPE presentation

SAFEs and convertible notes

A simple agreement for future equity (SAFE) or a convertible note is not stock until it converts. The holding period generally does not start until conversion. Some SAFEs, like the Y Combinator SAFE, state an intention to be treated as stock for tax purposes, but the IRS has not issued clear guidance. The conservative approach is to assume the clock starts only when the SAFE converts into shares. LinkedIn/Daniel Faierman

Gift and inheritance

If you receive QSBS as a gift, you inherit the donor’s holding period and basis. The stock keeps its QSBS character. If you inherit QSBS at death, the basis is stepped up to fair market value, but the per issuer cap still applies. The holding period includes the time the decedent held the stock. 26 U.S.C. § 1202(h)

Key takeaways

• Section 1202 can erase federal capital gains entirely on the sale of qualifying startup stock if you hold it long enough.
• The 2025 tax law added a tiered system (50 percent at three years, 75 percent at four, 100 percent at five) and raised the exclusion cap to $15 million and the company size limit to $75 million for stock issued after July 4, 2025.
• AI startups structured as C-corporations with scalable products usually qualify, but service businesses do not.
• The per taxpayer cap is the greater of $15 million (indexed) or 10 times your basis. Stacking with gifts and trusts can multiply the cap across family members.
• Many states, including California, do not conform to the federal exclusion. State tax can take a double digit percentage of the gain.
• Start planning early. The holding period, basis packing, and gift transfers must be in place years before an exit.
• Keep detailed, contemporaneous records of the company’s gross assets, stock issuance, and active business status at every funding round. Annual QSBS attestation is the gold standard.
• Use 83(b) elections within 30 days of receiving restricted stock or exercising NSOs to start the clock immediately.
• A Section 1045 rollover can defer tax when you reinvest in a new QSBS within 60 days, but it does not eliminate the gain permanently.

Frequently asked questions

Q:What types of businesses qualify for QSBS?

A:Most technology and software businesses qualify, along with manufacturing, biotech, and other non service trades. Businesses that primarily sell services (consulting, law, accounting, health, engineering, architecture, actuarial science, performing arts, athletics) do not qualify. Also excluded are banking, insurance, investing, farming, mining, and operating hotels or restaurants. 26 U.S.C. § 1202(e)(3)

Q:Can an LLC ever qualify for QSBS?

A:No. Only a C-corporation can issue QSBS. An LLC taxed as a partnership or an S-corporation cannot. However, an LLC can convert to a C-corporation and issue new stock that qualifies. The conversion must be structured carefully so the shareholders receive the new stock for cash, property, or services, not in a stock for stock exchange. A simple share swap may fail the original issuance test. 26 U.S.C. § 1202(c)(1)(B)

Q:Does the QSBS exclusion apply to state taxes automatically?

A:No. States must affirmatively adopt the federal rule. Nine states have no individual income tax (or no capital gains tax), so the benefit is effectively full. Many others conform, but Alabama, California, Mississippi, and Pennsylvania do not. Hawaii and Massachusetts offer partial conformity. New Jersey recently conformed, while Oregon decoupled. Always check your state’s current law before relying on the exclusion. Startup Law Blog, Jan. 15, 2026

Q:How soon can I sell and still get the 100 percent exclusion under the new law?

A:For stock issued after July 4, 2025, you need to hold it for more than five years to get the full 100 percent exclusion. If you sell after three years, you can exclude 50 percent. After four years, 75 percent. The clock starts when the stock vests (or when an 83(b) election is filed, which starts the holding period at the transfer date). 26 U.S.C. § 1202, 26 C.F.R. § 1.83-4

Q:Can I give QSBS to my children to increase the total tax free gain?

A:Yes, that is the core of stacking. Each donee gets their own per issuer exclusion cap (the greater of $15 million or 10x basis). Gifts must be genuine and made well before any planned sale. If you wait until a deal is imminent, the IRS may disregard the gifts. Gifts to non grantor trusts are also effective, but the IRS has not yet issued final guidance on grantor trusts. Startup Law Blog, Apr. 6, 2026

Q:What happens if the company grows beyond the $75 million asset threshold after I bought the stock?

A:The gross asset test is measured only at the time the stock is issued and immediately afterward. If the company later raises more money and its assets exceed $75 million, your stock remains QSBS as long as the other requirements (active business and C-corporation status) are met during your holding period. The key is that the company was a qualified small business when you acquired the shares. 26 U.S.C. § 1202(c)(1)(A)

Q:Do stock options count as QSBS?

A:Stock options themselves are not QSBS. QSBS is stock that you actually hold. For NSOs, you get stock when you exercise the option. That can be QSBS if all the rules are met. For ISOs, the same. Filing an 83(b) election within 30 days of early exercise for NSOs starts the holding period immediately. IRS CPE presentation

Q:Is there a way to defer QSBS gains without selling?

A:Yes, a Section 1045 rollover lets you sell QSBS and defer the gain by buying replacement QSBS within 60 days. You must have held the original stock more than six months. The replacement stock must itself be QSBS. The deferred gain reduces your basis in the new stock, so tax is merely postponed, not avoided. 26 U.S.C. § 1045

Q:How do I prove to the IRS that my stock qualifies?

A:Keep records that show the company’s gross assets on each stock issuance date, evidence that you paid cash or property for the shares (or that they were issued for services), and that the company met the active business test throughout your holding period. Contemporaneous financial statements, tax returns, and board resolutions are best. Services like Carta’s QSBS attestation create annual summaries and shareholder letters. Carta, Feb. 18, 2026

Q:What is the 28 percent tax on non excluded gain?

A:For stock subject to a 50 percent or 75 percent exclusion (including the new 3 year and 4 year tiers), the portion of gain that is not excluded is taxed at a flat 28 percent rate, instead of the normal 20 percent long term capital gains rate. This 28 percent rate applies only to the non excluded gain from QSBS. Gain above the per issuer cap is taxed at the normal 20 percent rate. Tax alert

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Junde Liu, JD, LL.M. (Taxation) candidate at UF Law. Originally published on Compute Law Blog. This article is general information and does not constitute legal advice. Reading it does not create an attorney client relationship. The reader should not act on the basis of any content here without first consulting a licensed attorney in the relevant state. Last reviewed for accuracy May 23, 2026.