Qualified Small Business Stock (QSBS) Exclusion

The One Big Beautiful Bill Act (OBBBA) made significant improvements in the taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. code’s treatment of capital investment. The law made expensing of short-lived assets and domestic research and development permanent, eliminating the tax penalty for capital investment while promoting economic growth.

Despite this, OBBBA also maintains and expands parts of the US tax code that add complexity and distort economic activity. Among them is Section 1202 of the Internal Revenue Code, which allows taxpayers to exclude up to 100 percent of their capital gains from the sale of qualified small business stock (QSBS) from taxation.

The provision was initially introduced in 1993 to incentivize investment in small, early-stage companies. Since then, it has undergone several changes, including recent updates as part of OBBBA. The exclusion amount is limited to $10 million or 10 times the basis, whichever is greater. OBBBA increased the exclusion limit to $15 million or 10 times the basis, whichever is greater, for stock issued on or after July 4, 2025. The law also adjusts the limit for inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spendin after 2026.

To qualify for the exclusion, the taxpayer must meet the following criteria:

The company must be a domestic C-corporation
The company’s gross assets must not have exceeded $50 million at any point before and right after the issuance of shares. (OBBBA increased the gross asset limit to $75 million for shares issued on or after July 4, 2025. The law also adjusts the limit for inflation for tax years after 2026)
The company must be an active business, meaning that it must use at least 80 percent of its assets in the active conduct of a qualified trade or business
The stock must be purchased directly from the company
The stock must have been held for 5 years prior to the sale to qualify for the exclusion. For stock acquired on or after July 4, 2025, OBBBA introduced a phase-in for the exclusion:

3-year hold: 50 percent exclusion
4-year hold: 75 percent exclusion
5-year hold: 100 percent exclusion

The company must not be an excluded business as determined by §1202(e)(3)

According to the US Department of Treasury, the QSBS exclusion was projected to cost taxpayers $44.5 billion over the 2025-2034 period under prior law. The expansion of the QSBS exclusion under OBBBA is estimated by the Joint Committee on Taxation to cost an additional $17.2 billion over the same period, with the majority of cost occurring after 2030 due to the holding period requirements.

Section 1202 clearly undermines at least two of the principles of sound tax policy: neutrality and simplicity.

QSBS Betrays Neutrality

A neutral tax system should neither encourage nor discourage economic decisions. Many of the eligibility criteria for the QSBS exclusion directly influence investor and company behavior in ways that may not reflect the optimal investment decisions.

First, the requirement for a business to be a domestic C-corporation creates disadvantages for other business forms, such as LLCs and S-corps, which are the most common form for new businesses. By allowing exclusion only for the sale of C-corps, Section 1202 pushes some firms to choose an organizational structure that is more expensive to maintain and may not be the most optimal for a given business.

Next, the gross asset test, expanded under OBBBA, may affect the decisions by companies to expand. Certain businesses can delay expansion plans to allow investors to acquire stock that would be eligible for the QSBS exclusion. This is distortionary, as investment decisions are made to maximize tax benefits and not to achieve the best possible return on investment.

In addition, the requirement to hold the stock for a certain period to qualify for the QSBS distorts capital allocation decisions as investors may be incentivized to hold the stock for longer than is economically justified. This, in turn, may prevent capital from being deployed in the most promising ventures and weakens the dynamism of the economy as capital may be tied up in less productive ventures.

Furthermore, Section 1202 explicitly excludes many types of businesses, further eroding the neutrality of the tax code. This makes it so that certain businesses are favored in comparison to others, meaning that tax policy rather than market fundamentals shape investment flows.

QSBS Is Highly Complex

In addition to not adhering to the principles of neutrality, Section 1202 is also highly complex. A single failure to meet any of the requirements immediately disqualifies the stock from the exclusion. This forces businesses and investors to allocate attention and resources towards compliance instead of maximizing the return on investment. Not only that, the rules on what constitutes an excluded business aren’t clear cut, creating uncertainty for many businesses that may fall in either bucket depending on interpretation.

Due to complex rules, numerous tax practitioners are devoted solely to making sure that the businesses are compliant with QSBS rules as well as trying to further increase the exclusion amount by using trusts, gifting, partnerships, and other complex planning strategies. This rewards investors with access to sophisticated legal resources rather than those who allocate capital most efficiently.

Expensing Is a Better Policy Choice

While originally enacted to incentivize investment, Section 1202 doesn’t do so effectively. It distorts business structure decisions, influences the timing of firm expansion, and favors certain industries over others. It is also too complex, which rewards investors with access to sophisticated planning rather than efficient capital allocators.

Policymakers should consider scaling back or even repealing the QSBS exclusion, while using the savings to expand policies that adhere to sound tax policy principles. One such policy is further expansion of full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs., which directly reduces the cost of capital and is one of the most pro-growth policies available. A starting point would be making expensing for manufacturing structures permanent.