How to Utilize Qualified Small Business Stock to Mitigate Capital Gains Tax

If you (or a friend) own a business and plan to sell it someday, Qualified Small Business Stock (QSBS) can be one of the most powerful tools to reduce—or even eliminate—capital gains tax on the sale. QSBS is relatively straightforward to implement from a tax‑ and estate‑planning standpoint, and it’s become a go‑to strategy for founders looking to keep more of the wealth they’ve built. Let’s dive into how QSBS works, explore specific strategies, and walk through a case study to see it in action.

What Is QSBS?

Qualified Small Business Stock was created to incentivize investment in C corporations by individual (non‑corporate) shareholders. In plain English: the government says, “We’ll let you keep most—or all—of your gains when you sell your company, if you meet these rules.”

Key requirements:

C corporation only: The business must be organized as a U.S. C corp.
Five‑year hold: You must hold the stock more than five years.
$50 million asset cap: The company’s gross assets must be under $50 million both before and right after your stock issuance. In the case of startups who raise capital, this also means that if you’re raising substantial capital you may go over this limit.
Non‑corporate owner: Only individuals, partnerships, trusts and estates (not other corporations) can claim the exclusion.
Qualified trade or business: This is where it may get vague. The IRS explicitly excludes companies that perform services related to health, law, engineering, architecture, accounting, consulting, finance, banking, insurance, leasing, and more. Basically the IRS wants to know your company is generating jobs, and creating something net-new of value.

And yes—it must be actual stock. Stock options, warrants, phantom equity, etc., don’t qualify.

If all of that lines up, you can exclude the greater of:

$10 million of gain, or
10 × your stock’s cost basis. This second point is important as it means you could potentially exclude significantly more than the $10 million floor. If for example, your stocks cost basis was $200.00 per share and you owned 10,000 shares, you’re new exclusion amount could be up to $20 million. This strategy is of particular importance when converting from an LLC to C Corp as we’ll see later.

—and remember, this is per individual taxpayer, not per company. So you can multiply the benefit by gifting shares to family members or into separate non‑grantor trusts.

For example: A founder gifts some of his shares to a spouse and two children. That’s three taxpayers, each with their own $10 million exclusion—up to $30 million of additional tax‑free gain!

S Corporation Conversion

Since QSBS works only with C corporations, an S corp must convert before any qualifying stock is issued. To do this:

Revoke the S election: File the revocation with the IRS and you’re back to a C corp.
Asset transfer to new C corp: Move assets into a newly formed C corp in exchange for stock, then distribute that stock to shareholders.

The new holding period starts the day after your new C corp shares are issued—so you’ll need to hold those shares five years post‑conversion. If your acquisition occurs prior to the end of the 5 year holding period then there are other advanced methods to still qualify for QSBS such as rolling the stock into a new business and maintaining the holding period, or doing a stock for stock rollover with the acquiring company. For the sake of this article, we won’t get too far into these methods though.

LLC Conversion

Another common conversion situation occurs when the entity is initially formed as an LLC then later converted to a C Corp. While relatively straightforward to execute operationally, this provides benefits as it relates to excluding 10x your shares cost basis. Reason being, that when you convert your LLC to a C Corp, your shares in the C Corp are valued at what the LLC conversion amount is.

For example, let’s say you convert your LLC to a C Corp and at the time of conversion your C Corp is values at $10 million. You own 50% of the shares meaning your shares are worth $5 million. Under the 10x exclusion rule, you can now exclude up to $50 million assuming the new C Corp still meets all the QSBS rules previously discussed.

Watch Your State Taxes

Federally, you get that juicy exclusion—but some states don’t follow the federal QSBS rules. California, New Jersey, and Pennsylvania, for instance, still tax the full gain. You might:

Relocate to a QSBS‑friendly state before your exit, or
Set up non‑grantor trusts in states that honor QSBS and gift shares to them.

Stacking QSBS Exclusions Case Study

Meet Tom. He owns 70% of a manufacturing C corp that’s about to sell for $100 million. His basis was just $5 million, so without planning he faces tax on $65 million of gain. Rough.

Instead, Tom:

Gifts QSBS shares—$10 million’s worth—to each:

Himself (still holds his portion)
His spouse
Each of his two adult children

Optionally funds an irrevocable non‑grantor trust (with beneficiary controls) to protect his kids’ inheritance.

Each recipient has a separate $10 million exclusion, so the family can shelter up to $40 million of that gain. Tom’s remaining taxable gain falls to $25 million instead of $65 million.

If you’re looking to learn more about how QSBS could apply to your situation or someone you know, feel free to reach out and we can help guide you based on your unique circumstances.

Case studies are for illustrative purposes only. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.