QSBS: The $10 Million Decision Most People Make By Accident

The benefit nobody plans for

There is a provision in the U.S. tax code that allows certain shareholders to exclude up to $10 million in capital gains from federal income tax. For shares acquired after July 4, 2025, that cap rises to $15 million.

The provision is Section 1202, governing Qualified Small Business Stock. At a combined federal and state rate that can exceed 37%, this exclusion is worth $3.7 million or more in avoided taxes on a qualifying $10 million gain.

Most people who hold QSBS-eligible stock do not know they hold it. Most people who know they hold it do not fully understand the requirements to preserve it. And most people who understand the requirements make decisions - often small, seemingly administrative decisions - that inadvertently disqualify their shares.

This is not a minor oversight. It is one of the largest single financial decisions a founder or early employee will ever make, and it is usually made by accident.

What QSBS actually requires

Section 1202 is not automatic. It requires that several conditions be met simultaneously, and that they remain met for the duration of your holding period.

The company must be a domestic C corporation at the time of issuance and for substantially all of the time you hold the shares. The company's gross assets must not have exceeded $50 million at the time your shares were issued (now $75 million for shares issued after July 4, 2025). The company must be engaged in a qualified active business - which excludes certain industries like financial services, hospitality, and professional services. And you must have acquired the shares at original issuance, meaning directly from the company in exchange for cash, property, or services.

The holding period requirement is where most people focus: you must hold the shares for more than five years to qualify for the full exclusion. For shares issued after July 4, 2025, a tiered system applies - 50% exclusion after three years, 75% after four years, 100% after five years.

But here is what most people miss: the holding period is only the final requirement. All the other conditions must be satisfied first, and they must remain satisfied throughout substantially all of your holding period. If the company briefly converted to an S corporation, if it exceeded the asset threshold at issuance, if your shares were transferred through a structure that broke the original issuance chain - you may have lost QSBS eligibility without ever knowing it.

The ways eligibility is lost

The most common ways QSBS eligibility is destroyed are subtle and often irreversible.

Transfers that break the chain. QSBS status generally cannot survive a sale. If you sell your shares to another party, they do not inherit your QSBS eligibility - and you have now disposed of the shares without the benefit of the exclusion if you have not yet met the holding period. There are narrow exceptions: gifts, inheritance, certain divorce transfers, and distributions from partnerships to partners can preserve eligibility. But selling shares in a secondary transaction, even to another individual, typically ends the QSBS benefit permanently.

Entity structure changes. If the company converts from a C corporation to an S corporation, or merges into an entity that does not qualify, your shares may lose eligibility. Some mergers preserve QSBS status through specific provisions, but many do not. The rules are technical, and companies do not always consider QSBS implications when making structural decisions.

Redemptions and buybacks. Section 1202 includes anti-abuse provisions that can disqualify shares if the company has made significant stock redemptions within certain windows around the time your shares were issued. This is designed to prevent gaming the system, but it can inadvertently affect shareholders who had nothing to do with the redemption decisions.

Business activity drift. The company must be engaged in a qualified trade or business for substantially all of your holding period. If the company pivots into an excluded category - financial services, certain professional services, hospitality - your shares may lose eligibility even if they qualified at issuance.

Exceeding the asset threshold. The gross asset test applies at the moment of issuance, but different issuances have different measurement dates. If you received shares through multiple grants, some may qualify while others do not. If the company raised a large round that pushed assets above $50 million (now $75 million), shares issued after that point may not qualify.

The holding period trap

The five-year holding period creates a specific vulnerability for anyone considering liquidity before the clock runs out.

If you sell shares before satisfying the holding period, you realize the gain without the exclusion. The entire benefit is lost. There is a partial remedy - Section 1045 allows you to roll the proceeds into other QSBS within 60 days - but this requires finding another qualifying investment and creates additional complexity.

For many shareholders, the practical problem is this: they need liquidity before five years have elapsed. Perhaps they are exercising options and owe substantial taxes. Perhaps they want to diversify. Perhaps life circumstances require capital. The traditional options - selling shares in a secondary transaction or through a company tender - trigger the very realization event that destroys the benefit.

This is where the decision becomes consequential. Selling $1 million of shares three years into the holding period does not just cost you today's taxes. It costs you the future exclusion on those shares, which at full QSBS eligibility would have been worth $370,000 or more in avoided federal taxes alone.

What this means in practice

Consider a senior engineer who joined a company at Series A. She exercised her options early, paid the exercise price and the associated taxes, and has held common shares for four years. Her position is now worth $8 million. The company has told her an IPO is likely in 18-24 months.

She is 12 months away from satisfying the five-year holding requirement. Her shares, if held to that point, would qualify for the full QSBS exclusion. On an $8 million gain, that exclusion is worth approximately $2.96 million in avoided federal taxes - and potentially more depending on her state.

But she needs capital now. Her family is relocating, and she needs $500,000 for a home purchase.

If she sells $625,000 worth of shares (to net $500,000 after the secondary discount), she triggers a taxable event. She owes approximately $230,000 in combined federal and state taxes on the sale. And she has permanently forfeited the QSBS exclusion on those shares - an additional $230,000 she would have saved had she held them another 12 months.

Her total cost for accessing $500,000: roughly $460,000 in taxes paid or forfeited.

The alternative arithmetic

There is another way to think about this problem.

If she could access $500,000 without selling - without triggering a realization event - she would preserve the QSBS eligibility on all her shares. The holding period would continue to run. When the IPO occurs 18-24 months later, she would satisfy the five-year requirement and exclude the full gain.

A credit facility secured by her shares, structured properly, is not a sale. It does not trigger realization. It does not reset or interrupt the QSBS clock.

The cost of such a facility - at a 9-10% annual rate - would be approximately $112,500 over 2.5 years on a $500,000 advance. That is the cost of preserving a $230,000 tax benefit (on the shares she would have sold) plus maintaining the exclusion on the rest of her position.

Put differently: she pays $112,500 to avoid losing $230,000 and to preserve approximately $2.7 million in additional future tax savings.

This is not a close call mathematically. But it requires understanding that the decision is being made, and that the cost of "just selling a little" is far higher than it appears.

The decisions that are actually being made

Every time a shareholder with QSBS-eligible stock sells shares before satisfying the holding period, they are making an implicit decision: they are paying 37%+ in taxes on the sale, plus forfeiting the future exclusion, in exchange for immediate liquidity.

Sometimes this is the right decision. If the company is failing, or if the shareholder has no confidence in the future value, taking liquidity now - even at a tax cost - may be rational.

But often the decision is made without recognizing it as a decision at all. The shareholder needs cash, selling seems like the obvious path, and the QSBS implications are either not understood or not calculated.

The same is true for shareholders who transfer shares into structures that break the original issuance chain, or who do not track which of their multiple grants qualify and which do not, or who assume QSBS eligibility without verifying it.

These are not small oversights. On a $10 million position, the difference between preserving QSBS eligibility and losing it is $3.7 million in federal taxes - before considering state taxes. That is the kind of number that changes family balance sheets permanently.

What this framework suggests

We do not provide tax advice, and anyone holding potentially QSBS-eligible shares should work with a qualified tax advisor to verify their specific situation.

But there is a framework for thinking about these decisions that applies broadly:

First, verify eligibility. Do not assume your shares qualify. Understand when they were issued, what the company's asset base was at that time, whether the company has always been a C corporation, and whether the business activities have remained qualified. Many shareholders discover, too late, that their assumptions were wrong.

Second, calculate the true cost of selling. If you are considering selling shares before the holding period is satisfied, calculate not just the immediate tax but the forfeited exclusion. On a $1 million sale, the immediate tax might be $370,000 - but if those shares would have qualified for QSBS, the true cost is $370,000 paid now plus $370,000 in future savings forfeited.

Third, consider alternatives that do not trigger realization. Credit structures, when properly designed, do not constitute sales. They do not trigger gain recognition. They do not interrupt holding periods. If you need liquidity but want to preserve QSBS eligibility, this distinction matters.

Fourth, understand what happens at each decision point. Secondary sales, tender offers, company buybacks, mergers, conversions - each of these events has QSBS implications. Some preserve eligibility, some destroy it. Know which is which before you act.

The decision that is being made by default

Most shareholders with QSBS-eligible stock do not think about Section 1202 until they are about to sell. By then, it is often too late to do anything about the shares they have already disposed of, the holding period they did not complete, or the eligibility they did not verify.

This is a $10 million decision - potentially a $15 million decision under the new rules - and it is usually made by accident, by omission, or by default.

The shareholders who preserve this benefit are typically those who understood the stakes early enough to structure their decisions around it. They verified eligibility. They tracked their holding periods. They found ways to access liquidity without triggering realization. They treated QSBS preservation as a design constraint, not an afterthought.

The tax code does not reward good intentions. It rewards careful structure.

Bedrock Bridge Capital provides tax-efficient credit facilities for concentrated private positions. This material is for informational purposes only and does not constitute tax, legal, or investment advice. Consult your tax advisor regarding your specific situation.