The Meandering History of QSBS

Written By Zach Bennedsen

Have you ever looked at a specific tax provision and thought “how the hell is that the rule?” I know I have, frequently. The internal revenue code can be dense, difficult, and dry as a bone sitting in the desert sun. But the logic, history, and politics that lead to today’s tax system can be fascinating. Behind every line of the tax code is a revenue bill, a backroom negotiation, a special carve-out, or perhaps just an accident of fate. Sometimes a provision is introduced with specific intention, only to meander away from that goal with each subsequent overwrite of the tax law. Still other times a provision is purposely kneecapped or bolstered due to the political climate at the time. In almost all cases, there are unintended consequences to important provisions that only become clear over time.

In a new series I’ll dive into the history of some of the most relevant tax rules for the startup ecosystem and dissect how we got here. In the first post of this series, I’ll focus on Qualified Small Business Stock, or QSBS.

What is QSBS

Generally speaking, the QSBS tax provisions exist to incentivize innovation and startup formation. They allow a taxpayer who owns stock in a qualified small business to exclude the greater of the first $10,000,000 of gains, or 10X basis from their federally taxable income. This incentive makes it more lucrative to invest in or to actively work at a startup and helps to counterbalance the high risk of failure that startups face.

The core concept is straightforward, but there’s plenty of nuance to the law. For example, what counts as a “qualified small business”? A startup running from the garage? A lemonade stand? A venture fund? To learn more, let’s dive into the history of QSBS law.

Initial History

QSBS was originally introduced as part of the Revenue Reconciliation Act of 1993. This was the first tax bill passed by Bill Clinton’s administration after taking over from Reagan. As an omnibus revenue bill, there was obviously more addressed than just QSBS. However, the provisions were deemed important enough to get speech-time in Clinton’s remarks about the bill:

“Others talked about the importance of small business as a job generator. This plan passed a pro-jobs capital gains tax that reduces tax rates by 50 percent for people who invest their money in new and small businesses and hold those investments for 5 years or more, the most dramatic incentive we have ever had to encourage people to take money out of their savings and take a chance on the free enterprise sector in America in the places where the jobs are being created, in the small business sector.”

It’s clear from Clinton’s remarks that the original purpose of the law was to incentivize participation and investment in startups and small business. After the recession of 1990-91, there was political will to boost the economy via tax breaks. It’s also possible that the provisions were put in place to rebut claims from Republicans that the revenue bill would raise taxes on job-creating small businesses.

So, was QSBS successful in creating more small business opportunities, especially in the tech world?

Looking at the aggregate amount of investment from VC funds in the 1990s, it seems that Silicon Valley was already ramping up their activity before the QSBS provisions were introduced. That said, investment doubled in the three years from 1993 to 1996. It’s difficult to extricate the effect of QSBS from other macro factors, but it’s hard not to think the QSBS incentives played a part in the growth of VC activity in the 90s and beyond.

QSBS 1.0

The first iteration of the QSBS laws set the baseline for how the provisions still work today. Most importantly, the definitions of a “qualified small business” were established, signaling what type of companies and investments could take advantage of the statutes. If you want to drink from the firehose, you can check out Section 14133 of the 1993 Revenue Reconciliation Act. For a spark notes version, see here:

  • Must be a domestic C-Corp (no S-Corps or other pass-through entities)

  • Aggregate capitalization (cash, property, short-term debt) of less than $50MM

  • Actively in business

  • Can’t be a regulated investment company (VC funds don’t qualify, just the things they typically invest in), or a real estate investment trust, or a cooperative.

  • Can’t be a subsidiary of a company that doesn’t meet the other requirements

  • Stock must be held (not just granted) for at least five years

This definition is still used today. However, there have been many key changes to the actual tax rates and exclusion percentages that have changed the nature of the statute over time.

QSBS Changes Over Time


The incentive provided by the QSBS tax provisions has not been static in its magnitude. Changes to both the QSBS provisions themselves and to the rest of the capital gains tax system have periodically increased or decreased the effectiveness of QSBS since the law’s inception in 1993. For example, in 1998 the top capital gains tax rate dropped from 28% to 20%, but the QSBS tax rate stayed at 28%. This reduced the QSBS incentive, as a gain classified as QSBS was taxed at a rate 8% higher than a normal capital gain. For a more drastic change, look to 2009 and 2010, when the QSBS exclusion rose from 50% to 75%, then again to 100%. This greatly increased the incentive for your stock to qualify as QSBS. Further complicating the QSBS incentive is its treatment under the Alternative Minimum Tax (AMT) system. While the history of AMT is a subject for another day, the important fact here is that under the original law and up until 2010, 50% of the QSBS exclusion amount  was subject to AMT. This means that you might have a large reduction in your regular tax bill due to QSBS exclusions, but could still owe AMT.

In table form, here’s a summary of the major updates that have influenced the QSBS incentive since 1993:

And a timeline of how much a taxpayer would save on $10MM of QSBS-eligible stock:

It’s important to note that changes to the QSBS incentives are not always intentional, and are often indirect in nature. A change in a different part of the tax code can change the relative benefit of the provision in question. For instance, the 2003 Jobs and Growth Tax Relief Reconciliation Act reduced the top capital gains tax rate to 15%, but the QSBS rate stayed at 28%. A taxpayer would now only save 1% on a QSBS-eligible gain vs. a regular capital gain. The capital gains rate drop was newsworthy as it affected a large swathe of taxpayers. The fact that QSBS tax rates weren’t updated to align with the regular capital gains system was less newsworthy, but effectively killed the benefits of the provision. Later changes were made directly to the QSBS provision to bring back the benefits, and the current structure provides the greatest incentive to date.

QSBS Today

Today’s QSBS incentive is stronger than it’s ever been before. The 100% exclusion and 23.8% max capital gains rates mean there’s a huge benefit to selling QSBS-eligible stock. However, there are still some roadblocks and ambiguous provisions that make planning for a potential QSBS-eligible sale difficult.

One of the primary barriers to determining QSBS eligibility is that some companies are refusing to vouch for the status of the stock their employees hold. This is doubly true for ex-employees. The onus to determine QSBS eligibility falls to the shareholder and their tax preparer, who may not have access to all the information necessary to make that determination. It’s generally easier for founders or C-Suite employees to access the necessary information, but for others it’s sometimes a matter of luck. Some advisors and tax preparers have their own QSBS checklists that they send to a company to make the attestations less cumbersome, but you’re still at the mercy of the company choosing to cooperate. Carta has launched their own QSBS attestation tool for companies, but its adoption is scattered.


Another confounding factor is that QSBS is a federal provision, and not every state conforms to the Federal definition of QSBS, with California being an important holdout. This means that you could still owe up to 13.3% to California on your QSBS-eligible stock sale. QSBS expert has a great overview of how each state treats QSBS.


Perhaps the biggest open question regarding QSBS right now is what exactly the provision means by “taxpayer.” Recall that the provision states that each taxpayer has a $10MM (or 10X basis) exclusion. Some are interpreting this to mean that a couple filing a joint return can double the exclusion to $20MM by transferring $10MM into the spouse’s name. Others are going further and claiming that, since an irrevocable trust has its own taxpayer ID, it too gets a $10MM exclusion. This would allow someone to supercharge their QSBS exemption by opening multiple irrevocable trusts, for each of their kids, for instance. The IRS has yet to weigh in definitively on this practice, and any changes to this interpretation could have a huge effect on the QSBS

What’s Next for QSBS

As we can see by tracing the history of QSBS, its incentive structure is anything but evergreen. Changes to capital gains rates, QSBS exclusion percentages, or the interpretation of the taxpayer provision could all change the QSBS landscape in the future. The cultural discourse surrounding silicon valley and the startup ecosystem could also change the political incentive to bolster or weaken QSBS. It’s also uncertain whether a change to the QSBS provisions would apply retroactively or only to newly-issued stock. In any case, future changes will certainly have unforeseen consequences, and will likely influence how savvy investors navigate the QSBS landscape.

Zach Bennedsen
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