How to Preserve QSBS Status Through Series A to Exit

QSBS stands for “Qualified Small Business Stock,” an IRS tax provision under Section 1020 that allows investors to exclude a significant portion of capital gains from the sale of eligible stock. QSBS status can be a huge advantage for founders, investors and your startup’s employees — and this status can also help each stakeholder save significant federal capital gains while building a successful business.

However, certain requirements need to be met to preserve QSBS status from Series A fundraising through exit. For instance, federal tax exclusion is capped at $15 million for stock acquired after July 4, 2025, or 10 times the adjusted basis of the stock. There’s a serious risk of losing this if your startup is experiencing exponential growth.

In this post, we’ll discuss QSBS and how it can represent a competitive advantage for founders, investors and employees. We’ll also discuss what you need to do to ensure that you preserve it and maintain eligibility during crucial funding rounds and other events. Read on to learn more:

Understanding QSBS Vulnerabilities During Growth Stages

QSBS can represent a significant advantage for your startup. However, during growth stages, it may be subject to various vulnerabilities that could jeopardize its status. From exceeding the gross asset limit to entry into ineligible industries, even just a seemingly harmless misstep can disqualify your startup for QSBS and revoke the potential for up to $15 million in federal capital gains exclusion under the Internal Revenue Code.

The three primary categories of QSBS risk are:

• Asset threshold: For any stock that’s issued on or after July 5, 2025, your startup must have less than $75 million in aggregate gross assets immediately after the stock is issued. If any subsequent funding rounds raise the value past the $75 million threshold, it won’t disqualify any existing QSBS shares, but any new stock issued thereafter will not be eligible.
• Redemption violations: If your startup redeems too much stock within a specific timeframe, it can invalidate QSBS status. A significant redemption is one where a startup repurchases more than 5 percent of its stock’s total value over a 12-month period.
• Business activity changes: If your startup uses less than 80 percent of its assets to conduct business, it could fail the active business test. Accumulating significant cash reserves from fundraising or profits and holding them passively as investments can also cause your startup to fail this test.

The best way to manage QSBS risk is to create a risk assessment framework that helps monitor gross asset values, maintains robust records, and can help inform and educate stakeholders.

The $75 Million Asset Threshold Challenge

Series A funding and subsequent fundraising rounds can significantly impact gross asset limitation by increasing cash and assets. This can cause stocks to no longer qualify as QSBS. Remember, your startup’s gross assets are the sum of its cash and the adjusted tax basis of its other property, measured at fair market value.

Capital that’s raised during Series A funding and later rounds has the potential to put gross assets over the $75 million threshold. This makes timing very important, as the QSBS asset test is always applied before the issuance of stock and after the issuance of stock. Here are some tips to plan timing accordingly:

• Track gross assets continuously: Ensure records of your startup’s financial position are always up-to-date.
• Plan funding rounds strategically: Time compensation grants to occur prior to large financing rounds that could push assets past $75 million.
• Grant stock options early: Granting stock options to employees and key stakeholders early in your startup’s tenure almost certainly ensures that they are QSBS-eligible.
• Prepare strategically for conversions: If your startup is an LLC or S-Corp, it must be converted to a C-Corp before issuing QSBS stock. Conversions must occur when its assets are still under the $75 million threshold. Note that only growth in your startup’s value following conversion qualifies for the tax exemption.

Critical Redemption Rules and Cap Table Management

The redemption restrictions that can disqualify you from QSBS retroactively are complex, yet crucial to be aware of.

The most important is the two-year window restriction. Per this rule, any stock issued is disqualified as QSBS if the startup purchases more than 5 percent of its stock by value during the two-year window that begins one year before the issuance and one year after. This 5 percent threshold is calculated based on the aggregate value of your startup’s stock at the beginning of the two-year period. What’s more, this rule has a broad impact. It can retroactively disqualify all shareholder stock, not just those involved in the redemption.

Alternative approaches to achieve liquidity without triggering a QSBS disqualification include secondary sales to third parties, tender offers from third parties or borrowing against QSBS shares. Strategically gifting shares is another option.

Maintaining Qualified Business Activities

Remember, if your startup uses less than 80 percent of its assets to conduct business, it could fail the active business test and lose QSBS status. So, how can you ensure ongoing compliance with the 80 percent active business requirement while still scaling your startup? Here’s a look:

• Cap your cash holdings: Per QSBS regulations, cash is treated as an active asset only to the extent it is needed for reasonable working capital. Any excess cash that exceeds these limitations could be considered passive and cause you to fail the test.
• Limit passive investments: Track all your investments that are not actively used in your business. Any startup corporation will immediately lose eligibility status if more than 10 percent of its total assets consist of non-subsidiary stock or passive real estate.
• Keep a close watch on your financials: You should be routinely reviewing your startup’s balance sheet to calculate the ratio of active business assets relative to total assets. You should also be documenting everything to ensure you can prove you’re meeting the 80 percent test. Keep thorough records of your accounting data, new asset acquisitions and financial statements.

Strategic Planning for Series A and Beyond

Keeping QSBS status can be challenging as your startup hits funding milestones. One of the best things your startup can do to stay on track is create a comprehensive QSBS preservation roadmap that aligns with your fundraising timeline and can help balance growth objectives with QSBS compliance requirements.

Pre-Series A QSBS Optimization

Some tactical measures you can implement before Series A funding to help maximize QSBS benefits include:

• Files Section 83(b) early: A Section 83(b) election allows you to recognize compensation income based on the stock’s value at the time of the grant (rather than at each vesting event).
• Make sure to structure equity grants and option pools strategically before crossing certain asset thresholds. This helps minimize dilution for founders, attract top talent and ensure a smoother fundraising process while maximizing potential federal tax savings.
• Consider trust structures and gift strategies to multiply the benefit and shelter any significant gains from capital gain taxes. This strategy is known as “stacking.”

Documentation and Compliance Infrastructure

Documentation is crucial for proving QSBS compliance, and it’s best practice to establish a comprehensive record-keeping process for stock issuance, asset valuations and other activities. We also suggest implementing QSBS questionnaires and annual certification processes with investors and establishing a culture of board-level oversight for QSBS preservation decisions.

Navigating Corporate Events While Preserving QSBS

Managing Recapitalizations and New Share Classes

Complex equity restructurings can test QSBS status. QSBS regulations tend to permit tax-free internal restructurings, but impermissible stock-for-stock exchanges can violate the original issuance rule. Preferred stock terms can also influence eligibility, the amount of excluded gain and the allocation of proceeds. Understanding how these transactions are classified for federal income tax treatment is critical to preserving QSBS eligibility and avoiding unintended disqualification.

IRS code also provides safe harbor rules to preserve QSBS, such as tax-free recapitalization, stock splits and stock dividends. Investor provisions in NVCA documents also often support QSBS preservation. NVCA documents often include protective provisions of the restriction on stock repurchases, maintenance of C-corp status and more.

Exit Planning with QSBS Optimization

Exit planning should be structured to maximize QSBS tax benefits for all stakeholders involved. Some M&A structures that preserve such benefits include tax-free reorganizations, Section 351 changes and Section 1045 rollovers. Conversely, asset acquisitions and taxable stock acquisitions terminate QSBS eligibility. These distinctions are especially important for federal income tax purposes, as the structure of an exit can determine whether the QSBS exclusion remains available to shareholders.

Another consideration is state-level QSBS considerations for non-comforming states. This is notable because Section 1020 does not apply at the state level. States that do not conform tax capital gains upon sale.

Working with Professional Advisors

Navigating QSBS eligibility can be confusing and complex — and startup founders may need more help to ensure QSBS status remains the competitive advantage that it can be. That’s why it can be beneficial to work with an expert to ensure compliance. Tax advisors, Fractional CFOs and legal counsel can all play an important role in ensuring stock qualifies for QSBS by ensuring proper record keeping and high-level navigation of the complex tax laws to maximize capital gains and reduce risk.

Tax experts, Fractional CFOs and legal professionals often need to collaborate to ensure compliance and establish regular QSBS review cycles that are aligned with fundraising and corporate events.

Securing Your QSBS Benefits Through Strategic Financial Leadership

Managing QSBS eligibility is all about being proactive and vigilant from incorporation through exit. As an expert financial partner that specializes in working with startups, we have deep QSBS expertise and can help your founders, investors and employees get the most out of this eligibility. Contact us today for more information and to schedule a consultation.

FAQs

How does Series A funding typically impact QSBS eligibility for existing shareholders?

Series A funding does not jeopardize the QSBS eligibility of existing stakeholders’ stock so long as the startup meets QSBS requirements both before and after the funding round. The QSBS status of existing stock is determined at the time of its original issuance, yet any influx of capital from fundraising rounds can have tax implications, including potential impacts on the alternative minimum tax. To maximize QSBS status when Series A is approaching, stakeholders should verify the startup’s QSBS status, time any option exercises carefully and understand potential redemption to ensure eligibility of other holdings isn’t jeopardized.

What redemption activities are safe during the two-year window around stock issuance?

Redemption activities have to meet certain exemptions or else shareholders risk facing significant tax implications. Redemption exemptions include de minimis amounts, if there’s an incident related to an employee’s termination, if there are secondary sales instead of redemption or if there are redemptions due to other special circumstances (i.e., shareholder death, divorce, or other significant life event).

Can we still qualify for QSBS if we converted from an LLC to C-Corp?

Yes, but only for the stock issued after the conversion. This makes conversion timing crucial. Any stock issued in the conversion can be eligible for the QSBS exclusion, but all other QSBS requirements must be met. Given the complexity of this, it can be beneficial to work with a professional financial expert or a tax advisor.

How do stock option exercises after crossing the $75M threshold affect QSBS status?

Exercising stock options after a startup crosses the $75 million asset threshold will prevent shares from qualifying as QSBS.

What documentation should we maintain to prove QSBS eligibility at exit?

Proving QSBS eligibility at exit requires extensive documentation to satisfy the main IRS requirements. The IRS requires documentation to meet five main requirements: that the stock was an original issuance, the issuer was a C-Corp with limited assets, the issuer operated a qualified active business and the required holding period was met. A QSBS attestation letter is also helpful, though not always required. Simply put, it’s important to be able to carry the burden of proof to show that you meet the IRS’ requirements.

How do participating preferred shares and complex liquidation preferences impact QSBS qualification?

Participating preferred shares and complex liquidation preferences don’t automatically disqualify stock for QSBS. However, they can create complications and various risks that need to be addressed. Preferred stock tends to be eligible, but new classifications of stock can invite IRS scrutiny. The best way to manage this is to work with a financial expert or tax advisor who can help you evaluate redemption features and keep detailed records to verify eligibility throughout the process.