QSBS Strategies for Multi-State Startups: Preserving Tax Benefits as You Scale

QSBS, or Qualified Small Business Stock, is one of the most valuable benefits startups can offer their shareholders. It represents up to $10 million in tax-free gains per investor. QSBS is important because it makes startups’ stock options more attractive to investors due to the potentially significant tax-free payout on the investment, which can be a huge advantage for securing capital during fundraising rounds.

However, QSBS isn’t just something that you declare and always qualify for. Startups have to maintain their status and meet certain operational requirements to ensure shareholders receive the tax benefits, which can be a challenge as startups scale. What’s more, not all states conform to QSBS rules, meaning any capital gains from federal tax may still be taxable at the state level.

The bottom line is that preserving QSBS status can represent a huge competitive advantage for your startup, but doing so requires proactive financial management and tax planning across various jurisdictions.

Why QSBS Qualification Should Be Part of Your Startup Strategy

The QSBS qualification helps provide founders and early employees with up to $10 million in federal tax exclusions, essentially making it a powerful tool for startups that influences fundraising, hiring and exit outcomes and can translate into direct tax savings against federal capital gains tax. QSBS eligibility creates a strong competitive advantage for your startup by making equity more valuable. It can attract investors and top talent, and even make your startup more attractive to a potential buyer if it’s in a position to sell or merge. The One Big Beautiful Bill Act, which was signed into law on July 4, 2025, only made QSBS benefits more impactful for eligible startups by expanding the scope of QSBS tax benefits.

Investors specifically seek QSBS-eligible companies for the tax benefits they can attain, making such status a significant competitive advantage. Conversely, a loss of QSBS status can reduce your startup’s valuation or complicate any future acquisitions, underscoring the importance of maintaining this status as your startup grows. It can also diminish the perceived value of equity compensation for employees who are counting on favorable tax treatment at exit.

The Core QSBS Requirements Every Startup Must Monitor

To maintain QSBS status, your startup must meet certain requirements. This includes:

• It must be a domestically-based C Corporation.
• Aggregate gross assets cannot exceed $50 million immediately before or after any stock issuances.
• At least 80 percent of all assets must be used in active conduct or qualified trade or business throughout the shareholder holding period.
• It must operate in a qualifying industry. For example, personal services, banking/finance, farming, mining and hospitality startups do not qualify for QSBS. Popular QSBS-qualifying startups include technology, biotech, manufacturing and retail trade.

The $50M Gross Assets Test: Timing Your Funding Rounds

The gross assets test is an important requirement for maintaining QSBS eligibility. It’s also one of the most common disqualification triggers, which underscores the importance of properly timing fundraising rounds to ensure QSBS preservation. More specifically, your startup’s total gross assets must not exceed $50 million for stock issued before July 4, 2025, or $75 million for stock issued on or after July 4, 2025 to maintain small business stock QSBS eligibility and preserve the capital gains exclusion.

Gross assets are measured immediately before and after each stock issuance and include cash, property and FMV of all assets. Large capital raises during fundraising rounds have the potential to increase your startup’s gross assets and may push the total beyond the QSBS threshold, disqualifying any new stock issuance from these benefits.

That’s why it’s important to issue stock when assets are lower and close funding immediately after to manage the test.

The 80% Active Business Requirement: Where Startups Go Wrong

Beyond meeting gross asset requirements, there are also operational compliance issues that could jeopardize QSBS status as startups accumulate capital. At least 80 percent of your startup’s assets must be used in the active conduct of a qualified trade or business to ensure QSBS eligibility. Some important considerations to take note of include:

• Any excess cash from fundraising that sits idle counts against the 80 percent threshold. Startups should create a deployment plan within the 2-year working capital safe harbor.
• Real estate ownership can create QSBS problems unless it is used directly in business operations.
• Portfolio investments and any passive holdings can also threaten qualification.

Multi-State Operations and the Active Business Test

While multi-state expansion can be a boon for your startup, it can have an impact on QSBS eligibility.

For instance, while operating in multiple states doesn’t serve as a disqualifier for QSBS, each state location must support qualified business activities. Many states don’t conform to QSBS rules, meaning benefits can still be earned at the federal level, but not at the state level including potential exposure to state income tax.

Proper documentation is necessary for all interstate activities to support qualification during audits and other periods and to substantiate significant tax benefits.

Multi-State Tax Treatment: Why Geography Matters for Your Shareholders

QSBS is a federal benefit that can have some state-specific benefits. However, state treatment varies based on whether specific states conform to QSBS rules, which can affect investor and employee value.

While most states conform to federal treatment, four states specifically reject QSBS: California, Pennsylvania, Mississippi and Alabama. This means that shareholders in these states will pay full state tax on any capital gains. Startups must know where shareholders are located and proactively disclose tax implications to investors and employees in non-conforming states.

California Startups and QSBS: What Your Investors Need to Know

Of the four states that reject QSBS, California is the most unique, especially when you consider its strong startup ecosystem. The state eliminated its QSBS benefit in 2013, meaning shareholders now pay up to 13.3 percent state tax on gains, despite the federal exclusion available under small business stock QSBS. It’s worth noting that the federal benefit still saves California investors anywhere from 20 to 24 percent in federal taxes (or about $2 million on a $10 million gain).

Even with all of this, California still remains a top venture market, signaling that disclosure tends to matter more than location.

Corporate Actions That Can Destroy QSBS Status

QSBS eligibility can also be undone via several actions. Here’s a look at what you’ll want to be sure to avoid so as not to disqualify any previously issued QSBS:

• You can’t redeem more than 5 percent of stock value within one year before or after the issuance to the same shareholder.
• Conversion from LLC or S-Corp to a C-Corp establishes a new start date for the 5-year holding period. In other words, any S Corp stock won’t qualify.
• The structure of acquisitions or reorganizations may preserve or destroy QSBS depending on the transaction design.

Documentation and Compliance Requirements

Proper documentation is also critical in proving and protecting QSBS status, especially during audits and exits. It’s best practice to maintain records that provide QSBS qualification at issuance and annual attestation letters for shareholders. Be sure to also document the 80 percent active business test quarterly with asset schedules and track gross assets before each stock issuance. Consider a cap table management that shows all original issuance dates and consideration paid.

QSBS in M&A: Preserving Benefits Through Acquisitions

If your startup merges or is acquired, it can still preserve QSBS eligibility. However, various factors affect this.

For instance, stock-for-stock reorganizations can preserve QSBS status in an acquiring company if the acquirer also qualifies. Any cash acquisitions also trigger the realization of QSBS gains for shareholders meeting the 5-year holding requirement satisfying the five year holding period required for exclusion under federal capital gains tax. Finally, acquirers often structure deals to preserve QSBS for target shareholders as a value-add in the process.

Common QSBS Mistakes Multi-State Startups Make

Some QSBS mistakes are unintentional, but can have severe consequences by disqualifying shares or reducing shareholder benefits. Some common mistakes that many startups make include:

• Raising too much capital without planning for the $50 million gross assets test or failing to strategically time stock issuances.
• Letting excess cash accumulate without deploying it within the 2-year working capital window.
• Purchasing real estate (rather than leasing property) without analyzing the QSBS impact or making significant redemption without considering the 5 percent limit.

How Your Fractional CFO Protects QSBS Status as You Scale

Managing QSBS eligibility can be complicated, and it can help to work with a tax professional or a Fractional CFO to ensure compliance. A Fractional CFO can help you avoid many of the common pitfalls that can disqualify your startup. This includes monitoring gross assets before each funding round, tracking for the 80 percent active business requirement, coordinating with legal counsel on corporate action and preparing documentation, and modeling multi-state implications for shareholders including the interaction with income tax, net investment income tax, and alternative minimum tax.

Preserve Your Shareholders’ QSBS Benefits From Day One

Don’t treat QSBS eligibility as an afterthought. Preservation is important for your startup, and there are a lot of factors that can complicate it. By working with one of Graphite Financial’s Fractional CFOs, you can give QSBS status the proper attention it needs to help maintain eligibility through growth stages. Contact Graphite today for more information and to get started.

FAQs

What is QSBS and why should my startup care about it?

QSBS stands for “Qualified Small Business Stock.” It’s a tax benefit that allows shareholders to exclude a certain amount of capital gains tax when they sell stock in a qualified company through a capital gains exclusion defined by the internal revenue code. Startups should care about QSBS because it makes their stock more attractive to investors, due to the potentially significant tax-free payout on the investment.

How do we know if our startup qualifies for QSBS?

Your startup must check various boxes to qualify for QSBS. For instance, it must be a C Corporation, have gross assets under $50 million at the time of stock issuance (or gross assets of $75 million for shares issued post-July 4, 2025) and ensure that at least 80 percent of assets are used for qualifying business purposes. Finally, stock must be acquired directly from the startup upon its original issuance and your startup must operate in an industry that qualifies.

What happens to QSBS status when we raise a large Series A?

Raising a large Series A can potentially jeopardize QSBS status for any shares issued both during and after the round. Any stock that already qualified as QSBS that was issued before Series A will retain its status. To qualify, your startup must have gross assets under $50 million at the time of stock issuance pre-July 4, 2025, or gross assets of $75 million for shares issued post-July 4, 2025.

Does operating in multiple states affect our QSBS qualification?

While operating in multiple states doesn’t disqualify your startup from QSBS eligibility by itself, it can complicate the overall process for state taxes. Your startup can still meet the federal requirements, but any state tax benefits for shareholders may vary depending on how states recognize QSBS. State conformity tends to differ, requiring shareholders to assess the tax laws in their respective state of residence to determine eligibility.

How do we maintain QSBS compliance as we scale?

Managing QSBS eligibility as your startup scales involves managing its gross asset limits and business activities. QSBS status is determined at the time of each share issuance, meaning a single mistake can significantly impact a round of equity without disqualifying any previously issued stock. This is where it can help to engage a tax professional or a Fractional CFO.

What should we tell California-based investors about QSBS benefits?

California-based investors can claim the federal QSBS tax exemption, but the state does not follow QSBS rules. This means that any capital gains that are excluded from federal tax are still taxable at the state level, meaning more strategic planning may be necessary to take full advantage of all tax benefits.