By Ethan D. Berkebile, CFA, CAIA and Nick G. Demetrios, CPA, MBA
Small businesses have long been a driver of innovation, job creation, and economic growth in the United States. As a result, policymakers on both sides of the aisle have consistently supported initiatives that encourage entrepreneurship and small business investment. Whether through Small Business Administration lending programs, research grants, or targeted tax incentives, support for small businesses remains one of the few issues that enjoys broad bipartisan backing in Washington, D.C.
One of the most valuable, yet often overlooked, tax incentives available to investors is Qualified Small Business Stock (“QSBS”). Under Section 1202 of the Internal Revenue Code, when an eligible investor realizes a capital gain from a QSBS, the investor may exclude some or all of it from federal taxation.¹ While the rules can be complex, the benefit is simple: Investors may be able to keep more of their investment gains.
Updated QSBS Rules
Changes to the QSBS rules that became effective on July 4, 2025, with the passage of the One Big Beautiful Bill Act made the program even more attractive, for business owners as well as investors. To qualify for the exclusion, investors must generally be non-corporate taxpayers, and the company must meet several requirements:
- Company Structure: Must be a domestic U.S. C corporation. S corporations and most LLCs do not qualify unless they convert to a C corporation, which involves adhering to complex restrictions.
- Active Business Requirement: At least 80 percent of corporate assets must be used in the active conduct of a qualified trade or business.
- Industry Exclusions: Certain service-oriented industries, including health care, law, accounting, consulting, financial services, athletics, and hospitality, do not qualify.
- Original Issuance: Stock must be acquired directly from the company, not purchased on the secondary market.
- Company Size: Initial company valuations must be of less than $75 million at issuance, an increase from the previous $50 million threshold.
- Holding Period: Investors may qualify for a 50 percent exclusion from federal taxation after three years, 75 percent after four years, and 100 percent after five years or more.
The first way QSBS arises for our clients is through business ownership. Some clients own successful private companies and want to determine whether their business may qualify for QSBS treatment before a future sale. Because qualification often depends on factors such as entity structure, industry, and holding period, advanced planning is critical. If this situation applies to you, your HBKS advisor and HBK tax professional can help evaluate the requirements and analyze your options.
A second, more commonly employed opportunity to take advantage of the QSBS tax exclusion comes through private equity investing. Our private equity program is designed to maximize exposure to businesses that may qualify for QSBS treatment through a combination of small buyout and early-stage venture capital investments. Because both strategies focus on smaller companies, most of the underlying portfolio companies fall within the size parameters established under the revised QSBS rules.² The table below highlights how key QSBS criteria commonly align with both small buyout and early-stage venture investments.
Small Buyout |
Early-Stage Venture Capital |
|
Domestic C-Corp |
Historically a majority – we see an increased adoption of C-Corp structure | Almost Always |
Direct Issuance |
Majority | Majority – SAFEs (Simple Agreement for Future Equity) can create complexity |
Hold Period |
Almost Always > 3 years and
Frequently > 5 years |
Almost Always > 5 Years |
Industry Focus |
Broadly Diversified – Historically
< 25% in excluded industries |
Predominantly Technology – limited exposure to excluded industries |
Potential Impact of QSBS on Investor Returns
Although QSBS eligibility cannot be guaranteed, we can illustrate the potential impact of the federal tax exclusion using a hypothetical private equity investment with the following characteristics:
- 10-year fund life
- Capital drawn evenly over the first five years to fund five investments
- Each investment is held for five years and generates the same return
- Sale proceeds distributed shortly after each investment is realized
- Net investment performance of 16% IRR and 2.10x MOIC (meaning that while dollars are invested, they compound annually at 16 percent and over the course of the investment every $1 million invested grows to $2.1 million before taxes)³
Under this example, the investor earns $1.1 million of capital gains. Without QSBS treatment, those gains are fully subject to a maximum 23.8 percent federal tax rate.4 Investors should be mindful that state rates and Section 1202 decoupling will vary. As QSBS eligibility increases, investors retain a larger share of their returns. The following illustrates the potential after-tax return advantages:
QSBS Eligibility5 |
After-Tax IRR |
After-Tax MOIC |
| 40% of Companies | 12.9% | 1.80x |
| 20% of Companies | 11.5% | 1.70x |
| 0% Of Companies | 9.9% | 1.60x |
Assuming the maximum federal tax burden, a portfolio in which 10 percent of gains qualify for QSBS generates nearly $50,000 additional after-tax value for every $1 million invested compared to a portfolio where none of the gains qualify. Importantly, this benefit comes entirely from tax efficiency rather than additional investment risk. The underlying investments produce the same pre-tax return; investors simply keep more of what they earn.
When evaluating private equity opportunities, pre-tax performance tells only part of the story. After-tax results ultimately determine how much wealth is created. As tax policy continues to reward investment in smaller, growth-oriented businesses, QSBS has become an increasingly important consideration in portfolio construction. By emphasizing small buyout and early-stage venture investments, our private equity program seeks to maximize exposure to this potentially valuable tax benefit. Investors interested in learning more should speak with their HBKS advisor.
IMPORTANT DISCLOSURES:
The information and examples included in this document are for general, educational, and informational purposes only. It does not contain any financial or investment advice and does not address any individual facts and circumstances. As such, it cannot be relied on as providing any financial or investment advice. If you would like financial or investment advice regarding your specific facts and circumstances, please contact a qualified financial advisor.
Any investment involves some degree of risk, and different types of investments involve varying degrees of risk, including loss of principal. It should not be assumed that future performance of any specific investment, strategy, or allocation (including those recommended by HBKS Wealth Advisors) will be profitable or equal the corresponding indicated or intended results or performance level(s). Past performance of any security, indices, strategy, or allocation may not be indicative of future results.
The historical and current information as to rules, laws, guidelines, or benefits contained in this document is a summary of information obtained from or prepared by other sources. It has not been independently verified but was obtained from sources believed to be reliable. HBKS Wealth Advisors does not guarantee the accuracy of this information and does not assume liability for any errors in information obtained from or prepared by these other sources.
HBKS Wealth Advisors is not a legal or accounting firm, and does not render legal, accounting or tax advice. You should contact an attorney or CPA if you wish to receive legal, accounting or tax advice.
Investment Advisory Services offered through HBK Sorce Advisory LLC, d.b.a. HBKS Wealth Advisors. Not FDIC Insured – Not Bank Guaranteed – May Lose Value, Including Loss of Principal – Not Insured By Any State or Federal Agency.
¹ The amount excluded from federal taxation is the greater of 10 times the taxpayer’s basis in the QSBS sold during the year or the applicable dollar limit: $10 million for stock acquired on or before July 4, 2025, and $15 million for stock acquired after July 4, 2025, with the $15 million amount indexed for tax years beginning after 2026.
² Within small buyouts we expect more than two-thirds of portfolio companies to be less than $75M of enterprise value at entry. In venture capital, we focus on pre-seed and seed rounds with tertiary exposure to series A, and limited exposure to later rounds. Data from Pitchbook suggests that from 2022 – 2025, 75% of seed and Series A rounds had a post-money valuation of less than $20 million and $81 million, respectively.
³ Internal Rate of Return (“IRR”) is the discount rate that makes the fund’s net present value (NPV) of all cash flows equal to zero. It is calculated with aggregate cash flows and is a compound annualized return. Multiple on Invested Capital (“MOIC”) is calculated as the fund’s net of fee aggregate ending balances plus aggregate distributions divided by aggregate capital calls.
4 The maximum federal tax rate is the sum of the highest long-term capital gains rate (20%) and the Net Investment Income Tax (3.8%)
5 In this example, we assume the QSBS eligible companies are the first ones sold first.
