The 2025 QSBS overhaul: New rules, bigger opportunities

The 2025 QSBS overhaul: New rules, bigger opportunities

Nerre: Welcome back to Building More Than Business. I'm Nerre Shuriah, a certified business exit consultant and certified mergers and acquisitions advisor. I head up our wealth and business planning capabilities. I'm joined by my co-host Ann Lucchesi. She's a CFP and a CEP and a senior director here at First Citizens Wealth.

Today, we're diving into one of the most generous tax benefits available to business owners: the qualified small business stock exclusion, or QSBS, for short. And some recent changes in tax law have made it even more valuable.

Ann: Yeah, we talk with our clients about QSBS all the time, especially within the innovation economy, but it's a topic that is full of nuance, legal gray areas and definitely missed opportunities. So we're thrilled today to be joined by Christopher Karachale, a leader in QSBS and tax law, and he is with the firm of Hanson Bridgett. He is my go-to for my most difficult QSBS questions. Christopher, welcome. Will you introduce yourself to our listeners?

Christopher: Yeah, thanks, Ann. As Ann said, my name is Christopher Karachale. I'm a tax attorney in San Francisco, and since 2015 I've had the luxury of just working on QSBS. So I work with founders, early investors and early employees on proving out various QSBS issues. So we think about corporations at their formation, we think about mid-lifecycle, making sure the companies qualify, and then we work with lots of different taxpayers to prove that they get the QSBS benefits.

Nerre: It's so great to have you here, Christopher. Before we dive into what's changed, let's cover the basics for those who may be learning about this deduction for the first time. Ann, would you mind giving us a quick primer on what QSBS deduction is and why it matters?

Ann: Yeah, Nerre, I'd be happy to. So I thought maybe we'd start with just setting the stage for what QSBS has been in the past, and then we're going to lead into, kind of, talking about what's changed recently.

So QSBS has been around for a long time, going back to 1993. At the end of the financial crisis, there were several changes that were made, the most important one happening in September of 2010, whereby if your shares qualified and you sold them, you could exclude up to the first $10 million—or 10 times your cost basis—which meant instead of paying that 23.8% that you otherwise would pay on those shares, you got to keep it in your pocket. So for a founder, for instance, who had qualified shares that he was selling and had a $5 million gain, he would save a little over $1.1 million in his pocket.

Now, it's important to understand what it took to qualify for that. So the first is that it had to be acquired from a domestic C corporation. All the way up to the time of the acquisition and then immediately after, the gross assets of the company had to be less than $50 million. The shares had to come directly from the issuer, so you could not get them in a secondary transaction. The shareholder had to be like individual, trust, partnership, estate. The other big piece of it, of course, is that the company itself had to qualify as a small business. And then you had to have held the shares continuously for 5 years in order to claim this exclusion.

Nerre: This is truly a robust tax break. But I want to put it out there that there are many qualifiers. There are a lot of gray areas, and some of the formulas are not intuitive. I'd encourage our listeners to check out the additional resources we've included in the show notes. They offer a great primer on how this deduction works and who typically qualifies.

Ann: Well let's dive right in and discuss what's new because the QSBS deduction recently saw three major updates under the new 2025 One Big Beautiful Bill Act, including a tiered exclusion structure, changes to the cap on capital gains and an increased gross-asset threshold. Christopher, can you walk us through these changes, starting with the new tiered exclusion structure?

Christopher: Sure, yeah, I'm happy to, Ann. Right, and so you said this earlier, Ann, that in the past—in order to get the QSBS exclusion benefit under Section 1202, a taxpayer had to hold shares for 5 years. Provided you get the shares after July 4th, 2025, right—the enactment date of OBBBA—then there is a tiered structure. In other words, if you hold shares of QSBS just for 3 years and then sell, you can exclude 50% of the gain. If you hold shares for 4 years, you can exclude 75% of the gain. And then the same rule from before July 4th applies for shares held for 5 years.

Ann: You know, these changes, it always takes time to kind of see them play out in the real world and how that works. But certainly for people that are, you know, having shares acquired before they meet the 5 years, I think this gives them some leeway to having different choices than they had before.

Christopher: Absolutely.

Ann: Previously, the capital gain exclusion was capped for each taxpayer at the greater of $10 million or 10 times the aggregate adjusted cost basis in the shares. Can you walk us through what changed in this regard, Christopher?

Christopher: So in the past, as you said, Ann, taxpayers could exclude the greater of $10 million or 10 times their basis, right? The OBBBA changes this to say now taxpayers can exclude the greater of $15 million or 10 times your basis. So from an investor standpoint, if I invest $2 million into a qualified traded business, the rule says I can exclude the greater of $15 million—right, under the new rules—or 10 times $2 million. I can exclude $20 million. And so it's important to remember that you get the greater of $15 million or 10 times your basis.

Ann: Yeah, absolutely. I just spoke with a founder recently—and I won't say founder, he actually went and bought the company before it hit the $50 million in gross assets—and he had paid $16 million of his own money to buy it, but he's setting himself up to have $160 million eligible on the back end of this, which is something that's almost mind boggling that you can exclude that from taxes. So it's a big deal.

Now lastly, there is also the increased gross-asset threshold for the qualification. What does this mean for business owners who haven't previously qualified for the QSBS deduction?

Christopher: Yeah, this final increase, quite frankly, is what I think is the most valuable. Congress set an artificial ceiling to say, "Hey, look, once a company has gotten more than $50 million of cash into the company, whether through fundraising or investors, then you can no longer issue any more QSBS," right? Doesn't mean that the shares aren't still QSBS, it just means that once you have that much money on your books, you can't give any more QSBS. So what the OBBBA did is increase this level to $75 million with—actually, it's interesting—with an adjustment for each year for inflation. This is actually true of the $15 million. We didn't mention this in the last section, but for the $15 million it's true as well.

But for the $75 million, that means as long as I invest in the company, right—either I'm a founder so I definitely invested, I'm an early employee so I exercise my options, or I'm an investor, a venture capitalist or other person coming in—as long as I invest now, when the company has less than $75 million of cash in the bank, my shares are QSBS-eligible. With the inflation adjustment, I was just looking at some draft numbers. Assuming, for example, like a 2.3% inflation adjustment annually, 9 years from now it'll be $90 million. So this opens up a huge potential planning opportunity, and I think quite frankly, we'll have a lot more QSBS for many more shareholders.

Ann: One question that has been coming up a lot is "I received my shares before July 4th, 2025. Can I benefit from the new rules?" And I'd love to get your thoughts around this, Christopher, because I'm sure you're hearing it too.

Christopher: Yeah, that's been the number one question that I've gotten since July 4th. And I think the answer is generally no. For people who got their shares before July 4th, 2025, I think the appropriate approach is just to assume that you're going to be under the old rules.

Nerre: That's a pretty definitive answer, Christopher, which is nice coming from an attorney. Usually they say, "It depends."

Christopher: It always depends. It always depends.

Nerre: So what about shares acquired at different times? How does that impact eligibility?

Christopher: Let's say Ann and I started our company last year in July of 2024, and we got issued our shares, right? There's nothing that prevents us from buying more stock today, right? We could buy more common, exercise options, and then we would have to basically keep track of our shares to show which are the pre-OBBBA and which are the post-OBBBA. And that's fine. We could have certain shares get the $15 million benefit and some get the $10 million.

Nerre: With traditional business owners, we see a lot of S corporations as their entity structure. Can longtime S corporations drop down to become QSBS-eligible?

Christopher: For S corporations, the rules are slightly more complicated, but it's still certainly possible to get to QSBS. The issue is this—remember at the beginning, Ann talked about the requirements to get QSBS benefits. One of those requirements is that you have to get shares of a domestic C corporation in exchange for cash or property.

And so the solution is for S corporation shareholders to do one of two things. They can either drop down the assets out of the S corporation into a C corporation—in other words, we contribute the assets of the S into a C—and then the S corporation takes back shares, which makes it a holding company. But now we own shares of a C corporation through an S corporation. That qualifies us.

The alternative is to do a reorganization and actually convert the S corporation into a C corporation with a new S corporation holding company. It's called an F re-org. But my point is for longtime S corp owners, they can certainly get to QSBS. They just have to be really careful that they do it through the right path to ensure they satisfy that original issuance requirement.

Ann: Wow, that sounds really complicated and sounds like you need some expert advice when you go down that path. I'd like to pivot now to one of the other rules that surround QSBS, which is this idea of the Section 1045 rollover clause. And, you know, essentially, I think in the early days we talked about it a lot around in terms of, "Hey, I'm getting acquired and I haven't hit my 5-year mark. How do I extend it to get to the 5 years and, you know, get some exemption?" I am also hearing a lot out there now around the idea of utilizing it to multiply the QSBS, and I'd love to get your thoughts around that.

Christopher: Yeah, yeah. Well, I think it's a great point, Ann. Section 1045 is a deferral provision, right, and it says if you hold QSBS just for 6 months and then you sell your QSBSand within 60 days reinvest in other QSBS, your holding period keeps clicking along. So, 1045—I think people sometimes forget about it—that it's a way to defer and potentially extend your holding period. But as you say, Ann, it's also an interesting way of stacking QSBS.

Stacking is this idea that, you know, each taxpayer can exclude $10 million of each startup. Let's say I'm going to sell my company for $40 million, and let's furthermore assume it's pre-OBBBA, so I can exclude $10 million. Absent doing anything else, I am going to pay tax on $30 million. But let's say instead I take that $30 million and I invest it in three new startups, right? Ten million in startup one, $10 million in startup two and $10 million in startup three. If each of those three startups are successful and I sell there, I can exclude another $10 million of startup one, startup two and start three. So 1045 unlocks this possibility for founders to reinvest. Now, of course, there's lots of risk for me to invest in a bunch of startups—you know, they could go ahead and lose my money—but that is part of what QSBS is all about. Are you prepared to put your money back at risk?

Ann: Why don't we go ahead and just go right into that idea of stacking using trusts because it comes up a lot as well. So same kind of thing, they want to extend out that QSBS from the $10 million to get more exclusion.

Christopher: So QSBS trust stacking is a way to multiply the $10 million, right, because again—now we say it's the greater $15 million or 10 times your basis. So assume I'm a founder and I start my company on August 1st, 2025. I'm under the OBBBA rules, which is great, right? I can exclude $15 million. And let's just say I buy my shares for $300 or $1,000, typical startup funding. But let's say now we're being successful and we're growing and I raised funding rounds and we've raised a B round or a C round, and now potentially we're going to be acquired by some big strategic.

And let's furthermore assume that I'm going to sell my shares for $45 million, right? If I do nothing, I can exclude my $15 million, assume a 5-year holding period, and I have to pay tax on the $30 million delta. But 1202(h)(4) says that if I gift shares to another taxpayer, that taxpayer steps into my shoes for holding period for original issuance.

So if I'm going to sell for $45 million, one possibility is for me to set up a trust for my son and a trust for my daughter and transfer what I think will be worth $15 million into each of those trusts. Then if we sell, I exclude my $10 million and my son's trust excludes—excuse me, $15 million, we're in the $15 million world. I've got to keep remembering that, right? My son's trust excludes $15 million and my daughter's trust excludes $15 million. Now we've essentially wiped out any tax liability.

Of course, there's important considerations. Oftentimes we encounter founders who are so intent on minimizing tax that they sometimes make poor financial decisions. It's sometimes better to have post-tax cash in your pocket rather than, you know, if you give a gift to a trust for your child to maximize QSBS, that money's not yours anymore. So I think it's important to meet with advisors and think through carefully what makes the most financial sense, not just what's the best way to minimize tax.

Ann: Yeah, that's exactly what happens is they get what I call myopic on the tax world and forget all the risks that are associated with whatever you're doing—whether you're putting it into another QSBS company or stacking it and giving it away. I think they need to take a pause and really think this through because these are decisions you don't get to reverse easily.

So now I'd like to pivot into something that I come across a lot in working with tech companies and life science companies, which is this idea that one of the requirements is what we call this active business requirement.

And I thought it'd be good for you to touch a little around what does that mean. And then the second piece of this that I run into is because tech firms will go out and raise a pile of cash, and they're worried about violating the idea of the active business requirement. And so how they should think about that would be great.

Christopher: Yeah. So what we don't want is service industries. So 1202(e)(3) lists 20 different categories: health, accounting, financial services, banking. Basically every fintech company in Silicon Valley is on that list, right? And so one of the concerns that we see with QSBS is this question, are you within the ambit of those 20 listed categories, okay?

A second concern is this working capital. So 1202(e)(3) says you can't be in one of these categories. 1202(e)(6) is actually kind of a backstop to make sure that you're not in one of those categories, right? 1202(e)(6) says that for the first 2 years a business is in business, you can just have working capital. But after 2 years, no more than 50% of the value of the company can be working capital.

But if you're actually building something, you can satisfy those 1202(e)(3) requirements. In general, I think we find that most startups, they'll meet those requirements because one, they're actually building something, right, and notwithstanding being in one of these fields, they meet these requirements that they're actually creating value. And two, they'll satisfy that working capital requirement because they show that they're actually building value in the company and on their books, there's not too much cash.

Nerre: Christopher, you've done a great job of laying out the planning considerations and just really underlining that each scenario comes with nuance, especially around intent, IRS scrutiny and whether a structural change is truly beneficial. And this should also really get across the message to business owners that they should seek out professional advice when trying to navigate QSBS. Can you give us a few more rules of thumb that you've learned in this space?

Christopher: It's a great question, Nerre. I think documentation is the most important, right? We find we run into trouble with folks who haven't done a good job keeping track of these various requirements. So for example, if you're a founder and you bought your shares and you filed an 83(b), make sure you keep track of all that stuff, right? If you are an investor investing in a qualified trade or business, make sure that you ask for documentation. Oftentimes, for example, the financial statements, audit financials, all those documents will help prove out down the road what you need to show the shares of QSBS. So I think good documentation is the most important.

And then, of course, the rules are hard, right, and are getting increasingly more complex with OBBBA. And so I do think it's important to reach out to someone. Make sure that you get advice and pay for advice that's, kind of, commensurate with the stage you are at the life cycle of the company.

Nerre: So we're coming to a segment that we have that concludes all of our episodes, and I really like this segment because it helps other people learn from prior people's mistakes. So my question to you, Christopher, is what's a common thing—like an action that you've seen entrepreneurs take—that you wish had been done differently?

Christopher: Well, okay, so there's a few different mistakes we see people making. I think one of the more common is for founders to elect for their companies to be taxed as S corporations. We talked about this a little bit earlier. It's okay. If you make an S election, you can reorganize a company or do a dropdown to get to QSBS, but it's very easy once you make that S election to end up losing QSBS or never being able to qualify. One of my cautions is that if you've made an S election, just be very careful about how you unwind that if you want to get into QSBS.

Also, when we do see the IRS audit QSBS, the agents are smart, and there's a lot of great IRS agents, and they also know how to Google, right? And so every qualified small business and its founders and investors should think about telling a story. Why does the company meet these requirements? Tell that story in your documentation on the website because I think, ultimately, if you do get audited that will help tell a more coherent story.

Nerre: Those are great points, Christopher, and thank you for adding something for our listeners who are experiencing this to keep in mind. I want to thank you so much for joining us. You've been a wealth of information. This is a terrific conversation, and I think Ann will agree with me that we hope you come back again and join us soon.

Christopher: I'd be happy to. That'd be great. Thank you.

Nerre: The new QSBS rules create exciting opportunities—but only if you're proactive. Entity structure, timing and documentation all matter. The earlier you plan and seek guidance regarding the gray areas and complexity, like in the basis calculations, the better positioned you'll be.

Ann: Yeah, Nerre, these are very complex decisions, but they don't have to be made alone. Having the right team around you can make all the difference. If this episode sparked questions, we encourage you to explore our show notes for additional information and reach out to an advisor to ask how these changes might apply to you.

Nerre: Thanks for joining us for today's episode of Building More Than Business. Be sure to follow the show on Apple Podcasts, Spotify and YouTube Music. And if you liked what you heard, share it with someone who might find it valuable too. We'll see you next time.

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