QSBS After the 2025 Tax Law: What LA Founders Need to Know

For many startup founders, the biggest tax break they will ever use is one they set up on day one and then forget about for years. It is called qualified small business stock, or QSBS, under Section 1202 of the federal tax code. The rules changed meaningfully in the July 2025 federal tax law, and the new version is now well into its second year. If you are forming a company, raising a round or issuing stock to early employees in Los Angeles, here is what changed, what did not, and one California wrinkle that catches local founders off guard.

What QSBS does

In plain terms, QSBS lets eligible shareholders exclude some or all of their capital gain from federal income tax when they sell stock in a qualifying small company. Before the 2025 law, the deal was all-or-nothing: hold the stock for five years and you could exclude up to $10 million of gain per company, or ten times your basis if that was larger. Sell earlier and you got nothing.

The three big changes

The law signed July 4, 2025, often called the One Big Beautiful Bill Act, made three changes for stock issued after that date. Law firms including Foley & Lardner and Holland & Knight have laid them out:

• A shorter path to partial benefits. Stock held at least three years now qualifies for a 50% exclusion. At four years it rises to 75%, and at five years it reaches 100%.
• A bigger cap. The per-company limit on excluded gain rose from $10 million to $15 million, and it will be indexed to inflation after 2026. The alternative cap of ten times your basis is still available.
• Bigger companies can qualify. A corporation can now have up to $75 million in aggregate gross assets, up from $50 million, when it issues stock and still have that stock count as QSBS. That threshold is also indexed for inflation after 2026.

The three-year tier matters in a market where acquisitions often happen before year five. A founder whose company sells in year three or four now gets a partial federal benefit instead of none.

What did not change

The basic qualification rules are the same, and they are where most founders slip up. As the Foley summary notes, the company must be a C corporation; the stock generally must be acquired directly from the company at original issuance, not bought from another shareholder; and the business must actively run a qualified trade or business during the holding period. Chase's QSBS overview also points to the requirement that at least 80% of the company's assets be used in that active business.

The "qualified trade or business" test is especially important in Los Angeles. Section 1202 excludes many service fields, including health, law, consulting, performing arts and other businesses whose main asset is the reputation or skill of their people. A software company, consumer product brand or hardware startup is more likely to fit. A creative agency, production services shop or professional practice often is not. If your company sits between those categories, get an opinion before you rely on the exclusion.

Also note that stock issued on or before July 4, 2025 stays under the old rules, including the five-year holding period and the $10 million cap.

California does not follow it

Here is the local catch. California does not conform to Section 1202. The state's Revenue and Taxation Code section 18152 says plainly that the federal QSBS exclusion does not apply. The state's broader 2025 conformity update, described by the Franchise Tax Board, moved California's general conformity date forward but did not change that carve-out.

So a California resident who sells qualifying stock may owe no federal capital gains tax on the excluded portion but still owe California income tax on the full gain. California taxes capital gains at ordinary income rates, so that bill can be large. Founders who plan to stay in LA should model a state tax bill into any exit scenario, rather than assuming QSBS makes a sale tax-free.

What to do now

• Form as, or convert to, a C corporation early if QSBS is part of your plan. The holding clock generally starts when stock is issued, so delaying the conversion delays the benefit.
• Track your gross assets around each financing. Raising a large round can push a company past the $75 million line for later issuances.
• Keep records of when and how each grant was issued, including any 83(b) elections for restricted stock, so a future buyer's diligence team can confirm eligibility.
• Watch redemptions. Buying back stock around an issuance can disqualify shares under Section 1202's anti-abuse rules.
• Talk to a tax advisor about the California gap, especially if you are considering where you will live when a sale might happen.

QSBS rewards founders who plan from the beginning. The 2025 changes made it more generous, but only for companies that meet every requirement and keep the paperwork to prove it.

This article is general information, not tax advice. Consult a qualified tax professional about your situation.