Should QSBS Exist?: Qualified Small Business Stock as a Policy Choice

The Qualified Small Business Stock (QSBS) exclusion, governed by Section 1202 of the Internal Revenue Code, was intended to promote investment in small and growing businesses. By allowing investors to exclude up to $10 million (or more) in capital gains from federal taxation, the provision was meant to stimulate entrepreneurship and capital formation. However, some academics and tax professionals argue that in practice, Section 1202 has disproportionately benefited wealthy investors, particularly in the technology sector, while imposing a significant and largely underestimated cost on US taxpayers. This article briefly summarizes how the QSBS exclusion has been thought of as an inefficient and regressive tax policy, benefiting the “already-wealthy” at the expense of the general tax-paying public.

Beneath each section, however, we also provide our team’s perspective on the policy implications of QSBS and the assertions made by these common arguments.

Argument 1: The Tech Startup Advantage

Although Section 1202 was designed to encourage investment in small businesses, its structure heavily favors high-growth venture-backed startups rather than the broader small business ecosystem. To qualify for QSBS treatment, stock must be issued by a C-corporation with less than $50 million in gross assets and held for at least five years. This requirement effectively excludes the vast majority of small businesses, which typically operate as pass-through entities such as LLCs or S-corporations. Instead, the primary beneficiaries of QSBS have been early investors and employees of tech startups that rapidly increase in value while remaining under the gross-assets threshold.

Many venture-backed startups that are now household names have leveraged QSBS to create massive tax-free windfalls for early shareholders. For example, a venture capital investor who purchased $5 million in QSBS from one of these companies and later sold it for $70 million could exclude up to $50 million of that gain from taxation. Venture capital firms, angel investors, and startup employees who receive stock-based compensation are uniquely positioned to exploit this tax break, while traditional small businesses—such as local retailers, manufacturers, and service providers—gain no comparable advantage.

(While it is true that many of America’s traditional "Main Street" businesses, such as small retailers and service providers, are less likely to benefit from QSBS, the provision serves a critical role in fueling high-growth sectors that drive substantial economic expansion. The incentive structure of QSBS is designed to encourage investment in scalable, high-impact businesses, particularly in technology and advanced manufacturing, which are among the most powerful engines of job creation and innovation in the modern economy.

Though the term Qualified Small Business Stock may be somewhat misleading, the core principle behind the tax incentive remains strategic and forward-looking—it rewards entrepreneurs, early employees, and investors who take significant financial risks, often foregoing stable income and career security, to develop groundbreaking businesses. Many of today’s most transformative companies—those that have revolutionized transportation, communication, healthcare, and energy—began as small startups that met the QSBS criteria. By enabling early-stage capital formation, Section 1202 helps these businesses scale and generate thousands of high-paying jobs, contribute to technological advancement, and ultimately expand the nation’s economic competitiveness on a global level. )

Argument 2: Underestimated Burden on Taxpayers

The true cost of the QSBS exclusion has been grossly underestimated. The Joint Committee on Taxation (JCT) initially projected that Section 1202 would result in a revenue loss of $1.1 billion to $1.3 billion in 2019. However, analysis of IPO data and private acquisitions suggested that the real cost is far higher—potentially exceeding $4.5 billion annually. This discrepancy arises from several factors:

Exclusion Multiplication: The exclusion applies per company, allowing investors with stakes in multiple startups to repeatedly claim the $10 million tax-free benefit.

Private Acquisitions: Many QSBS shareholders exit their investments through private acquisitions rather than IPOs, further amplifying the tax revenue lost long term.

Loopholes in Gross-Asset Calculations: Startups can remain under the $50 million gross-assets threshold despite being valued at hundreds of millions or even billions of dollars, ensuring continued eligibility for QSBS benefits even at massive scale.

The cumulative effect is a substantial erosion of federal tax revenue, which ultimately shifts the tax burden onto the broader population. While intended to encourage small business investment, Section 1202 primarily functions as a massive tax subsidy for the wealthy.

(While critics highlight the estimated $4.5–$5 billion annual cost of the QSBS exclusion, this figure should be weighed against the billions in GDP growth driven by the very industries QSBS helps fuel. The tech and advanced manufacturing sectors alone contribute trillions to the U.S. economy each year, with high-growth startups playing a disproportionate role in driving productivity, job creation, and global competitiveness.

For context, the U.S. technology sector contributes over $2 trillion to GDP annually, and the advanced manufacturing sector adds another $2.3 trillion. Many of the companies at the forefront of these industries—whether in AI, biotech, semiconductors, or clean energy—began as QSBS-eligible startups, relying on early capital investment to fund their breakthroughs. The relatively modest tax incentive of $5 billion per year is a small price to pay for the immense economic value these sectors generate.

Additionally, the economic ripple effects of QSBS-driven businesses extend well beyond direct GDP contributions. These companies create high-paying jobs, increase tax revenue from payroll and corporate taxes, and sustain entire ecosystems of suppliers, service providers, and adjacent industries. By fostering innovation at its most critical early stages, QSBS ensures that capital continues flowing into the startups that will define the next generation of American economic leadership.

While critics focus on the revenue "lost" from tax exclusions, the reality is that these dollars are reinvested into fueling industries that generate exponentially greater returns for the U.S. economy. Instead of framing QSBS as a cost, it should be recognized as an economic catalyst that more than pays for itself over time and keeps the US ahead in key sectors.)

Argument 3: QSBS Fails as Good Policy

Beyond its regressive nature, the QSBS exclusion is ineffective in achieving its stated goal of stimulating investment in small businesses. Several critical flaws undermine its legitimacy as a tax incentive:

It Does Not Encourage Additional Investment: There is little evidence that QSBS incentivizes investments that would not have occurred otherwise. Startups, particularly in Silicon Valley, have been flush with venture capital for years. Investors are drawn to high-growth opportunities for their intrinsic potential returns, not because of a tax break that materializes only after five years.

It Creates Unnecessary Windfalls: Early employees and venture capitalists—who are already well-compensated—receive disproportionate benefits from QSBS. Software engineers at top startups, for instance, often earn six-figure salaries before factoring in stock-based compensation, which is further enriched by Section 1202’s tax exclusions.

It Excludes the Majority of Small Businesses: Over 90% of small businesses operate as pass-through entities, meaning their investors and owners receive no benefit from QSBS. If the goal is to encourage small business investment, a more effective policy would provide incentives to businesses regardless of their corporate structure.

The 2017 Tax Cuts and Jobs Act (TCJA) Worsened the Problem: The TCJA reduced corporate tax rates to 21%, making C-corporations even more attractive and further solidifying the benefits of QSBS. At the same time, the TCJA limited the Alternative Minimum Tax (AMT), which previously constrained some of the excessive benefits of the QSBS exclusion.

(Again, while some argue that QSBS does not stimulate additional investment, this overlooks its role in encouraging risk-taking in early-stage businesses, particularly in capital-intensive industries where traditional financing is scarce. Angel investors and emerging fund managers rely on tax-efficient structuring to balance risk and maximize after-tax returns, making QSBS a key factor in funding decisions. While Silicon Valley may have ample capital, QSBS has helped fuel investment in emerging innovation hubs across the U.S., supporting growth beyond the coastal venture capital strongholds (think Texas, Florida, Illinois, Virginia, Massachusetts, and beyond).

While QSBS applies only to C-corporations, it supports the scalable, high-growth businesses that drive job creation and economic expansion. The lower corporate tax rates under the TCJA have only strengthened this impact, making the U.S. more competitive for entrepreneurship. This is an exchange relationship: the US government says, “we’ll take a portion of profits now, and you get a benefit if you’re successful at scale.” Rather than eliminating QSBS, policymakers should focus on refining it - perhaps expanding access to more small businesses, implementing annual deferral limits, or a staggered credit system to spread out the yearly net tax revenue loss.)

Notes:

The true measure of QSBS’s effectiveness is not just in its immediate tax cost but in its long-term economic impact. By fueling the creation of companies that redefine industries, expand markets, and generate lasting economic value, QSBS has proven to be a highly effective catalyst for growth. The capital that flows into startups today will shape the industries of tomorrow—advancing AI, clean energy, biotech, and critical infrastructure—sectors where American leadership is essential for global competitiveness.

Rather than eliminating QSBS based on short-term tax revenue concerns, policymakers should take a forward-thinking approach by exploring refinements that enhance access while preserving its core incentives. Expanding eligibility to more business structures, setting reasonable guardrails, or increasing regional investment incentives could further broaden its impact. However, dismantling a tool that has successfully fueled America’s most dynamic industries would be a costly mistake. If the goal is to sustain economic leadership, job creation, and breakthrough innovation, QSBS is not just justified— from our perspective it is essential.