The Business Decision That Could Give You a Tax-Free Exit

The first thing I’m often asked by many new founders isn’t a tax return question; it’s a business entity question. Should the company be an LLC taxed as partnership, LLC taxed as S-corporation or C-corporation?

Many founders see the business entity question as simply a matter of checking a box. Depending on what entity you selected, it will impact future growth and profitability because one type of entity has one of the most powerful tax incentives for business owners: Qualified Small Business Stock (QSBS).

When I talk about QSBS with new business owners, they get excited. Who wouldn’t get excited about potentially being able to pay zero federal income tax on millions of dollars of gain from selling a company?

Here comes the part that is important: Qualified Small Business Stock is specifically crafted to be difficult to achieve, and picking the wrong entity from the very beginning could prevent you from ever benefiting from QSBS. This is why I tell every founder to think about where the business is going to be in the next two, five and ten years before making any decisions. 

Here are the top five things that every founder needs to know about QSBS before forming a company.

1. Qualified small business stock exists inside a C-corporation

The first thing about QSBS is that it is stock of a domestic C-corporation, issued to you in exchange for money, property or services. LLCs and S-corporations are not eligible entities.

Therefore, if you form a company as an LLC or S-corporation, the clock on QSBS has not started yet, and it won’t start until you issue some C-corporation stock.

2. The clock changed recently, and now there are options for shorter holding periods

For many years, QSBS required holding stock for more than five years to get any benefit from it. Starting July 4, 2025, the rules changed to tiered benefits based on a holding period. If you own stock acquired on or after July 4, 2025, and you hold it for three years, you’ll be able to exclude 50% of gain from federal tax.

Four years of holding will allow you to exclude 75%, and five years of holding will qualify you for a full 100% exclusion of gain. Stock issued on or before that date is still subject to the old rule: either five years or no benefit at all.

3. The company needs to be small enough at the time the stock is issued

There is a certain size test that is measured on the date when the stock is issued. As of July 4, 2025, the gross aggregate assets of the corporation generally should not exceed $75 million (up from $50 million under the old rule).

Gross assets of the corporation include all the contributed property measured at fair market value, not your cost basis. Most founders focus on the size of the business in terms of revenues or market valuation; however, the statute focuses on the gross assets at issuance, which is a completely different number.

4. Not every kind of business qualifies for QSBS

Being a C-corporation is only one requirement. Law specifically excludes from QSBS the following industries: health care, law, accounting, consulting, financial services, brokerage, farming and hospitality and any business in which the principal asset is the skill or reputation of its employees. Being in an excluded business means that you don’t qualify for QSBS, no matter what you say about yourself.

5. Savings from QSBS are large but capped

Qualified small business stock provides substantial tax exemption from the gain from selling the stock, but it’s not unlimited. There is a cap on the exemption on a per-taxpayer and per-company basis. As of July 4, 2025, the cap is the greater of $15 million (up from $10 million for older stock) or ten times your basis in the stock.

In other words, if founders bought the stock in the business for almost nothing and then sold it for $10 million, assuming that all requirements are met, they would be able to exclude the entire gain from their federal income tax. For most startup founders, the cap on the dollar amount will be the one to hit you.

If you start the business as an LLC or S-corporation, it doesn’t automatically mean that you can never benefit from QSBS, but it changes the situation greatly. First, the clock on QSBS cannot start until actual C-corporation stock is issued. Second, starting as an LLC and waiting to convert to C-corporation until you meet all the requirements takes some time off the clock.

Waiting too long to incorporate will reduce the amount of time that you are able to hold your stock for QSBS purposes. Finally, waiting until your business has grown substantially and then converting to C-corporation means that your company may become too large to pass the gross assets test at the moment the stock will be issued, in which case none of it will qualify for QSBS.

We had a new client come to us about six years ago. Their prior CPA advised them to be set up as an S-corporation because they were a small business. Three years later, they raised capital, and unfortunately, the founders were not able to get QSBS stock.

This is why I tell founders, the business entity question is not about saving on taxes in the current year. It’s all about where the business is going to be in the next two, five and ten years. If you plan to raise venture capital, build a business that will be eventually sold, and your business is not excluded from QSBS eligibility, the C-corporation entity choice that you make at the formation of the business may turn out to be worth millions of dollars at the time of selling the business.

The mistake is not choosing this or that entity; the mistake is treating the decision that has a five- or ten-year payoff like just another check-box.

The first thing I’m often asked by many new founders isn’t a tax return question; it’s a business entity question. Should the company be an LLC taxed as partnership, LLC taxed as S-corporation or C-corporation?

Many founders see the business entity question as simply a matter of checking a box. Depending on what entity you selected, it will impact future growth and profitability because one type of entity has one of the most powerful tax incentives for business owners: Qualified Small Business Stock (QSBS).

When I talk about QSBS with new business owners, they get excited. Who wouldn’t get excited about potentially being able to pay zero federal income tax on millions of dollars of gain from selling a company?