How QSBS Works for Limited Partners in Venture Capital Funds
Qualified Small Business Stock (QSBS) is a powerful U.S. tax incentive that can significantly boost after-tax returns for venture capital investors. For limited partners (LPs) in a venture fund, understanding QSBS means understanding how a fund’s qualifying investments can translate into tax-free capital gains on your K-1. In this article, we explain how QSBS works in a venture fund context, the recent legislative changes to QSBS, and what it all means for LPs – including examples, federal vs. state treatment, and international considerations.
QSBS Basics: Eligibility and Tax Benefits
Under U.S. federal law (IRC §1202), non-corporate investors (individuals, trusts, partnerships, etc.) who invest in certain small businesses can exclude a large portion of their gains from tax upon exit. In a nutshell, if you buy stock in a qualified small business and hold it for the required period, you may pay zero federal capital gains tax on massive gains (up to $10 million per company under the original rules, now higher – more on recent changes below). This is a huge tax break designed to reward long-term investment in startups and small businesses.
Key QSBS Eligibility Criteria: For stock to qualify as QSBS, it must meet several requirements at issuance and during the holding period:
U.S. C-Corporation: The company must be a domestic C-corp (LLCs or S-corps don’t qualify). This means many venture-backed startups (typically C-corps) can qualify, whereas foreign or pass-through entities cannot.
Gross Assets ≤ $50 Million: At the time of the stock purchase, the company’s assets must be $50 million or less (measured by adjusted basis). This test applies up to and immediately after the issuance. (Recent update: this threshold will increase to $75 million for new QSBS issuances – discussed later.)
Active Business Requirement: The company must use at least 80% of its asset value in the active conduct of a qualified trade or business during substantially all of the investor’s holding period. Certain industries are excluded – for example, services like consulting or law, finance or investing, real estate, farming, and hospitality are not “qualified” businesses. Most technology, biotech, and product companies do qualify as active businesses.
Original Issuance of Stock: The stock must be acquired directly from the company at its original issue, in exchange for cash, property, or as compensation. In practice, this means a fund needs to purchase shares in a financing round or via exercising warrants/convertibles. Secondary market purchases do not qualify – if your fund buys shares from an existing shareholder instead of the company, those shares won’t be QSBS.
5-Year Holding Period (Legacy Rule): Historically, investors had to hold QSBS for more than five years to get the full tax exclusion. Selling earlier generally meant no QSBS benefit (though one could defer tax by rolling over into new QSBS under Section 1045, as discussed later). We will explain below how new 2025 rules introduce some flexibility with shorter holds.
Tax Benefit: If these criteria are met, an LP investor can exclude 100% of the capital gain from federal tax on the sale of QSBS held 5+ years. The excluded gain is literally tax-free on your federal return – potentially saving $2.38 million in tax for each $10 million of gain (given the 20% capital gains rate). Even if your gain exceeds $10 million, Section 1202 provides a second limit: you can exclude up to 10× your cost basis in the stock if that yields a larger exclusion. For most early-stage investments, however, the flat $10 million per-company exclusion is the primary cap.
Important: The generous QSBS exclusion is available only to non-corporate taxpayers. If a corporate entity (C-corp) is an LP in the fund, it cannot claim the Section 1202 exclusion. QSBS is intended for individuals, partnerships, LLCs, trusts, etc., while corporations pay their normal tax on any gains.
QSBS in a Venture Fund: Pass-Through Benefits to Limited Partners
Most venture capital funds are structured as pass-through entities (limited partnerships or LLCs) for tax purposes. The good news is that QSBS benefits flow through such entities to the ultimate investors. In other words, if a VC fund realizes a gain on the sale of QSBS, each limited partner can claim the QSBS exclusion on their pro-rata share of that gain on their own tax return.
Each partner is treated as if they themselves had sold the QSBS, so they get their own $10 million (or 10× basis) exclusion limit per qualified company. This is incredibly powerful: a big QSBS win in the fund can potentially be tax-free for every LP up to their $10M cap each. For example, if a fund with 10 equal LPs sells QSBS stock for a $100 million gain, in principle each LP could exclude $10 million of gain on that single investment (totaling $100M collectively). The QSBS benefit essentially “stacks” across multiple investors, making it highly attractive in a fund setting.
Mechanics of Pass-Through: The fund itself doesn’t pay tax on the gain; instead, it issues K-1s allocating the gain to the partners. If the stock was QSBS and held the required period, the K-1 will typically report the gain as Section 1202 eligible. Each LP then applies the exclusion on their own tax filing. This pro-rata pass-through preserves the character of the gain as QSBS for the partners. You don’t need to personally hold the stock certificate; your beneficial share through the fund counts.
However, there are a few nuances for LPs to note:
Timing Matters: QSBS eligibility (like the 5-year clock) is determined at the fund level – the partnership must have held the stock for the full holding period. So if your fund sells a company too early (e.g. after 4 years under old rules), the gain wouldn’t qualify for the 100% exclusion. Limited partners cannot start their own holding period; it’s based on the fund’s holding of that investment.
LP at Time of Investment: You only benefit from QSBS on deals that were made while you were a partner in the fund. Under IRS rules, the exclusion is only available to those who were partners when the QSBS was acquired (and only to the extent of your partnership percentage at that time). This means if you joined the fund in a later closing or increased your commitment after an investment was made, your QSBS exclusion for that particular deal may be limited. For example, if you held a 10% interest when the fund bought the stock, but later increased to 20%, you cannot exclude gain attributable to that extra 10% – your exclusion is essentially capped at your original share.
Per-Issuer Limit Applies Per LP: The $10 million exclusion cap (now $15M under new law) is per investor, per company. Each LP calculates their own gain against their personal cap for that company. If your share of the fund’s gain from a single startup is, say, $2 million, it’s fully excludable (well under $10M). If your share is $12 million, you could exclude up to $10M and would owe tax on the remaining $2M (unless the 10× basis rule gives a higher limit). This cap resets for each different qualified company the fund exits. In practice, very few LPs will exceed their $10M per-company cap unless they hold a large percentage of the fund or the fund’s gain on one investment is extremely high.
Example: Tax-Free Gain for an LP from a QSBS Exit
To illustrate, let’s consider a simplified example of how QSBS can benefit a limited partner:
Fund Investment: Your venture fund invests $5 million in Startup ABC, a U.S. C-corp tech startup that meets all QSBS criteria (gross assets under $50M, active business, etc.). The investment is in Series A preferred shares purchased directly from the company, so it qualifies as QSBS from the start.
Holding Period: The fund holds the stock for just over 5 years. During that time, Startup ABC grows rapidly.
Exit Event: After 5+ years, a public company acquires Startup ABC. The fund sells its shares for $50 million, realizing a $45 million gain. As an LP, assume you have a 10% interest in the fund’s ABC investment. Your allocated gain from this exit is $4.5 million.
QSBS Exclusion: Because the stock was held >5 years and met all requirements, the entire $4.5 million gain allocated to you can be excluded from your federal taxable income under Section 1202. You pay zero federal capital gains tax on this profit. If you’re in the top tax bracket, this saves you roughly $1 million in federal tax (since ordinarily $4.5M × 20% = $900k, plus 3.8% NIIT - Net Investment Income Tax).
Cap Check: The $4.5M is below your personal $10M per-issuer limit, so no issue there. If the gain had been larger (say $12M to you), you could still exclude $10M and only $2M would be taxable (unless your basis share enabled a higher 10× exclusion).
State Tax: If you reside in a state that conforms to QSBS (or has no income tax), you would also pay no state tax on this gain. If you’re in California (which taxes QSBS gains fully), you’d still owe California tax on the $4.5M even though it’s federally exempt (roughly $600k at CA’s 13.3% top rate).
This example shows how a successful QSBS-qualified investment can significantly enhance your net returns. Essentially, the IRS gives you an equity kicker – you keep all of the gain instead of sharing ~23.8% of it with the government. For LPs, QSBS can make the difference in achieving higher effective IRRs after taxes.
State and International Tax Considerations
While QSBS is a federal tax boon, LPs should be aware of state and international nuances that can affect the ultimate tax outcome:
State Tax Treatment: U.S. states handle QSBS gains in different ways. Some states fully conform to the federal QSBS rules, meaning if a gain is tax-free federally, it’s also tax-free in that state. (States with no income tax, like Florida or Texas, naturally impose no tax on capital gains at all.) Other states partially conform, offering their own QSBS exclusions only if certain extra criteria are met (for example, a state might require the company to have substantial operations in that state). Importantly, a few states do not conform at all – they tax all capital gains, QSBS or not. California is the prime example: since 2013, California has denied any QSBS exclusion, so all QSBS gains are taxable under California law. In our example above, an LP who is a California resident would owe full California tax on that $4.5M gain, despite owing nothing federally. Always check your state’s treatment; it can significantly impact your after-tax result. If you’re investing from a high-tax, non-conforming state, you may consider strategies like trust structures or relocating before a liquidity event – but those go beyond the scope of this article.
Foreign (Non-U.S.) Investors: QSBS is a U.S. federal tax concept. If you are a non-U.S. LP investing in a venture fund, the U.S. QSBS exclusion generally won’t benefit you unless you are subject to U.S. capital gains tax. In many cases, foreign investors in U.S. funds are not taxed by the U.S. on capital gains from stock sales (the U.S. doesn’t typically tax foreign persons on securities gains, except in special cases like real estate or if effectively connected to a U.S. trade/business). Thus, a foreign LP often would not owe U.S. tax on the gain regardless of QSBS, and would pay tax in their home country according to local law. Most other countries do not offer a QSBS-equivalent exclusion for investing in U.S. companies, so the gain likely remains taxable back home. The bottom line: QSBS mainly matters for U.S. taxpayers. Non-U.S. investors should consult cross-border tax advisors to understand their situation – in some cases, structuring the investment through an entity that is taxable in the U.S. (like a blocker corporation) could inadvertently forfeit QSBS benefits or create taxable gains where an individual might have had none. International considerations can be complex, so it’s crucial to plan accordingly if you are a non-U.S. LP or a fund manager with foreign LPs.
Recent Changes (2025): Shorter Holding Periods & Enhanced QSBS Benefits
Significant enhancements to QSBS have arrived in 2025 via new federal legislation. Previously, the QSBS rules were “all or nothing” – you only got the exclusion if you held the stock at least 5 years (with 50%, 75%, or 100% exclusion depending on when the stock was acquired under legacy rules). If a company exited in, say, 4 years, you’d get no QSBS relief at all (unless you executed a special 1045 rollover into new QSBS to pause the gain). Now, as of mid-2025, Congress has introduced a tiered exclusion system to reward slightly shorter holds, along with other investor-friendly tweaks. Here are the key changes impacting LPs:
Tiered Exclusion by Holding Period: You no longer necessarily need a full five-year hold to get some tax benefit. For QSBS acquired after the new law’s effective date, the exclusion works on a graduated schedule:
Held 3+ years: Exclude 50% of the gain (50% tax-free).
Held 4+ years: Exclude 75% of the gain.
Held 5+ years: Exclude 100% of the gain (full tax-free, as before).
In other words, a sale after 3 or 4 years can now qualify for a partial exclusion, whereas before it would yield no exclusion. The portion of gain that is not excluded is still taxed at a special 28% capital gains rate under Section 1202 (instead of the normal 20%). So a 50%-excluded gain ends up taxed effectively at 14% federal, and a 75%-excluded gain at 7% federal (not counting the 3.8% net investment tax). This sliding scale encourages investment liquidity before five years in some cases, though the full 100% exclusion at 5 years remains the ultimate prize.
Higher Gain Cap per Investor: The law increased the per-investor cap from the long-standing $10 million to a new $15 million (for single filers; $7.5M for married filing separately) of eligible gain per company. This $15M cap will also be indexed to inflation starting in 2027. Practically, this means LPs can shield even more upside on a big win. For example, if your share of a huge exit is $12 million in gain, under prior law you’d pay tax on $2M (above the $10M cap); now you could potentially exclude the entire $12M (since it’s under the new $15M limit). The 10× basis alternative cap still remains in place as well – you get to use the higher of the two caps.
Larger Company Eligibility: The definition of a “qualified small business” has been modernized. A qualifying company can now have up to $75 million in gross assets at issuance (up from the old $50M threshold). This change, which will adjust with inflation, broadens the universe of companies that the fund can invest in while preserving QSBS status. It reflects the reality that startups often raise more capital today than in the 1990s when the $50M limit was set. Now, a later-stage company raising a big round might still qualify for QSBS, whereas before a post-money valuation pushing assets over $50M could disqualify it. For LPs, this means your fund could pursue some larger deals and still deliver QSBS tax benefits on exit – potentially giving you QSBS treatment on a growth-stage investment that previously would have been too large to qualify.
Minor Technical Tweaks: Other provisions and anti-abuse rules were adjusted, though they are less directly relevant to LPs. Notably, earlier proposals to extend QSBS to S-corporations or to allow “tacking” of holding periods for convertible debt did not make it into the final law. The new law explicitly prevents any games with exchanging old QSBS stock for new stock just to take advantage of the shorter holding periods or higher caps. Essentially, only newly issued stock after the effective date gets these benefits. Also, stock-for-stock acquisitions and rollovers under Section 1045 remain available strategies to defer or preserve QSBS status, but the law clarifies you can’t, for example, swap a pre-2025 QSBS into a post-2025 QSBS to suddenly get the 3-year/75% benefit.
Effective Date: These changes are not retroactive. They apply to QSBS issued after the law’s enactment date (the specific date will be when the new 2025 bill is signed into law). Any stock your fund already holds (acquired under the old rules) remains subject to the prior regime – generally requiring a full 5-year hold to get the 100% exclusion. So, if your fund has existing investments made in 2023 or 2024, you’ll still need to hit the five-year mark on those to enjoy QSBS benefits (the 3- and 4-year partial relief won’t apply retroactively). Going forward, however, new investments the fund makes can leverage the more flexible timeline. Fund managers may even strategize differently: for instance, a strong exit opportunity at 4 years used to pose a tough choice (sell and lose QSBS, or hold longer). Now, selling at 4 years would still grant a 75% exclusion – a valuable outcome – which could tilt decisions on exit timing.
Planning Note: Even with the new shorter hold options, the 5-year mark remains crucial for maximizing tax-free gains. Funds and LPs should aim, when feasible, to reach the full 5-year holding period on big winners for 100% exclusion, given the substantial additional tax savings. For exits that do happen earlier, there are still planning tools available. One is Section 1045 rollovers, which let the fund (or distribute to the LPs to) reinvest proceeds from a QSBS sale into a new QSBS within 60 days, deferring the gain. This effectively “tacks” the holding period onto the new investment. So an exit at 2 years could be rolled into another startup’s stock, continuing the clock toward 5 years. Another tool is structuring exits as stock-for-stock transactions (if a portfolio company is acquired in a merger where your fund receives stock of the acquirer rather than cash). Such a reorganization can allow QSBS status to carry over into the new shares, preserving the potential exclusion when those are eventually sold. LPs don’t need to manage these maneuvers themselves, but it’s useful to know that your fund manager and tax advisors have ways to optimize outcomes if an exit comes too soon. The recent law changes simply add another favorable option to the toolkit – permitting a sizable chunk of the gain to be tax-free even if the ideal 5-year window isn’t met.
Conclusion
For limited partners in venture capital funds, QSBS is a game-changing tax benefit that can dramatically improve after-tax returns. By investing through a fund that identifies and nurtures QSBS-eligible startups, an LP stands to potentially pay zero federal tax on millions of dollars of gains – a reward for patience and supporting small businesses. The structure of a VC fund as a pass-through means QSBS treatment passes along to you as an investor, essentially on a pro-rata basis, with each LP enjoying their own generous exclusion limits like in our YC Fund II (that we're raising now, check out a deck here).
That said, maximizing QSBS benefits requires careful planning and awareness. LPs should ensure their fund managers are attuned to QSBS qualification (e.g. purchasing original issue shares, tracking asset thresholds, and mindful of the 5-year clock). Knowing your state’s stance on QSBS is also critical – a tax-free deal federally might still carry a state tax bill, so plan for that if you live in a non-conforming state like California. International LPs should similarly be cognizant that U.S. QSBS benefits might not translate to tax savings in their home country.
The recent 2025 enhancements to Section 1202 further sweeten the deal for investors: even faster exits can yield major tax breaks, and the per-company gain cap and eligible company size have increased. These changes underscore the government’s continued support for venture investment in small businesses. For LPs, it means more flexibility and potentially more tax-free dollars in your pocket.
In summary, QSBS is a valuable advantage for venture fund investors – one that can turn a great investment into an outstanding one after taxes. LPs should discuss with their fund and tax advisors how QSBS applies to their portfolios, ensure proper documentation of QSBS stock, and remain abreast of any further legislative tweaks. By understanding the mechanics described above, limited partners can fully leverage QSBS to maximize their returns while fueling the growth of innovative companies – a true win-win made even better by recent tax law changes.
Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or investment advice. Readers should consult with their own tax advisors or legal counsel regarding their individual circumstances and how any current laws may apply to them.